Economics is the study of choice in the face of scarcity, and it has practical uses in every aspect of entrepreneurship. We each have a limited amount of time, money, and resources, and understanding economics can help maximize efficiency for all of them. Unlike finance or accounting, which is primarily concerned with money, the study of economics is a broad field that can create a sharp mindset that changes the way you make every decision in life.
Opportunity Costs and Sunk Costs
“There’s no such thing as free lunch.”
As the maxim of economics, the opportunity cost of any action is the most profitable alternative lost for performing it. For example, if you have twelve lemons that you sell as lemonade, the opportunity cost would be the lemon cake you could have sold from them instead. If the lemon cake is more profitable, you’ve lost the extra profit you could have made. Choices that may seem acceptable or harmless may be a gross misuse of scarce resources when examined fully. The cost of time spent watching TV may be in physical fitness, life expectancy, social life, or professional networking. Make sure you consider your options before closing doors to potentially profitable opportunities, and realize that every decision (or lack thereof) has an opportunity cost.
One of the most common mistakes entrepreneurs make is accounting for sunk costs. A sunk cost is simply a cost that has already occurred and can not be recovered. If you’ve invested a significant amount of time and money into an unprofitable idea, it can be hard to change directions. A sunk cost should not be considered in future decision making. If one thing isn’t working, regardless of how much time, money, or effort you’ve put into it, you need to be able to pivot towards success.
Comparative and Competitive Advantage
If your business can provide a product or service at a lower opportunity cost than other firms, you have a comparative advantage. If you can bill a client at $125/hr for consulting service, but have to spend two hours each day bookkeeping, you may be better off hiring a bookkeeper at $20/hr because their opportunity cost is less than the $105/hr you would be sacrificing to do your own bookkeeping.
Competitive advantages include price advantages and product differentiation. If you have access to natural resources, intellectual property, talent, or experience that allow you to supply goods or services at a lower cost, you have a competitive advantage. For example, you may have software that greatly increases efficiency and allows you to provide better service, or you might have an engineer that is outstanding in their field. Price advantages give you a higher profit margin at the market price and give you the opportunity to decrease your price while achieving the same profit margins as your competitors.
Similarly, if you supply goods or services that are perceived as superior and different from your competition, you will gain a price advantage that allows you to charge a premium. If you differentiate yourself from your peers, you may build an economic moat, or barrier to entry that makes entering the marketing more challenging for competitors.
Signal Theory
Know it. Love it. Understand it. Signal theory studies the way that human beings communicate value to influence decision making. For employers, the sheer amount of available labor requires quick ways to sort candidates, so the labor force invests in degrees, suits, ties, and extra curricular activities to signal a strong work ethic and team spirit. Firms use signal theory in marketing to differentiate themselves from competitors to charge a premium for goods and services. Signals may include a professionally designed website, reviews by third parties, and regularly published material that establishes the leadership as expert authorities in their fields. Marketing and advertising plays an important role in the distribution of goods and services, and superior signalling through marketing communications can give you an advantage over your competitors.
The Bottom Line
Every entrepreneur has to use their time, money, and resources effectively to succeed, and a basic understanding of economics can greatly increase efficiency. Remember that some costs are unrecoverable, and others may be hidden opportunities. Use signal theory to differentiate yourself from your competitors, and press every advantage you can to gain market share and increase profit margins with strategic decision making.
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