Elasticity for Entrepreneurs


I want to expand on an important topic that I addressed in the Wisdom of Niches post. The gist of that post was that niches solve very different problems than crowds, and that niches are where entrepreneurs should stay. The primary reason niches are better is that they offer a better chance for products and services that are price inelastic. Before I explain that last sentence, I'll give a quick economics review that will set the stage for our discussion.

Elasticity is a concept taught in most entry level economics courses, yet it is something that entrepreneurs never seem to think about. The basic definition of elasticity is

the ratio of the incremental percentage change in one variable with respect to an incremental percentage change in another variable

We primarily concerned with two types of elasticity – price elasticity of demand, and what I'll call attention elasticity.

When discussing the first type, an elastic good is something for which the demand drops sharply if the price goes up and increases sharply if the price drops. In other words, a small change in price causes a large change in demand. An inelastic good is one for which a price change has little effect on the quantity demanded. Gasoline is an excellent example of an inelastic good. If the price of gas doubles, what do you do? If gasoline had a unit elasticity, then doubling the price would cut the demand in half. In reality, doubling the price may only cut demand by a couple of percentage points. People try to drive less, but otherwise, what can you really do (at least, in the short term)?

Attention elasticity, which I'm not even sure is a real thing (at least, I've never heard an economist mention it) is how a change in the allocation of your attention is affected by a change in the cost of paying attention. Since many attention grabbing things are free, what really matters with attention is the opportunity cost. You allocate attention to something when there is nothing better to allocate your attention to at that moment. When you are bored, you hit this blog several times a day to see if there are any updates. When you are busy, you forget to check in at all. If you check this blog while ignoring important phone calls, then Businesspundit is attention inelastic to you. If you forget to check this blog because you are too busy watching it rain out the window, then this blog is very elastic with respect to your attention.

Entrepreneurs want inelastic goods and services. Entrepreneurs need to be able to change the price without significantly affecting demand, because startups usually make pricing mistakes. Pricing is difficult and in the early days because you want to entice people with low prices just to get some sales. The problem is that you get stuck with these low prices if you have an elastic good. Let me give you an example – LinkedIn. LinkedIn was free for a long time. I used it. Then they decided to charge for stuff. My demand for their services died with their decision.

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Web2.0 is full of attention elasticity problems. You launch a site, you get the buzz, everyone visits your site… until the next new thing comes along that is better. (Or people start going to PopUrls and read them all at once.) Of course, this isn't a new issue. Content providers like radio, tv, and periodicals have always dealt with elasticity of attention. The difference is that the web now makes it very easy to launch things that compete for that attention, which brings me to an important question. How do build an inelastic product?

Let's start by explaining what affects the elasticity of a good.
1. Are there substitutes? Gasoline is inelastic because you can't put anything else in your car. Your substitutes are alternate forms of transportation like walking, bicycling, or catching the bus.
2. Do people really need it? Cigarettes are inelastic because once you start smoking your body needs them.
3. How much do you spend on it? If something takes up a huge percentage of your budget, it will be much more price sensitive than something cheap. Cars are more elastic than cereal.

Taking all of this into consideration, what should an entrepreneur do to build an inelastic product or service? Start by solving a niche problem. Niches require expertise, which means you have to devote some time to understanding the industry and the problem. When you launch your product, there will be few substitutes because anyone that would compete with you has to learn and understand the industry as well as you do and that takes time. And even then, if your niche as a whole is inelastic, it is unlikely that the industry participants will compete on price.

As an example, my company wrote some software for a specific wireless chip. If you want the chip (which is from a third party), you need our software. The cost of the software is relatively low as a percentage of a customer's development budget for their project, so we have doubled our price over the last few months and still sell about the same number of packages. Our software is inelastic. Granted, there aren't 10 million people clamoring for it, but the point is that we are making more money than planned. It was a better use of our time than writing software for some hot industry that has tons of competitors and will have lots of losers going out of business. Always remember that niches can treat you well.

Don't take this as gospel. Lots of other things still matter when you start a business, and many of them are much more important than elasticity. But don't overlook the simple fact that your goal is to make money, and it's much easier when your product is an inelastic good.

  • Elasticity depends also on market sector. During the post-Katrina runup in gasoline price, sales at the gas station near my home in the inner city dropped significantly. A non-trivial percentage of driving around here is non-essential, and people decided to forego cruising the scene in their donks and hoopties until the cost came back down.

  • Hi Rob, I like your thoughts on elasticity. With social media abuzz, how do you think network effects will hold up?

    They’ve been killer for web 1.0 inelasticity – consider how eBay outlasted free and more featured rivals – but most entrepreneurs now know their value. Competing social media companies that launched at similar times can’t rely on first-mover advantage to outpace rivals. I think that means satisfying users (!) will determine success more this time around.

    An example is how MySpace entered late but trumped Friendster and Orkut with features, interface, and availability. Facebook also entered after MyCampusNetwork and earlier attempts, but is now dominant, arguably by limiting access. What will the web 2.0 lessons on network effects be?

  • Rob

    I think network effects will hold up in industries that hold up. What I mean is that if no one is interested in web auctions then ebay’s network becomes irrelevant. Of course, people will continue to be interested in web auctions, so ebay is fine. But, will they stay interested in these other new fads?

    The problem with these social sites and online communities is that a small percentage of the community is responsible for the majority of the activity and page views. MySpace, Facebook, etc. aren’t as popular as the numbers that they quote would lead you to believe.

  • David G

    BRILLIANT, simply brilliant.

    Attention elasticity = Price elasticity in a “freemium” world. Why web2 VC’s are not beating a path to your door, I don’t know (maybe they are).

    Now, is that your finger or a body-double?

  • Rob

    LOL! It’s a body double. I have that clause in all my contracts.