How the Market System Works: Economics 101 for Aspiring Entrepreneurs

The reading level for this article is Novice

Now that we have a good background on how the market system developed (see "The History of the Market System"), it is important to take a look at how the market system of today works. To do this, we will look at four important concepts—that of the factors of production, supply and demand, comparative advantage, and the circular flow.

The Resources Needed to Create Wealth

Let’s start things off with a question. What is needed to create wealth? Within the marketplace, there are many resources that go into the production of goods and services. These resources can be grouped into four categories. These categories are land, labor, capital, and entrepreneurial ability.

The land category consists of not just land, but all natural resources. Labor is the work that is performed by man. Capital is industrial machines and buildings, not financial capital (money is not capital by this definition). Finally, there is a special resource called entrepreneurial ability. This is where you come into play. It is the entrepreneur that organizes and arranges the use of land, labor, and capital to create an output demanded by the marketplace. It is the entrepreneur’s responsibility to decide on what amounts of each resource to use and then use those resources efficiently to create a product or service that is valued higher by the marketplace than the collective value of the resource inputs. As Campbell R. McConnell and Stanley L. Brue say in Economics, "Both a sparkplug and a catalyst, the entrepreneur is at once the driving force behind production and the agent who combines the other resources in what is hoped will be a profitable venture."

The Law All Entrepreneurs’ Must Understand

The second concept that is essential for all entrepreneurs to grasp is that of supply and demand. While you may have studied this in high school or college economics class, it is essential to have more than a classroom understanding of this principle.

Let’s begin with a simple demand graph.

As the demand curve illustrates, when the price of widgets are high, say $9, none are demanded. However, when the price is low, say $2, the marketplace demands many. As we can see from the following graph, the market would demand about 12 widgets when the price is $2.  

At a price of $2, twelve widgets will be bought. But would suppliers be willing to sell widgets for $2. Would they even make a profit at this price level? Let’s look at the supply curve to see what amounts producers of widgets would be willing to sell at each price level.

The supply graph illustrates that as the price the market is willing to pay for widgets increases, widget suppliers are willing to produce a greater quantity of widgets. This makes sense. If the market would be willing to pay you more for your homemade cookies, you’d be willing to make more.

From the below graph, we can see that if the market was willing to pay $2, suppliers would be willing to produce 3 widgets.

This is a bit of a problem, however. If at $2 the market demands 12 widgets and only 3 are produced, they’ll be 9 people without widgets. There is a shortage in the marketplace. Widgets are scarce. Because those nine people know they will not get a widget unless they pay more, they bid up the price. A few of these nine people will not be willing to pay as much as they must to obtain a widget. A few of them will, however. This process eventually leads to an equilibrium price and quantity, where the suppliers produce exactly how many the market demands at a set price.

To determine this equilibrium price and quantity of widgets, let’s put the demand and the supply curves together on the same graph.

From this graph we can see that at a price of about $4.80 there will be 8 widgets demanded by the market place and 8 widgets supplied by producers. We have found the equilibrium price and level of output. This equilibrium point occurs where the supply and demand curves intersect.

Now, if demand increases, the price and quantity supplied will also increase. If supply increases, perhaps due to a new technological innovation, widgets will be less scarce and the price will go down and output will go up. These are the laws of supply and demand.

So what does this mean to an entrepreneur? What is important to take out of this? Well, there are three important lessons here.

Lesson One: How to Price Your Products

If you charge too much you may make a large per product profit but not make many sales. Vice versa, if you charge too little you may make many sales but little profit or perhaps a loss. To find the price that will maximize revenue, you will have to experiment. Test different price points and see what the reaction is on sales, total revenue, and net profit. You likely will not have the resources to hire a team of Ph.D’s to do elasticity and econometric studies to determine the exact point, but you can come close through trial and error and by seeing what your competitors are charging.

Lesson Two: Sell What the Market Demands

The law of supply and demand holds true is all situations and can often be cruel to those who do not abide by it. Before you begin your business, make sure you take time to determine the approximate demand for what you will be selling in the marketplace. Ask yourself if there is a need? What problems does your product or service solve? How will you differentiate yourself from all the competitors doing the same thing? Use the MAR Opportunity Evaluation model provided in part three and be sure to do proper due diligence and market research. If you don’t you may find yourself out of business, not able to sell your product at the price your must in order to make a profit.

Lesson Three: Supply and Demand Works in Factor Markets as well as Goods Markets

While the models above use the example of a good, the widget, the law of supply and demand is equally applicable to factor markets, that is, the market for employees and workers. The difference is that supply is supply of workers and demand is demand for workers. As the business owner, you are no longer the provider, but rather, the consumer of labor. If the supply for labor in your area is low, you will have to pay more to attract the quantity and quality of employees you need to build your business. Similarly, if there are many employers in your area, there will be more choices for workers in the area and thus wages will be driven higher.

An Important Factor behind the World’s Wealth: The Principle of Comparative Advantage

While there is much work still to be done to reduce poverty across the world, over the past five hundred years a tremendous increase in prosperity and standards of living has taken place. There are numerous reasons for this. These include the humanist movement, the scientific revolution, the spread of liberalism, the promotion of innovation and enterprise by governments, the creation of laws that protect private property, the spread of access to credit, and a the development of a system which rewards hard work and investment. One of the most important reasons for the great increase in the standards of living across our world over the past five centuries, however, is the great increase in trade.

Returning to mercantilist times, it was thought that a nation could only increase its wealth if it sold more to other nations (exported) than it bought from other nations (imported). Thinking briefly, this notion might make sense. If a country started with $10 and bought $8 of goods and only sold $5 of goods, its ‘wealth’ would now be down to $7. This, however, does not take into effect the value of the goods purchased. In fact, there is now more wealth than there was before—for both countries. Trade allowed each country to purchase what it needed at a lower cost than what it would have paid if it would have produced it within its own borders.

Until the economist David Ricardo came along, this mercantilist view of trade persisted. It was not until Ricardo’s publication his Principles of Political Economy in 1817 that sense began to spread. Within, he explained and promoted the theory of comparative advantage, the key theory that explains why specialization and free trade are such a beneficial forces.

To illustrate this important principle, let’s look at a two good and two country market—that of bread and wine in England and France. Assume that France produces both bread and wine cheaper and more efficiently than England can. Will it benefit France to trade with England? Surprisingly, the answer is yes.

Let us further assume that before trade, England produced 14 barrels of wine and 350 loaves of bread and France produced 15 barrels of wine and 600 loaves of bread. Since France produces more of both, it has what is called a competitive advantage in the production of wine and bread. Before Ricardo, the analysis would stop there and France would decide not to trade with England. France, however, had not taken into account the principle of comparative advantage. Instead of each producing wine and bread for domestic-only consumption, if the two countries specialize in what they comparatively do best in and then trade, it will in fact increase its both the amount of wine and bread that each country has. Let’s see how.

Let’s use these two production possibility tables in our analysis.

As we can see from these tables, it costs England 1 barrel of wine for every 50 loaves of bread it produces and France 1 barrel of wine for every 40 loaves of bread it produces. England’s ‘cost-ratio’ is therefore is 1W:50B and France’s is 1W:40B.

As both countries desire both wine and bread, before specialization and trade, both choose Production Possibility B. England produces 14 barrels of wine and 350 loaves of bread while France produces 15 barrels of wine and 600 loaves of bread. It is clear that France is better in the production of both goods. However, gains can be made from specialization and trade.

Since France has to give up less loaves of bread than England (40 versus 50) to get 1 barrel of wine, it has a comparative advantage in the production of wine. Vice versa, since England has to give up less barrels of wine to get 1 loaf of bread (.2 versus .25), it has a comparative advantage in the production of bread. Also note that before specialization a total of 29 barrels of wine (14 + 15) are produced as well as 950 loaves of bread (350 + 600). Now let’s see what happens when England specializes in making bread and France specializes in making wine.

From our table, we see that if England specializes in making bread it will choose Production Possibility A and France will choose Production Possibility C and specialize in wine. Now, 1050 loaves of bread (instead of 950) and 30 barrels of wine (instead of 29) are produced. It is clear that specialization has increased the production of both goods. One problem remains, however. This is that England has no wine and France has no bread. This can be solved easily through trade.

Meeting in the middle between the cost-ratio of 1 barrel per 50 loaves for England and 1 barrel per 40 loaves for France, let’s assume the ‘terms of trade’ are set at 1 barrel of wine per 45 loaves of bread. It will always benefit both countries as long as the terms of trade are between 1:40 and 1:50. This exact number will be set based on the supply and demand in the market.

Let see what happens if France trades 14 barrels of wine for 630 loaves of bread (14 x 45 = 630). After the trade, France has 16 barrels of wine remaining and 630 loaves of bread while England has 14 barrels of wine and 420 loaves of bread. France now has 1 more barrels of wine and 30 more loaves of bread while England has the same amount of wine and 70 more loaves of bread. Specialization and trade created 1 extra barrel of wine and 100 extra loaves of bread! All due to comparative advantage and our good nineteenth century friend David Ricardo.

So why do all these numbers and theory affect the aspiring entrepreneur or small business person? There are three main reasons.

First, we as entrepreneurs must understand the basics of economics on a macro scale before we can impact industry, innovate, and create wealth for society and profits for our businesses. Secondly, while growing your business to one million dollars in sales and beyond, international sales will likely become a large part of your business. The nutraceuticals company that went from zero to one million in fourteen months, sold product in over thirty countries by the time I left to go to college. Finally, in the world of ideas there is much debate about policies. Confusion over free trade, fair trade, tariffs, and subsidies abounds. It is important to know the basis of the arguments for free trade and to understand how and why free trade has benefited this world to such a degree over the past two centuries. We’ll learn a bit more about the institutions behind this achievement later in this section.

Seeing Both Sides of the Coin: The Flow of Goods and Capital

To sum up our new economic knowledge, there is one more model that we as entrepreneurs-to-be must know. This is the Circular Flow Model.

The Circular Flow Model presents a simple method for understanding the relationships in the marketplace between businesses (the producers) and households (the consumers). It shows how producers provide goods and services to consumers who provide labor and entrepreneurial ability to businesses, both in exchange for money. Let’s take a look at the model.

In the model, the outer, clockwise, path represents the flow of money. Businesses pay households for services as workers, and households pay businesses for the products and services provided to the households.

The inner path represents the flow of goods. Households serve as a source of labor and entrepreneurial ability for businesses. These resources are purchased in the Resource Market, where the equilibrium quantity and price is set by supply and demand. Businesses purchase land, labor, capital, and entrepreneurial ability from the resource market, and then combine these inputs into valuable outputs known as goods and services. These goods and services go on sale in the Product Market, in which the desired quantity and equilibrium price for each and every service is simultaneously and automatically set through the dynamic workings of the marketplace. And thus the cycle continues on.

While this concept is basic, it is useful to have this simple model. Many younger persons, without experience in the workplace and living as a consumer their whole lives, can only envision the right side of this model. By knowing how this capital and goods flow works we can better understand our roles as consumers, employees, and entrepreneurs as well as the dynamic and constant interaction of supply and demand for both our services and the products we purchase.

So what was the purpose of this primer on the market system? Surely many readers, including perhaps yourself, would have wanted to dive right into the information on how to evaluate opportunities, raise funding, launch a product, build a team, get to the top of the search engines, and build international sales. Reviewing the basics of economics first, however, creates an important framework for understanding the concepts that will be presented later on how to build a company to one million dollars in sales. All entrepreneurs must understand economics, for if they do not they will not be entrepreneurs for long.