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Let’s first take a look at how the market system of today works. To do this, we will look at four important concepts—the factors of production, supply and demand, comparative advantage, and the circular flow of money.

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 resource of entrepreneurial ability 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 supply and demand in high school or college economics class, I want to review the principle as it can have a very practical impact on business decision making.

In a supply and demand graph, there are two curves and two axes. Demand is represented by a downward sloping curve and supply is represented by an upward sloping curve. On the vertical axis is price and on the horizontal axis is quantity. An equilibrium price and quantity will always be reached at the point the supply and demand curves intersect. Why? Simply because if the price were higher than the equilibrium price suppliers would produce more and buyers would buy less, bringing the price back down in short order, and if the price were lower than the equilibrium price, buyers would buy more and suppliers would produce less, bringing the price back up in short order.

As we can see from the following graph, the market would demand about 13 widgets when the price is $2.

At a price of $2, thirteen 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.

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 creates a bit of a problem, however. If at $2 the market demands 13 widgets and only 3 are produced, there will be 10 people without widgets. There is a shortage in the marketplace. Widgets are scarce. Because those ten people know they will not get a widget unless they pay more, they bid up the price. A few of these ten 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 widgets 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, right 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 basic 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 in 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 and not able to sell your product at the price you must in order to make a profit.

Lesson Three: Supply and Demand Works in Labor 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: Free Trade & 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 improvement including 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 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. Calculating wealth in this way, 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 within its own borders.

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

The theory of comparative advantage essentially states that the country that produces a good most efficiently, in terms of all the other possible production alternatives, should produce that good. In a two good model, the theory would state that if country A produces computers and cheese more efficiently than country B than country A should not produce both goods, but only produce only the good that it produces most efficiently in comparison to country B, and then trade with country B to obtain that second good.

So why does all this theory affect the entrepreneur? There are three 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 our 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 health products company I worked with in high school, was selling its 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, and especially policies related to free trade, fair trade, overseas competition, tariffs, and subsidies. It is important to know the basis of the arguments for free trade and to understand how and why trade has benefited the world and increased standards of living over the past few centuries, while also keeping in mind that while these benefits are significant and distributed, opening up markets can sometimes create short-term losers.

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

There is one more model that 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. This the cycle continues on ad infinitum.

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, market on the web, 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 the basic laws of the economy, for if they do not they will not be entrepreneurs for long.

The Important Role of the Entrepreneur in the Market System

As we learned before, the entrepreneur is the catalyst that brings together the resources of land, labor, and capital to create valuable goods and services and in the hopes of building a profitable business. The word entrepreneur is of French origin and derives from entreprendre , which means to undertake. The American Heritage Dictionary defines an entrepreneur as “a person who organizes, operates, and assumes the risk for a business venture.”

The entrepreneur plays a vital role in society. Without entrepreneurs, there would be no businesses, no inventions, no innovation, no progress, and no wealth. Without the entrepreneur and the system that provides incentives for entrepreneurs, we would have no printing press, no bifocals, no airplane, no air conditioner, no radio, no microwave, no computer, no telephone, no television, and no George Foreman Lean Mean Fat Burning Grilling Machine. In short, the standard of living would not be much better than that of 1450. The world would not be able to support the 6.5 billion persons it does, and the doomsday Malthusian predictions of overpopulation would have been realized many decades, if not centuries ago.

If it is your goal to become an entrepreneur, whether by running a small business in your home town or launching a high potential venture with VC funding, you should be commended. While being an entrepreneur is surely not for everybody, if you are the type who has a bias toward action, brings efficiency and innovation into everything you do, creates systems and processes, is not afraid to make mistakes, can build and inspire a quality team, and will persist until pigs fly in a frozen over hell while the cows come home and the Cubs win the pennant, you deserve a pat on the back. You are an entrepreneur. In mind, in body, in spirit, in soul—you are an entrepreneur.