Business and especially entrepreneurship is a realm where real-world experience beats theoretical knowledge nine times out of ten. At the same time, ignorance is not a virtue. Concepts from economics can be very helpful as mental models that give structure to your thoughts. Of course, they rarely give you definitive answers, but they can be extremely useful to help you avoid mistakes and find biases in your way of thinking.
So, here are a few concepts from micro and behavioral economics that can be useful when you think about your startup project and the market it operates in.
Table of Contents:
1. Sunk Costs In Startups
A sunk cost is simply money that has already been spent and cannot be recovered. This concept usually goes hand in hand with the sunk cost fallacy. This is the tendency to continue with a certain project or a certain direction after you’ve already invested in it. And it’s a fallacy because if the concept/direction is wrong, the outcome would be negative regardless of your initial investment in it.
The sunk cost fallacy only makes it so that you lose much more time and resources on your bad bets than you have to if you quit in time.
The sunk cost fallacy is an important one to be aware of in life in general. For example, if you’ve spent 4 years of your life and tens of thousands of dollars on a college degree that has a bad long-term economic outlook, the rational choice would be to change your field and re-specialize as fast as possible, rather than to continue fighting a losing battle. You can even use your knowledge of your old field as a competitive edge while working in a new field that is growing.
However, the sunk cost fallacy is even more important to master if you’re working on startups. There, being able to deal with the bad bets is crucial for your success. Very few people strike gold on their very first attempt, so the ability to quickly discard bad ideas in order to get to the good ones as quickly as possible is essential.
If you work on a bad idea too long you risk being stuck in the so-called land of the living dead – your project is alive, but barely, and there is no indication of growth despite your efforts. Working on such a project stubbornly because you’ve committed a lot of emotions, effort, and resources, and deluding yourself that success is perpetually behind the corner is a waste of your time and potential.
What you should do instead is to evaluate as objectively as possible if you’re seeing positive signs from the market about your project and to constantly reevaluate if you should continue working on the idea, if you should pivot, or if you should abandon the project altogether (regardless of how much you’ve invested in it).
Idea validation is one of the most important startup skills exactly because of this reason. Making sure you’re working on something the market needs is the only way to avoid the fate of startups like Quibi, who managed to fail despite investing $2B in their idea.
2. Opportunity Costs In Startups
The opportunity costs are the invisible cost of the path-not-taken.
For example, if you are a good developer, you could presumably be working in big tech for a yearly salary of $100k or more. This sum of $100k is the opportunity cost of working on your venture instead.
Let’s say that your startup idea has a (generous) 50% chance to succeed, and you own 50% of the company. This means that for this project to be worthwhile in purely economical terms, you need it to generate at least $400k in profits in a year (400k multiplied by the chance to succeed give the project expected returns of $200k, from which your share is $100k).
If it can’t reach this level of returns you’ll be better off working for an established company.
That said, the opportunity cost concept could also be used a lot more widely. An early-stage startup has very few resources to invest. You need to choose wisely in what activities to put your effort.
Everything has an opportunity cost. For example, fundraising is an extremely common process for startups, but if you’re fundraising this means you’re not building and marketing your product to your customers. In that sense, the opportunity cost of fundraising is high. This means that often for early-stage startups fundraising could be a value-destroying activity because at an early stage your chances to successfully fundraise are smaller. Often, you’re better off postponing the fundraising process and bootstrapping your early-stage startup until you reach a certain point – usually good traction proving you’re on the right track to product-market fit, which makes the investment much easier to attract.
3. Comparative Advantage In Startups
David Ricardo, a Scottish economist, had an intuitive insight: a few individuals (or firms, or countries) benefit from trading even if one is objectively the best at everything. This is because one of the activities generates the highest returns, which means that all other activities are better left to the other players in the market because of the opportunity cost of not focusing on your highest value-added activity.
This theoretical concept is interesting on the macro level but it becomes extremely practical on the level of small startups. You have very few resources to spare. Because of this, it’s much better to focus all of your efforts on your highest value-added activities and to outsource everything else (or not to do it at all).
This rule of thumb can clearly be seen in startup marketing. Since there are a lot of marketing activities you can do, companies try to cover all of their bases and do a bit of everything. They do this out of fear that they will miss out – a type of misunderstood opportunity cost of not investing in every marketing channel.
In reality, the way to minimize your opportunity costs and maximize your results is to invest all of your resources and effort into the activity at which you are the best.
In other words, for a small startup, the best marketing strategy is to choose the most effective channel for your market niche and to become the best at it. Everything else is a huge waste of money and effort.
4. Specialization In Startups
Adam Smith pointed out that an advantage in a free market system is that productivity increases when workers specialize. This insight leads to the development of the notion of division of labor and the assembly-line-led industrial revolution.
As the economy and technology grow more and more complicated, it becomes impossible to be a jack-of-all-trades. It’s a much better strategy to concentrate your efforts and to become the leading expert in a niche.
At the same time, while this is true for your company and the product or services it provides, this is not entirely true for the founder. As the person leading the whole project, your job wouldn’t be just to maximize efficiency. It would be to understand and coordinate the different aspects of the business. This usually requires you to know a bit about tech, marketing, finance, and to talk to the different stakeholders of your business in order to be able to take the optimal decisions.
5. Utility & Costs In Startups
Utility in economics represents the total satisfaction that the consumer receives from the good or service.
You could argue that a cheap modern smartphone gives consumers the same utility as an iPhone. However, the fact that people are paying a much higher price for iPhones suggests that you shouldn’t think about utility in such a narrow sense. People might be deriving subjective, intangible utility from the iPhone as a status symbol, a symbol of membership to a tribe and shared values, etc.
Because of this, you should be careful when you are putting forward the offering of your startup, especially in the context of replacing the current status-quo solutions. The superior tangible utility you offer as a new company might not be enough to give you an advantage in the market in the context of the intangible utility that an established brand is offering.
The same is true of cost. Cost is not simply the price that the consumer needs to pay. There is a cost to gathering information, understanding a new solution, switching from an old solution, and even a social cost to switching from a popular brand.
This is where the startup cliché that each new disruptive solution should give consumers 10x the value to motivate a behavior change comes from.
A market where people are generally happy with their status quo solution (even when it’s not perfect) is extremely hard to disrupt. It’s much better to compete in a market (niche) where utility and cost dynamics work in your favor – i.e. there will be a cost to not switching.
6. Satisficing In Startups
While classical economics talks about utility in straightforward terms under the assumption that consumers are rational actors (i.e. homo economicus), behavioral economics challenges this assumption and argues that in the real world people are subject to various cognitive biases and need to deal with limited information and time when they make decisions (i.e. they are subjects to bounded rationality).
This gives rise to the concept of satisficing – rather than maximizing the cost/utility function and making optimal consumption choices, people on average are following the path of least resistance. In other words – they are satisficing.
In the world of startups, this translates to the insight that the “build it and they will come” insight is an illusion. Building a better solution (higher utility at lower cost) isn’t enough. You need to make your solution as easy and obvious as possible for your target users, otherwise, they’ll be perfectly happy to ignore you and stick to the status quo (status quo bias).
Smart and persistent marketing efforts are just as vital for the success of any new project as building and pricing a new product.
7. In Summary
While we are mostly exposed to economists when we hear them argue over interest and inflation rates, the field of economics has very valuable concepts that could help manage your own startup project better once you understand them.
Remember that a business and a consumer are the central actors of an economy, which means that most economic concepts are directly applicable to your situation as a business owner. Understanding the actors in a market better will help you make more educated decisions regarding your offering and your resource allocation. This will help you reach product-market fit faster than you otherwise would, which is critical in the early stages of your startup project.