More Dismal Science for Would-Be Entrepreneurs

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Teaching entrepreneurship is a growth business for U.S. business schools. The number of the nation’s undergraduate entrepreneurship programs grew 15.3 percent from 2007 to 2011, while the number of master’s programs increased 19.1 percent, according to the Association to Advance Collegiate Schools of Business.

Much of the curriculum in these programs focuses on evaluating one’s entrepreneurial potential, understanding the process of starting a business, writing business plans and financial statements, and raising money. While providing this information helps many students, my experience as an educator and investor has convinced me that entrepreneurship programs would do well to expose their students to more microeconomics.

Before you recoil in horror at the notion of inflicting more of the dismal science on business students thinking of starting their own companies, please hear me out. Many company founders make mistakes that they could have avoided had they known more economics. Since I don’t have the space to discuss everything that a microeconomics class has to offer would-be entrepreneurs, I will limit myself to four big questions commonly asked by prospective entrepreneurs that microeconomics answers.

1. Should I start a business in X industry? If an industry is profitable, many people will enter the industry, lured in by the prospect of high profits. But all that entry will lead to competition that erodes profits. For an industry to remain profitable, the businesses in it must be able to bar others from entering. Thus, basic microeconomics makes it clear that entrepreneurs should pick industries with significant barriers to entry even though it’s much easier to start a business in industries with few of these obstacles.

2. Should I shut down my money-losing business even though it cost me a lot to build my plant and equipment? Microeconomics tells you to ignore your sunk costs—costs that have already been incurred and cannot be recouped—when making business decisions. If you understand this principle, you know that you should forget how much you spent to build your plant and equipment when making the decision whether to shutter operations.

3. Should I raise prices? Boosting prices is tricky because it affects revenue in two conflicting ways. Raising prices brings in more revenue on each unit you sell, but it also means selling fewer units as customer demand falls in response to price increases. Whether the net effect of the price increase is negative or positive depends on how much the demand declines in response to the price increase—something economists call price elasticity of demand, and the rest of us call price sensitivity.

When demand is price elastic (customers are price sensitive), increasing your price will cause your revenue to fall because the additional revenue you get from charging more per unit is less than the revenue you lose from the fall in sales. When products have a lot of substitutes (hot dogs, if you sell hamburgers) or they are luxuries (Disney vacations rather than heart medication) demand tends to be elastic. Raising prices causes so many customers to walk away that you end up worse off than when your price was lower.

4. Should I charge different customers different prices? Yes, microeconomics explains. Price discrimination—selling the same product to different customers at different prices—is a good way to earn higher profits, because some customers are willing to pay more. Failing to charge those higher prices to customers who are willing to pay more means giving up profits you could have earned. That’s why airlines, for instance, charge you more if you insist on returning home during the week rather than staying over Saturday night. They know business travelers will pay extra for tickets that allow them to spend the weekend at home.

I fully expect that some readers will criticize this column. Economics often seems abstract and irrelevant to business students, in part because those of us teaching it don’t do enough to emphasize its practical applications. But my experience both teaching entrepreneurship and investing in startups has convinced me that having a solid grasp of microeconomics helps entrepreneurs avoid making poor decisions that sink young companies.

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