How do businesses grow? Unfortunately, there is no simple answer to this question, mainly since it is evidently clear that offering the best service, the best price or the best promotion is no guarantee for success. Therefore, sound business administration implies that a wide array of internal and external factors must be taken into consideration when we try to open, expand or manage a business entity. One of the possible ways to examine this issue is to use tools and theories from the science of microeconomics, whose main concern is “the economic behavior of part(s) of an economic system” (Rutherford, 2002, p. 382). The microeconomic approach does not give us the complete picture of business performance, but it is surely handy in order to develop a logical and systematic decision-making at the single entity’s level. By that this science differs from other studies of economic behavior, such as macroeconomics, which deals with the economic conduct of groups, societies and markets.
This aim of this paper is twofold. First, it introduces in brief several key microeconomic concepts, which are relevant for a sound analysis of business growth opportunities. Second, it applies those concepts into practical context, by demonstrating how a small cleaning business can use microeconomics to develop its market share, revenues and profits.
2 Key Microeconomic Concepts
The main problem facing economists is the issue of scarcity (McKenzie & Lee, 2006). That is, since we not one can always satisfy all needs and wants, people will always seek for the conduct that will bring the most favorable outcome (in term of utility). In microeconomics, this assumption is tested in the level of individual players, who engage in various kinds of behavior to maximize their utility and minimize costs. In other words, businesses seek for profits, and wise management implies long-term thinking. As stated by French economist Frederic Bastiat (1801-1850):
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
2.1 Profit and Loss
Before discussing the competitive environment in which a small cleaning service can act, one should recognize that there are several ways to measure profitability. In order to do so, we should first introduce three concepts, namely utility, cost and opportunity cost, and apply them into our example. In order to survive, a cleaning service is constantly occupied with trading over utility. A prospective trade, or contract, can only be made with someone for who prefer a clean space (or object) over a dirty one; for her, the cleaning service is beneficial, and thus she might agree to give the business an incentive to give her this value. This incentive is the business’s utility. The most common example is money, a means that can provide other utility for the business in the future.
Upon entering the agreement, each party will have to give up on something. A cost is thus the resources, which each party needs to sacrifice in order to for the other – money, time, materials, comfort, and so on. However, not all costs are given to the other party, as the party may incur many indirect costs, such as the time one may spend from the moment of order until complete delivery and the physical efforts of cleaning a house. Costs are thus not necessarily quantifiable, just as utility.
But there is another type of cost. Remembering the concept of scarcity, opportunity cost is the value of utility that could have been gained when the resources would have been allocated differently. That is, when the cleaning service chooses to enter a contract, it may have to refuse other opportunities it may have, such as a contract with a different party or leisure time.
Combining utility, costs, and opportunity costs together, we can identify two types of profits. A profit is basically an excess of utility over the costs incurred to gain them; the higher this margin (also known as rent), the higher the probability that the party will agree to engage in the contract and/or will prefer it over other similar, alternative or unrelated utility. Normal (aka accounting) profits refer only to direct utility and costs of a particular transaction; in contrast, economic profits take into consideration the opportunity costs that underlie the transaction and are of great importance for long term decision-making, as demonstrated in the next section. A loss is obviously an excess of costs over utility. It should be noted that a contract can seem profitable in the accounting meaning, but when considering opportunity cost the same deal may proved as a potential loss.
The final step before discussing the cleaning service’s growth possibilities is the basic elements that comprise a competitive analysis. In short, competition is presumed to promote efficiency, and thus most markets fall into the category of imperfect competition . In such markets, sellers compete for buyers by offering differentiated goods and services (i.e. different utilities) and by trying to employ as few inputs as possible, thus minimizing costs and possibly increasing efficiency.
Three key types of imperfect competition are important for this supply-side analysis:
- Pure monopoly: The most extreme case, in which there is only one seller. Since no competition exists, the monopolist can set its output and prices at the optimal level to maximize its profits.
- Oligopoly: This situation, which is common in science-based industries that require considerable investments (Lipsey & Chrystal, 2004), describe a small number of sellers who cover the whole market.
- Monopolistic competition: Distinguished with high product differentiation and employment of excessive inputs to create competitive advantage, and thus bring about less efficient markets.
3 Microeconomics in Practice
In order for the cleaning service to thrive, we should first conduct a simple benefit-cost analysis. To keep our analysis simple, we consider all utility as revenues (R), describe all costs (C) as quantifiable, and assume a constant opportunity cost (OC). Each service given will have one price (P) and will be described as a single unit of quantity (Q). Total costs and revenues are denoted as TC and TR, respectively.
Obviously, there are many ways to grow, all of which involve the tradeoff between higher price and quantities and lowering costs. Here we will discuss two of the issues, concerning changing the economic performance of the service and changing the competitive environment in which the service operates.
3.1 The Microeconomic Behavior of the Business
The basic microeconomic assumption defines the equilibrium between the quantity sold and bought at the loss-avoidance point of supply and demand, or TC=TR on both sides. In a given competitive atmosphere, the cleaning service has at least two growth opportunities:
First, it can take the conventional marketing approach, which advocates a value-maximization innovation (Kotler & Keller, 2006). That is, by differentiating the service in some way, TR of the demand side will be higher and thus the demand curve will become more moderate, hence covering more quantities. To prove this point, we can assume a demand-side utility of $100 for the service. The demand function will be:
D = 100-C
And thus demand will be zero at C=100. However, when the utility is 20% higher, we will also have 20% higher demand at C=100:
D = 120-C = 20 (more units in demand).
Alternatively, we can also decrease costs in some way, thus allowing a rightward shift of the equilibrium because more quantities can still be deployed into the market at lower costs without a loss.
3.2 Changing the Competitive Environment
A major problem for any business is a rivalry between many players on a given level of demand at a certain price. As discussed above, monopolistic competitors must use too many resources at relatively low marginal revenue; monopolies, however, do not have to occupy resources in order to compete, and thus monopoles are much more efficient, at least in the short run.
In our case, it may be possible to expand the service towards a market where our business is the single seller. In this case, assuming that all the other factors remain equal, we can expect a reduction of costs (since less inputs, e.g. marketing, are needed to remain competitive), and thus profits are higher at any quantity level. Furthermore, by becoming a pure monopolist (i.e. by entering a market in which no one can provide similar services), we gain all the demand (D) at the quantity-price equilibrium level (E), thus creating:
That is, all the available revenues at the equilibrium are in fact our revenues. However, elasticity of demand must be considered to find a higher price level that insures profitability, and long-term profits depend to a large extent on supply-side effects such as economies of scale and the learning curve of the firm.
- Einav, L. & Nevo, A. (2006). Empirical Models of Imperfect Competition: A Discussion. Retrieved July 25, 2009 from http://www.stanford.edu/~leinav/WC_Discussion.pdf
- Kotler, P. & Keller, K. L. (2006). Marketing Management (Twelfth edition). Upper Saddle River: Prentice Hall.
- Lipsey, R. G. & Chrystal A. K. (2004). Economics (Tenth edition). Oxford: Oxford University Press.
- McKenzie, R. B. & Lee, D. R. (2006). Microeconomics for MBAs: Putting Economic Theory to Work in Understanding Markets and Managing Firms. Cambridge: Cambridge University Press.
- Rutherford, D. (2002). Routledge Dictionary of Economics (Second edition). New York: Routledge.