Operations

Alternate Title: An Exhaustive Introductory Guide To Demand, Supply, and Price Theory; For First-Time Tech Startup Founders.

To know that we know what we know, and that we do not know what we do not know, that is true knowledge.

– Henry David Thoreau

Introduction

I am always surprised when I am speaking with founders and come to the realization that they lack any understanding of the fundamentals of demand and supply. I do not think everyone should study economics – I avoided economics in college because I felt I could teach myself the basics outside school if I needed to. However, success as an entrepreneur is so dependent on those concepts that I expect founders to have made some effort to grasp the basics. This post is the outcome of what I have learned about economics since college, and how I apply that knowledge daily as I assess early stage startups.

Why do entrepreneurs need to understand the fundamentals of demand and supply?

How a startup’s customers/users think about a product affects how demand for that product might develop. Not understanding the fundamentals of demand puts founders at a disadvantage because it means that the way they talk about what they are doing to potential investors, potential customers/users, and the market, could be incongruent with the reality that is unfolding in front of them.

The target audience for this post is first time founders who have no prior exposure to introductory micro or macro economics. Ideally, they would be building a software-focused technology startup. Also, they should feel that a brief survey of some of the fundamental concepts of microeconomics will help them get a better grasp of the reality they are confronting as they try to raise capital or as they go about generating traction for their product/service. For these founders, this should serve as a comprehensive, but introductory survey of the relevant topics, and enkindle the desire to learn more about the topic.

Before I delve further into the discussion, an important caveat; I am not an economist. The majority of what I know about economics has been acquired through teaching myself. I am less focused on theory, and more focused on applications in the real world. Having said that I believe that practice without theory is the precise definition of bullshit. Also, this post will focus more on the qualitative aspects of the discussion . . . I think the quantitative aspects of these topics will be several levels of granularity too deep for this purpose.

I hope to raise more questions than I answer.

Motivation

Although I have been thinking about this topic for a while, the motivation to write this post did not crystallize until I read the July 14, 2016 issue of Dan Primack’s Term Sheet, a newsletter published by Fortune.

Instead of trying to paraphrase his words, I’ll let Dan speak for himself:

So far this year in the U.S. there have been over 500 children unintentionally injured or killed by a firearm. Last year, over 200 American adults were unintentionally shot by a child using a gun, with more than 80 fatalities. There also will be more than 10,000 suicides by firearm, often by teens or young adults who use a gun owned by their parents. These are the sorts of tragedies that I know upset a lot of venture capitalists. Not only because VCs are human, but also because I see many of the social media posts whenever one of these horrors gets widespread public attention. Very often those posts include some sort of plea for gun control ― sometimes mild reform, sometimes outright repeal of the 2nd Amendment. But here’s what I concluded yesterday, after our session on smart-gun technology during Fortune Brainstorm Tech: VCs are unintentionally complicit in this epidemic. There currently are many entrepreneurs working on smart-gun technologies that could take a giant chunk out of teen suicide and unintentional firearm deaths. Some are working in fingerprint technologies, which would primarily be used by target shooters and the like. Some are working on RFID technologies, which would prevent a gun from being fired by anyone not carrying the proper token (such as in a watch or a bracelet or even inserted surgically just under the skin). Some are working on smart-grip technology, which can recognize the “proper” user. The trouble, however, is that almost no venture capitalists have interest in funding these entrepreneurs. “It’s about investment,” said Margot Hirsch, president of The Smart Tech Challenges Foundation. “It’s very hard to create a real technology company on just grant funding.” To be sure, the preferred VC metric of TAM (total available market) is not an issue here. There are going to be around 15 million firearms sold in the U.S. this year, and surveys have shown that many buyers would purchase a smart-gun, were it to be both available and reliable (to date, no smart gun has ever been commercially available in the U.S.). But smart gun entrepreneurs get a nearly-universal cold shoulder from VCs, some of whom cite regulatory risks that don’t seem to bother them when investing in Uber or Airbnb or a pharmaceutical company. Legacy firearm manufacturers are not going to do the R&D here. Namely because they view the politics as too tricky, with many of their most loyal customers viewing smart guns as backdoor gun control (which it needn’t be). As always, real technological disruption will come from somewhere else, financed largely by venture capitalists. Or it won’t. And more kids will die.

Before I explain why I think Dan and the founders he’s speaking about are mistaken in the way they have chosen to think about this specific issue, let’s dive headlong into Economics 101. We’ll come back to this at the end. However, Dan’s comments echo comments I have heard from numerous other founders who are struggling to understand why investors do not see “the opportunity” in the same way that the founders see it.

Economic Goods, Demand, Supply, Types of Economic Goods

What is an Economic Good? An economic good is any good or service that is scarce in supply and commands a price on the open market, satisfies a need or a desire, and provides utility to its purchaser. In the remainder of this discussion I am thinking of a specific good/service . . . not all goods/services in an economy or market. I will also typically speak in terms of an individual consumer, but the reader should interpret that as synonymous with any entity, individual person or business, which pays for a good or service.

What is Demand? Demand is the term economists use for the amount of a good that a market of buyers wishes to consume. When demand at a specific price is discussed, the term Quantity Demanded is used instead. Aggregate demand refers to the sum of demand for the good at every available price. Demand is often analyzed using a demand curve. The demand curve is usually depicted as a downward sloping line, which conforms to the law of demand; the quantity demanded of a good varies inversely as the price of the good. In other words, the quantity demanded decreases as the price of the good increases.

What is Supply? Supply is the term economists use for the amount of a good that a market of suppliers are willing to produce in order to satisfy demand for the product. At a specific price, the quantity supplied refers to the amount of the good that suppliers are willing to produce. Aggregate supply refers to the sum of supply for the good at every available price. Supply is often analyzed using a supply curve. The supply curve is usually depicted as an upward sloping line, which conforms to the law of supply; the quantity supplied of a good varies directly as the price of the good. In other words, the quantity supplied increases as the price of the good increases.

How is Price Determined? The price that the average consumer pays for a good is determined by the interaction of supply with demand. Analytically, we look for the point at which the demand curve and the supply curve intersect. That combination of price – plotted on the vertical axis, and quantity demanded – plotted on the horizontal axis, is the price at which every unit of demand is satisfied by a unit of supply.

What is Opportunity Cost? An opportunity cost is the potential loss in utility from an alternative action that a consumer might have derived, because of a decision to consume a specific good or service. Put another way, it is the potential benefit that a consumer forgoes because of an actual choice to consume one good good/service instead of another. We care about the opportunity cost of the best alternative that is available to the individual consumer because we assume that is the choice they would have made in the absence of the one they have actually settled on.

What is utility? Utility is a measure of the satisfaction or benefit that a consumer derives from consuming a good/service.

So far, so good. There’s nothing to this. Right? It all seems really straightforward.

Things get a little less straightforward when we start to categorize goods by their types. What does that mean? I will explain.

Remember my use of “. . . satisfies a need or a desire . . . ” when I was defining a good. Well that turns out to be quite important. Why that is the case will become clearer as we continue our exploration below . . .

Types of Economic Goods

• Inferior Goods: An individual consumer demands less of an inferior good as that consumer’s income increases. In other words, they trade-up as they become wealthier.
• Normal Goods: An individual consumer demands more of a normal good as that consumer’s income increases.
• Luxury Goods: An individual consumer’s demand for a luxury good increases by a higher percentage than the percentage increase in the consumer’s income.
• Complementary Goods: These are goods that yield the highest utility when they are consumed together.
• Substitute Goods: These are goods that are normally not consumed simultaneously because they satisfy the same need or desire.
• Veblen Goods: An increase in price induces consumers to consume more of a veblen good. Usually, this is an indication of strong brand power.
• Public Goods: These are goods that are nonexcludable and nonrivalrous. They are nonexcludable because denying people who have not paid for the product from enjoying its benefits is prohibitively expensive. They are nonrivalrous because people who have not paid for them can consume them without any impact on the utility enjoyed by consumers who have paid for them. Public goods suffer from what economists term the free-rider problem.
• Merit Goods: These are goods whose benefits are underestimated by consumers.
• Demerit Goods: These are goods whose disadvantages are underestimated by consumers.
• Free Goods: These are goods that can be consumed with no opportunity cost to the consumer.
• Giffen Goods: An increase in price leads to an increase in the quantity demanded. Giffen goods are considered rare.

Elasticity of Demand, Substitution and Income Effects

Elasticity of Demand is a measure of the responsiveness of the quantity demanded to a change in some other variable on which quantity demanded is dependent, all other things held constant. This is equivalent to measuring the percentage change in the quantity demanded due to a one percent change in the other variable, assuming that everything else is held constant.

Price Elasticity of Demand is a measure of the responsiveness of the quantity demanded to a change in price of a good/service, all other things held constant. Equivalently, it’s a measure of the percentage change in quantity demanded due to a one percent change in the price of a good/service, all other things held constant. Generally, price elasticity of demand is negative, in conformity with the law of demand.

Income Elasticity of Demand is a measure of the responsiveness of the quantity demanded to a change in the income of the user/customer, all else held constant. Equivalently, it’s a measure of the percentage change in the quantity demanded due to a one percent change in the income of the user/customer, all else constant. Income elasticity of demand can be negative, positive, or zero.

Cross-Price Elasticity of Demand is a measure of the responsiveness of the quantity demanded of one good, X, to a change in the price of another good, Y, all other things held constant. Equivalently, it is a measure of the percentage change in quantity demanded of X due to a one percent change in the price of Y, all else equal. If X and Y are complements, this value will be negative. It is positive if X and Y are substitutes.

Comments about Elasticity of Demand: One can measure elasticity of demand in relation to changes in any variable that one chooses as long as one has the data required to perform such analysis. For example; suppose a startup is investing in paid SEO and SEM efforts, then it ought to be able to measure what may be called its “SEO/SEM Elasticity of Demand” which would be the percentage change in quantity demanded of its product/service per one percent change in its investment in SEO/SEM. Another example; A startup that is offering promotions as a means of generating traction and virality could measure a “Promotion Elasticity of Demand” which would measure the percentage change in quantity demanded of its product/service per one percent change in its investment in promotions. How this startup measures “quantity demanded” is a separate question that needs to be answered to perform the analysis. If you have a product in the market it might be a worthwhile exercise to think about what “quantity demanded” means for you specifically. Is it time spent engaging with the app? Is it number of in-app purchases? Is it something else? Is it the amount of advertising purchased by advertisers wishing to reach the audience/community that you have built?

Measuring Elasticity of Demand: The most accessible and convenient approach for most people will be to perform a regression analysis using a spreadsheet package like Microsoft Excel, or something more sophisticated. Unless the founders have enough training to do this themselves, it probably makes sense to get some help crunching the data. An extensive treatment of regression analysis is beyond the scope of what I feel is necessary right now . . . Founders can get a directionally accurate sense of what’s happening by using simple “back-of-the-envelope” calculations that require nothing more than a pencil, some paper, and perhaps a calculator.

Factors That Affect Elasticity of Demand: Quantity demanded and aggregate demand behave the way they do in response to numerous variables. The purpose of the kind of analysis I am describing is to isolate the handful of variables that affect quantity demanded disproportionately in order to reduce their impact – if it is negative, or increase their impact – if it is positive. The following factors are worth considering;

• Do substitutes for your good or service exist? How do they compare to yours in terms of price and quality? Here the substitution effect might come into play; The substitution effect occurs when consumers shift consumption between substitute goods/services because of a price change for one good relative to its substitute, all else held equal.
• How are you defining your good or service? If your definition is too narrow you’ll wind up with analysis that is meaningless . . . . . . This is often a concern when a startup founder says something like “No one else is doing this at all!” If your definition is too wide, you still may wind up with analysis that is meaningless.
• What budgetary constraints do your users/customers face? This is particularly relevant if you want to measure price elasticity of demand. Here the income effect might come into play; The income effect occurs when consumers shift their consumption patterns due to a real change in income, all else held equal. Sometimes the income effect is similar to the substitution effect.
• Is the price change permanent or temporary? If it is permanent, users/customers can seek an alternative if switching costs do not keep them locked in. If it is temporary, then they might forgo searching for a substitute, and so demand may hold steady or perhaps increase.
• How strong is your brand? High brand affinity will cause users/customers to stay after an increase in prices. Low brand affinity will cause users/customers to leave.
• How important is your product/service to your users/customers? I often smile when I am speaking with a founder who cannot understand why ” . . . no one else can see how important this app is . . . ” To that I often respond, your data refutes your assertion that this app is important to your users/customers. In one case the founder had stopped bothering to keep up with the daily, weekly, or even monthly numbers because they were so dismal, but was trying to convince investors that all he needed to solve the problem was a capital infusion of $500,000 or more. How potential users/customers react to a startup’s product is the ONLY VALIDATION THAT IS WORTH ANYTHING TO INVESTORS. Everything else is guesswork and hand-waving. One product might start out looking like a toy. Then users/customers extend the applications of the product, and it suddenly becomes integral to their day to day lives.  Another product starts out seeming like the most important thing in users/customers lives. Then it becomes clear that it is not robust enough to do more than one small thing among the multitude of things they want to get done using that product or one of its alternatives. All else equal, we should expect the latter product to experience more demand elasticity than the former. This is why investors usually will ask about a startup’s product roadmap as the founders think about what subsequent rounds of financing might look like.
• Who is the startup’s customer? Who is paying? How are they paying? In the age of business models that are supported by advertising this can be a complex issue to untangle. Am I paying Facebook in units of privacy, personal data, and attention? If so, at what point do I become less willing to continue using Facebook? Am I Facebook’s customer? Should Facebook even think about that issue? Or, should it focus all its attention on the advertisers who pay it cash in order to direct advertising and marketing messages to me? Definition: A customer pays for a product/service by exchanging something of value for the right to use/own the product/service. For some consumer-facing startups every customer uses some form of the product – every customer is a user, but not every user of the product is a customer since not every user pays for the product with something that user considers valuable in conventional terms. For example; Facebook’s customers are businesses that want to sell advertisements to its 1.5 billion users. The product they are paying for is the attention of the users Facebook has amassed. The product its customers use to reach its users is a flexible advertising platform that serves large, medium, and small businesses alike.

Interpreting The Data for Own Price Elasticity of Demand

• Absolute value of Elasticity > 1; Demand is elastic, and changes by a proportion that is greater than the percentage change in price. Demand is relatively responsive to changes in price.
• Absolute value of Elasticity < 1; Demand is inelastic, and changes by a proportion that is less than the percentage change in price. Demand is relatively unresponsive to changes in price.

Paging Professor Clayton Christensen – The Jobs To Be Done Framework

Another way to think about your product/service is using Professor Clayton Christensen’s Jobs-To-Be-Done framework. Prof. Christensen is the management theorist responsible for popularizing the concept of disruptive innovation.

The keys to this framework are;

• Understanding the “job” your users/customers are “hiring” your product to do for them, and
• Understanding the alternatives your users/customers would consider hiring to do that job, and finally
• Understanding what you need to improve in order to be the first product/service your potential customers think of when they need to hire a product/service to do that job for them.

The JTBD framework helps you understand why and how people hire your product.

For example, a founder I was chatting with once thought she was building a chat app. Yet it seemed to me that the handful of users she had used her app to organize informal groups of friends to do things. For example one use case was a group of friends who used the app to get together after work to play pickup basketball in Manhattan or Brooklyn. Another use-case was a hairdresser and makeup artist who needed to let her customers know where and when they could meet here during the weekend. As it turned out, the hairdresser was the most engaged, most active user of the app. The problem? The founder up to that point did not think of this hairdresser as her typical user, and had never spoken with the hairdresser to find out what features were important and needed improvement, and which ones could be cut.

Was she building a chat app? I don’t know . . . However, none of the use-cases that she described to me sounded like what I think of when I think of a chat app. Instead it sounded like people were using her app to organize groups to get together and do something. Chat seemed like a by-product. It did not seem like chat was the main thing. I suggested she go back and find out what it was about her app that the folks using it the most liked and why.

Wrapping Up and Connecting The Dots

Let’s think about Dan’s rant about venture capitalists’ disinterest in funding smart gun technology startups. We can flip that issue; should those founders even be pitching to venture capitalists, or would they be better off seeking alternative sources of capital?

How would you categorize smart gun technology? Is it a normal good? Is it a veblen good? Is it an inferior good? What is it?

Smart gun technology is a public good; it is non-excludable and non-rivalrous in nature . . . That places a cap on how much value the startups working on smart gun technology can extract from the market in exchange for the value that they create for that market. For an investor focused on financial returns that is a non-starter.

How public goods get financed can change based on changes in regulation, but usually such goods are brought to market with funding from sources that are not focused on financial returns.

Dan Primack’s rant was misguided. The founders he describes who are pitching venture capitalists are misguided too. Dan should know better. The founders working on smart gun technology should also know better than to be pitching venture capitalists. In this specific case, venture capitalists are not the problem. Ignorance is.

The startups I am thinking of build software-centric products/services. For such startups the supply side of the equation is a relatively simple issue to figure out. Startups building relatively complex hardware products have to worry more about the supply side of their business than their software-focused peers. Software startups have the advantage of building a product once, and being able to sell it many times over without incurring significant costs.

Understanding the basics of supply, demand, and price theory will not solve all the problems a startup founder faces. However, a firm grasp of the basics will help founders understand why consumers/customers behave in certain ways. Understanding that is priceless.

References

• Managerial Economics And Business Strategy – Michael R. Baye, 5th Edition.
• Price Elasticity of Demand, Wikipedia.
• Public Goods, Library of Economics and Liberty.
• Different Types of Goods, Economics Help.
• Note: Price Theory and Applications by Steven Landsburg is my favorite introductory textbook on microeconomics.