Startup Economics 101

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design – Friedrich Hayek 

I have been meaning to write about this for while but never got around to it. I meet a lot of founders and I have invested in quite a few early stage companies, for someone who started with nothing. The last 7 years has been a fantastic learning experience and one thing that I believe totally changes the trajectory of a startup is Startup Economics. Let us start with the basics, bear with me I am pretty sure if you have taken any economics class, you definitely were shown the Demand – Supply graph. 

The red line is the demand curve and the blue line is the supply curve. The x-axis is quantity and the y-axis is the price. The image above shows a scenario when the demand curve shifts to the right due to some exogenous factor, for example the shift in demand for Iceland as a travel destination happened after the Eyjafjallajokull volcanic eruption. With all things being equal in Iceland just the number of people wanting to come to Iceland went from Q1 to Q2, or you can see in the graph below where I have plotted the number of visitors to Iceland

You can see clearly the inflection point in the year 2011, the number of visitors to Iceland jumped from 488,622 in 2010 to 565,611 in 2011, a 15.8% jump. When something like that happens, typically the demand curve shifts. You can get the entire data set here thanks to the Tourism Board of Iceland. I was impressed to find the Founders of Guide to Iceland who understood this dynamic and saw the need for a marketplace solution, they met me in early 2013 and the rest as they say is history. Guide to Iceland is growing nicely, the team growing, there are plans to launch multiple marketplaces around the world. The technology platform that powers Guide to Iceland is robust because it is tested in the hardknox of actually building a sustainable business in Iceland using the platform.

When starting a new business, it is critically important to build demand for the product or service that is being created. I see most of the founders try to do this in reverse i.e build the supply and capacity first and then go and build demand. That can work, but what is even better is to first build the demand. Building demand is done by taking to your potential market, therefore the initial stage of startup development should be marketing and building traction… i.e telling the story about why the demand exists, writing about the problem and how it can be improved through technology. That being said, I agree with Henry Hazlitt 

Need is not demand, effective economic demand requires not merely need but corresponding purchasing power

In other words, it is not important that someone thinks your product or service is needed they should be willing to pay for it. Again, economics to the rescue, a demand curve has price on the Y-axis for a reason. If you were observant you would have noticed that with limited quantity the price is much higher than when the quantity or demand increases, there is a reason for the downward sloping demand curve. So, you need to charge for your product or service, typically a high price at the start, which is again the exact opposite of what most startups try to do. I think the first interaction that you have with your customer is a good indicator for evaluation if you can charge for value. I see startup founder cringe at the idea of asking for money when they talk to their potential customer, why is that? I think it is because founders believe that the product is not ready so they should charge nothing, this is nonsense. If you are able to articulate the value of your product or service, your customer should be able to commit to paying something for getting her problem solved through your solution. It also forces the founders to think about the value of their startup. Startups fail, don’t fail because you ignored this aspect of building your company.

With the new and established network distribution platforms like Facebook, Snapchat, Instagram, Twitter, Youtube, LinkedIn etc, there is no excuse for not building demand first. The nice thing about this approach is that it can be done with no or very little money.

Even intuitively we can see that building demand first is how one should start, when you try to draw the above graph, we always draw the demand curve first and then draw the supply curve. Try it for yourself. Connecting the dots at the start in the right sequence can help you immensely in your journey of building your company.