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 Cover Contents 
CONTENTS

Part 1: Innovation
Chapter 1: Innovation: the clever country
1.1 Innovation matters
1.2 Innovation isn’t easy!
1.3 Sources of innovation
1.4 Different types of innovation
1.5 What do successful innovators and entrepreneurs do?
Summary
Endnotes
Chapter 2: Creativity, innovation, opportunities and entrepreneurship
2.1 The nature of creativity
2.2 Creativity as a process
2.3 Components of creativity and creativity techniques
2.4 Linking creativity, innovation and entrepreneurship
Summary
Endnotes

Part 2: Marketing
Chapter 3: Marketing, the environment and market analysis
3.1 What is marketing?
3.2 The marketing environment
3.3 Internal environment
3.4 Micro environment
3.5 Macro environment
3.6 Situation analysis, organisational objectives and the marketing plan
Summary
Endnotes
Chapter 4: Identifying customers
4.1 Target marketing
4.2 Segmentation
4.3 Targeting
4.4 Positioning
Summary
Endnotes
Chapter 5: Elements of the marketing mix
5.1 The marketing mix
5.2 Product
5.3 Price
5.4 Promotion
5.5 Place
5.6 The services marketing mix — people, process and physical evidence
Summary
Endnotes

Part 3: Microeconomics
Chapter 6: Economics, demand and supply
6.1 What is economics?
6.2 Economics as a science
6.3 Demand
6.4 Supply
 6.5 Market equilibrium
6.6 The price elasticity of demand
Summary
Endnotes
Chapter 7: Profit, cost and revenue
7.1 Profit
7.2 A firm’s costs of production
7.3 A firm’s revenue
7.4 Choosing the optimal amount to produce
Summary
Chapter 8: Market structures
8.1 Competition and market structures
8.2 Perfectly competitive firms in the short-run
8.3 Perfectly competitive firms in the long-run
8.4 Monopoly
8.5 Monopolistic competition
8.6 Oligopoly
Summary
Endnotes

Part 4: Enterprise
Chapter 9: Entrepreneurs and opportunities
9.1 Business and the private enterprise system
9.2 Who are the entrepreneurs?
9.3 Understanding the profile of an entrepreneur
9.4 Entrepreneurs and opportunities
9.5 The risks of a career in entrepreneurship and relevant performance measures
9.6 Entrepreneurs in a social context
Summary
Endnotes
Chapter 10: Entrepreneurship: definition and evolution
10.1 Defining entrepreneurship and its key elements
10.2 The process of new venture creation
10.3 The role of entrepreneurship in economic growth and development
10.4 Common features of entrepreneurship in the Asia–Pacific region
Summary
Endnotes
Chapter 11: Starting an enterprise: the entrepreneurship alternatives
11.1 Issues to consider before going into business
11.2 Three forms of market entry
11.3 Procedural steps when starting a business venture
11.4 Going global and developing a strategy for international business
Summary
Endnotes

 Copyright Part 1 Innovation 

CONTENTS

Cover Page

Copyright

Contents

Part 1: Innovation
Chapter 1: Innovation: the clever country
1.1 Innovation matters
1.2 Innovation isn’t easy!
1.3 Sources of innovation
1.4 Different types of innovation
1.5 What do successful innovators and entrepreneurs do?
Summary
Endnotes
Chapter 2: Creativity, innovation, opportunities and entrepreneurship
2.1 The nature of creativity
2.2 Creativity as a process
2.3 Components of creativity and creativity techniques
2.4 Linking creativity, innovation and entrepreneurship
Summary
Endnotes

Part 2: Marketing
Chapter 3: Marketing, the environment and market analysis
3.1 What is marketing?
3.2 The marketing environment
3.3 Internal environment
3.4 Micro environment
3.5 Macro environment
3.6 Situation analysis, organisational objectives and the marketing plan
Summary
Endnotes
Chapter 4: Identifying customers
4.1 Target marketing
4.2 Segmentation
4.3 Targeting
4.4 Positioning
Summary
Endnotes
Chapter 5: Elements of the marketing mix
5.1 The marketing mix
5.2 Product
5.3 Price
5.4 Promotion
5.5 Place
5.6 The services marketing mix — people, process and physical evidence
Summary
Endnotes
Part 3: Microeconomics
Chapter 6: Economics, demand and supply
6.1 What is economics?
6.2 Economics as a science
6.3 Demand
6.4 Supply
6.5 Market equilibrium
6.6 The price elasticity of demand
Summary
Endnotes
Chapter 7: Profit, cost and revenue
7.1 Profit
7.2 A firm’s costs of production
7.3 A firm’s revenue
7.4 Choosing the optimal amount to produce
Summary
Chapter 8: Market structures
8.1 Competition and market structures
8.2 Perfectly competitive firms in the short-run
8.3 Perfectly competitive firms in the long-run
8.4 Monopoly
8.5 Monopolistic competition
8.6 Oligopoly
Summary
Endnotes

Part 4: Enterprise
Chapter 9: Entrepreneurs and opportunities
9.1 Business and the private enterprise system
9.2 Who are the entrepreneurs?
9.3 Understanding the profile of an entrepreneur
9.4 Entrepreneurs and opportunities
9.5 The risks of a career in entrepreneurship and relevant performance measures
9.6 Entrepreneurs in a social context
Summary
Endnotes
Chapter 10: Entrepreneurship: definition and evolution
10.1 Defining entrepreneurship and its key elements
10.2 The process of new venture creation
10.3 The role of entrepreneurship in economic growth and development
10.4 Common features of entrepreneurship in the Asia–Pacific region
Summary
Endnotes
Chapter 11: Starting an enterprise: the entrepreneurship alternatives
11.1 Issues to consider before going into business
11.2 Three forms of market entry
11.3 Procedural steps when starting a business venture
11.4 Going global and developing a strategy for international business
Summary
Endnotes
 PART 1
Innovation
1 Innovation: the clever country
2 Creativity, innovation, opportunities and entrepreneurship

 Contents 1 Innovation: the clever country 

 CHAPTER 1

Innovation: the clever country

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1.1 understand the meaning of innovation, six aspects of innovation, and innovation and entrepreneurship
1.2 explain the difficulties in managing what is an uncertain and risky process
1.3 list some sources of innovation, both from within companies or industries and in the social environment
1.4 discuss different innovation types
1.5 understand the key practices of successful innovators and entrepreneurs.
Where could Australia genuinely innovate?
Written by Peter C. Doherty, Laureate Professor, The Peter Doherty Institute for Infection and Immunity
There is a lot of talk about innovation these days, but are we really innovating in the areas where we could generate the
most benefit for Australia and the world?
What is clear is that the decline in mining revenue, the elimination of manufacturing jobs and climate–dependent
uncertainties in agricultural productivity mean Australia’s future prosperity cannot depend on endlessly repeating the
past.
The decline of coal and, indeed, all fossil fuel exports is inevitable if nation states are to comply with the Paris agreement.
That won’t happen overnight, but the pace of change will inevitably accelerate as a more concerned and aware younger
generation seizes political control.
Future prospects for our greatest single tourism asset, the Great Barrier Reef seem increasingly dim. The bleaching that’s
killing the corals is a direct consequence of ocean warming.
With 0.3% of the world’s population, we produce around 1.4% of the world’s greenhouse gas emissions (and that’s
excluding the emissions from our coal exports). But the fact remains that there’s relatively little Australia can do to
protect the long-term health of the reef.
We could act to limit agricultural runoff. And, thinking innovatively, we might research if it’s possible to engineer or
transplant more heat resistant corals. But apart from the technical challenges, any long-term success will depend on how
hot the seas eventually become.
If we’re thinking about places where a country like ours with a small population can hope to innovate in ways that
generate new technologies and more jobs, the area with the greatest potential is renewable energy.

Playing to our strengths

We live on the world’s largest solar collector. How do we exploit that to serve our own energy needs and, beyond that to
develop a clean energy export industry? One possibility is to produce an Asia–Pacific solar ‘super grid’, with Australia
exporting solar energy to our neighbours.
Given that we have massive solar resources, and assuming a realistic global price for carbon (say A$100/ton levied on
everything from energy generation to transport), Australia would become a highly desirable place to site activities that
require a lot of energy. An obvious, immediate application is to host global data centres.
We also have a strong record of innovation in the medical area, with the new Medical Research Future Fund being
tangible evidence that this is recognised at the political level.
Vaccines, such as Gardasil, and devices such as the ResMed sleep mask and the bionic ear have been major dollar
earners, although each hasn’t necessarily created many domestic jobs.
Given our increasing ethnic diversity and our centrally organised national health system, Australia is a great place to do
clinical trials that will be acceptable to the emerging powerhouses, such as China, in drug discovery and development.
And we have established great models for networking university and research institute talent across the nation.
Sometimes, I fear our politicians take too narrow a view of medical research. They fail to grasp that the Australian
Research Council and CSIRO-funded chemists, physicists, mathematicians and so forth are centrally important to this
enterprise, although that is understood by those who administer the funding agencies. And cutting research support funds
to universities is a major regressive step.
Australia has a long history of innovation in agriculture, including through the CSIRO.

Research prosperity
That said, a great deal of innovation has nothing to do with the formal research sector. Innovation in areas such as design,
visual imagery, fashion, surfboards, bicycles and so forth is based on the insight and energy of inventors and
entrepreneurs.
That’s also true, to some extent, for innovation in engineering and architecture, although developing novel solutions is
likely to benefit from regulations and/or investment strategies that mandate, for instance, energy efficiency and
‘greening’.
Government definitely has a part to play here. If we look at Silicon Valley, for example, an enormous amount of support
has been supplied by US Department of Defence and Department of Energy grants.
CSIRO chief Larry Marshall’s strategy to take the institution down a more entrepreneurial road is understandable. What is
regrettable, though, is that there has been no real political commitment to continuing the ‘public good’ (and long-term
economic good) science that has been a major focus for CSIRO and should, perhaps, find another home.
One option would be to establish a new National Institute for Earth Systems Science that incorporates some of the CSIRO
activities that are slated for cuts.
If we don’t understand what is happening with the climate, tides, soils, water, biodiversity and so forth, we limit our
capacity to innovate in response to environmental stress. We also risk making very bad political decisions about where to
invest for future development and to mitigate the effects of climate change.
Surely Australia should be the great laboratory for water conservation and dry land agriculture. That won’t happen if we
compromise the necessary science.

Finding the advantage

As a research scientist, the principle I’ve always adopted is to align with selective advantage. That means collaborating
with talented people (especially those at close range with different expertise) and tackling issues where there is real need.
The big questions are: what are our selective advantages as a nation? And how do we exploit them?
Although there are signs of erosion, one great advantage we still have is that we live in a socially progressive and
generally tolerant society with a strong record in science, education and the arts.
So, although governments can help get the settings right and provide some resources, genuine innovation depends on the
actions of smart, courageous and determined entrepreneurs.
Where the US prospers, it’s because it has outstanding tertiary educational institutions that produce such people, it invests
in science and technology and it recruits talent from across the world.
That’s one place where we can take a lesson from their book. Although, when it comes to social policy, other centres of
innovation such as Scandinavia and Germany seem to be more relevant to us.
Innovators want to live in places that are safe, decent, have affordable education, and value personal freedom, bold ideas
and creativity. What we are as a culture is a major component of our selective advantage, and we need to preserve that
distinctiveness.
Source: Originally published on The Conversation.

 Part 1 Innovation 1.1 Innovation matters 

1.1 INNOVATION MATTERS
Learning objective 1
understand the meaning of innovation, six aspects of innovation, and innovation and entrepreneurship

The meaning of innovation

The dictionary defines ‘innovation’ as ‘change’; it comes from Latin in and novare, meaning ‘to make something new’.
That’s a bit vague if we’re trying to manage it; perhaps a more useful definition would be ‘the successful exploitation of new
ideas’. Those ideas don’t necessarily have to be completely new to the world, or particularly radical; as one definition has it:
‘innovation does not necessarily imply the commercialisation of only a major advance in the technological state of the art (a
radical innovation) but it includes also the utilisation of even small-scale changes in technological know-how (an
improvement or incremental innovation).’1
Whatever the nature of the change the key issue is how to bring it about, in other words how to manage innovation. Can we
do it? One answer comes from the experiences of organisations that have survived for an extended period of time.
You don’t have to look far before you bump into the innovation imperative. It leaps out at you from a thousand mission
statements and strategy documents, each stressing how important innovation is to ‘our customers/our shareholders/our
business/our future’ and, most often, ‘our survival and growth’. Innovation shouts at you from advertisements for products
ranging from hairspray to hospital care. It nestles deep in the heart of our history books, pointing out how far and for how
long it has shaped our lives. And it is on the lips of every politician (looking at you, Malcolm Turnbull), recognising that our
lifestyles are constantly shaped and reshaped by the process of innovation.

Innovation in action
Everybody's talking about it

‘We have the strongest innovation programme that I can remember in my 30-year career at P&G, and we are
investing behind it to drive growth across our business’ — Bob McDonald, Chairman, President and CEO, Procter
& Gamble
‘We believe in making a difference. Virgin stands for value for money, quality, innovation, fun and a sense of
competitive challenge. We deliver a quality service by empowering our employees and we facilitate and monitor
customer feedback to continually improve the customer's experience through innovation’ — Virgin Life Care
‘Adi Dassler had a clear, simple, and unwavering passion for sport. Which is why with the benefit of 50 years of
relentless innovation created in his spirit, we continue to stay at the forefront of technology’ — Adidas
‘Innovation is our lifeblood’ — Siemens
‘We're measuring GE's top leaders on how imaginative they are. Imaginative leaders are the ones who have the
courage to fund new ideas, lead teams to discover better ideas, and lead people to take more educated risks’ — J.
Immelt, chairman and CEO, General Electric
‘We are always saying to ourselves. We have to innovate. We've got to come up with that breakthrough’ — Bill
Gates, former chairman and CEO, Microsoft
‘Innovation distinguishes between a leader and a follower’ — Steve Jobs, co-founder and former chairman and
CEO, Apple

This isn’t just hype or advertising babble. Innovation does make a huge difference to organisations of all shapes and sizes.
The logic is simple: if we don't change what we offer the world (products and services) and how we create and deliver them,
we risk being overtaken by others who do. At the limit it’s about survival, and history is very clear on this point: survival is
not compulsory! Those enterprises which survive do so because they are capable of regular and focused change. (It’s worth
noting that Bill Gates used to say of Microsoft that it was always only two years away from extinction. Or, as Andy Grove,
one of the founders of Intel, pointed out, ‘Only the paranoid survive!’)
 Innovation in action
...and it’s a big issue

OECD countries spend $1500 billion/yr on R&D.

More than 16 000 firms in the US currently operate their own industrial research labs, and there are at least 20 firms
that have annual R&D budgets in excess of $1 billion.
In 2008, 16.8% of all firms’ turnover in Germany was earned with newly introduced products; in the research-
intensive sector this figure was 38%. During the same year, the German economy was able to save costs of 3.9% per
piece by means of process innovations.
‘Companies that do not invest in innovation put their future at risk. Their business is unlikely to prosper, and they
are unlikely to be able to compete if they do not seek innovative solutions to emerging problems’ — Australian
government website, 2006.
‘Innovation is the motor of the modern economy, turning ideas and knowledge into products and services’ — UK
Office of Science and Technology, 2000.
According to Statistics Canada, the following factors characterise successful small and medium-sized enterprises
(SMEs):
Innovation is consistently found to be the most important characteristic associated with success.
Innovative enterprises typically achieve stronger growth or are more successful than those that do not
innovate.
Enterprises that gain market share and increasing profitability are those that are innovative.

On the plus side innovation is also strongly associated with growth. New business is created by new ideas, by the process of
creating competitive advantage in what a firm can offer. Economists have argued for decades over the exact nature of the
relationship but they are generally agreed that innovation accounts for a sizeable proportion of economic growth. William
Baumol points out that ‘virtually all of the economic growth that has occurred since the eighteenth century is ultimately
attributable to innovation’.2

Innovation in action
Growth champions and the return from innovation
Tim Jones has been studying successful innovating organisations for some time (see growthchampions.org). His most
recent work has built on this, looking to try to establish a link between those organisations which invest consistently in
innovation and their subsequent performance.3 His findings show that over a sustained period of time there is a strongly
positive link between the two: innovative organisations are more profitable and more successful.
An audio clip of an interview with Tim Jones discussing the link between innovation and growth is available on the
Innovation Portal.

Survival and growth poses a problem for established players but a huge opportunity for newcomers to rewrite the rules of the
game. One person’s problem is another’s opportunity and the nature of innovation is that it is fundamentally about
entrepreneurship. The skill to spot opportunities and create new ways to exploit them is at the heart of the innovation
process. Entrepreneurs are risk-takers, but they calculate the costs of taking a bright idea forward against the potential gains
if they succeed in doing something different — especially if that involves upstaging the players already in the game.

Innovation in action
Global innovation performance
 The consultancy Arthur D. Little conducts a regular survey of senior executives around the world exploring innovation.4
In its 2012 survey of 650 organisations, the following emerged:
Top quartile innovation performers obtain on average 13% more profit from new products and services than average
performers do, and 30% shorter time-to-break-even, although the gap is narrowing.
There is a clear correlation between capability in innovation measurement and innovation success.
A number of key innovation management practices have a particularly strong impact on innovation performance
across industries.

Of course, not all games are about win/lose outcomes. Public services like healthcare, education and social security may not
generate profits but they do affect the quality of life for millions of people. Bright ideas when implemented well can lead to
valued new services and the efficient delivery of existing ones at a time when pressure on national purse strings is becoming
ever tighter. New ideas — whether wind-up radios in Tanzania or micro-credit financing schemes in Bangladesh — have the
potential to change the quality of life and the availability of opportunity for people in some of the poorest regions of the
world. There’s plenty of scope for innovation and entrepreneurship and sometimes this really is about life and death.

Innovation in action
Finding opportunities

There has always been a need for artificial limbs and the demand has, sadly, significantly increased as a result of
high-technology weaponry such as mines. The problem is compounded by the fact that many of those requiring new
limbs are also in the poorest regions of the world and unable to afford expensive prosthetics. The chance meeting of
a young surgeon, Dr Pramod Karan Sethi, and a sculptor, Ram Chandra, in a hospital in Jaipur, India has led to the
development of a solution to this problem: the Jaipur Foot. This artificial limb was developed using Chandra’s skill
as a sculptor and Sethi’s expertise and is so effective that those who wear it can run, climb trees and pedal bicycles.
It was designed to make use of low-tech materials and be simple to assemble, for example in Afghanistan craftsmen
hammer the foot together out of spent artillery shells, while in Cambodia part of the foot’s rubber components are
scavenged from truck tyres. Perhaps the greatest achievement has been to do all of this for a low cost: the Jaipur
Foot costs only $28 in India. Since 1975, nearly one million people worldwide have been fitted for the Jaipur limb
and the design is being developed and refined, for example using advanced new materials.
Not all innovation is necessarily good for everyone. One of the most vibrant entrepreneurial communities is in the
criminal world where there is a constant search for new ways of committing crime without being caught. The race
between the forces of crime and law and order is a powerful innovation arena — as work by Howard Rush and
colleagues have shown in their studies of cybercrime.

Six aspects of innovation

Innovation is about identifying or creating opportunities, new ways of serving existing markets, growing new markets,
rethinking services, meeting social needs and improving operations — doing what we do but better. Each of these aspects of
innovation is discussed below.

1: Identifying or creating opportunities

Innovation is driven by the ability to see connections, to spot opportunities and to take advantage of them. Sometimes this is
about completely new possibilities, for example by exploiting radical breakthroughs in technology. New drugs based on
genetic manipulation have opened a major new front in the war against disease. Mobile phones, tablets and other devices
have revolutionised where and when we communicate. Even the humble window pane is the result of radical technological
innovation — almost all the window glass in the world is made these days by the Pilkington float glass process which moved
the industry away from the time-consuming process of grinding and polishing to get a flat surface.

2: New ways of serving existing markets

Innovation isn’t just about opening up new markets; it can also offer new ways of serving established and mature ones. Low-
cost airlines are still about transportation, but the innovations firms like Southwest Airlines, easyJet and Ryanair have
introduced have revolutionised air travel and grown the market in the process. Despite a global shift in textile and clothing
manufacture towards developing countries, the Spanish company Inditex (through its retail outlets under various names,
including Zara) has pioneered a highly flexible, fast turnaround clothing operation with over 2000 outlets in 52 countries. It
was founded by Amancio Ortega Gaona, who set up a small operation in the west of Spain in La Coruña — a region not
previously noted for textile production — and the first store opened there in 1975. The company now has over 5000 stores
worldwide and is the world’s biggest clothing retailer; significantly, it is also the only manufacturer to offer specific
collections for northern and southern hemisphere markets. Central to the Inditex philosophy is close linkage between design,
manufacture and retailing and its network of stores constantly feeds back information about trends, which are used to
generate new designs. It also experiments with new ideas directly on the public, trying samples of cloth or design and
quickly getting back indi-cations of what is going to catch on. Despite its global orientation, most manufacturing is still done
in Spain, and it has managed to reduce the turnaround time between a trigger signal for an innovation and responding to it to
around 15 days.

3: Growing new markets

Equally important is the ability to spot where and how new markets can be created and grown. Alexander Bell’s invention of
the telephone didn’t lead to an overnight revolution in communications — that depended on developing the market for
person-to-person communications. Henry Ford may not have invented the motor car but in making the Model T — ‘a car for
Everyman’ at a price most people could afford — he grew the mass market for personal transportation. And eBay justifies its
multi-billion-dollar price tag not because of the technology behind its online auction idea but because it created and grew the
market.

4: Rethinking services
In most economies the service sector accounts for the vast majority of activity, so there is likely to be plenty of scope. And
the lower capital costs often mean that the opportunities for new entrants and radical change are greatest in the service sector.
Online banking and insurance have become commonplace but they have radically transformed the efficiencies with which
those sectors work and the range of services they can provide. New entrants riding the Internet wave have rewritten the rule
book for a wide range of industrial games, for example Amazon in retailing, eBay in market trading and auctions, Google in
advertising and Skype in telephony.

5: Meeting social needs

Innovation offers huge challenges — and opportunities — for the public sector. Pressure to deliver more and better services
without increasing the tax burden is a puzzle likely to keep many civil servants awake at night. But it’s not an impossible
dream: right across the spectrum there are examples of innovation changing the way the sector works. For example, in
healthcare there have been major improvements in efficiencies around key targets such as waiting times. Hospitals like the
Leicester Royal Infirmary in the UK or the Karolinska Hospital in Stockholm, Sweden have managed to make radical
improvements in the speed, quality and effectiveness of their care services, such as cutting waiting lists for elective surgery
by 75% and cancellations by 80%, through innovation.

6: Improving operations — doing what we do but better

At the other end of the scale Kumba Resources is a large South African mining company which makes another dramatic
claim: ‘We move mountains.’ In Kumba’s case, the mountains contain iron ore and the company’s huge operations require
large-scale excavation — and restitution of the landscape afterwards. Much of its business involves complex large-scale
machinery — and its ability to keep it running and productive depends on a workforce able to contribute innovative ideas on
a continuing basis.

Understanding innovation and entrepreneurship

Innovation matters — but it doesn’t happen automatically. It is driven by entrepreneurship — a potent mixture of vision,
passion, energy, enthusiasm, insight, judgement and plain hard work which enables good ideas to become reality. The power
behind changing products, processes and services comes from individuals — whether acting alone or embedded within
organisations — who make innovation happen. As the famous management writer Peter Drucker put it:5
Innovation is the specific tool of entrepreneurs, the means by which they exploit change as an opportunity for a different business or service. It is
capable of being presented as a discipline, capable of being learned, capable of being practised.

Innovation in action
Joseph Schumpeter

One of the most significant figures in this area of economic theory was Joseph Schumpeter, who wrote extensively on the
subject. He had a distinguished career as an economist and served as Minister for Finance in the Austrian government. His
argument was simple: entrepreneurs will seek to use technological innovation — a new product/service or a new process
for making it — to get strategic advantage. For a while, this may be the only example of the innovation so the
entrepreneur can expect to make a lot of money — what Schumpeter calls ‘monopoly profits’. But of course, other
entrepreneurs will see what he has done and try to imitate it — with the result that other innovations emerge, and the
resulting ‘swarm’ of new ideas chips away at the monopoly profits until an equilibrium is reached. At this point the cycle
repeats itself: our original entrepreneur or someone else looks for the next innovation that will rewrite the rules of the
game, and off we go again. Schumpeter talks of a process of ‘creative destruction’, where there is a constant search to
create something new which simultaneously destroys the old rules and establishes new ones — all driven by the search for
new sources of profits.
In his view ‘[what counts is] competition from the new commodity, the new technology, the new source of supply, the new
type of organisation … competition which … strikes not at the margins of the profits and the outputs of the existing firms
but at their foundations and their very lives.6

Entrepreneurship plays out on different stages in practice. One obvious example is the start-up venture in which the lone
entrepreneur takes a calculated risk to bring something new into the world. But entrepreneurship matters just as much to the
established organisation which needs to renew itself in what it offers and how it creates and delivers that offering. Internal
entrepreneurs — often labelled as ‘intrapreneurs’ or working in ‘corporate entrepreneurship’ or ‘corporate venture’
departments — provide the drive, energy and vision to take risky new ideas forward within that context.7 And of course, the
passion to change things may not be focused on creating commercial value but rather on improving conditions or enabling
change in the wider social sphere or in the direction of environmental sustainability — a field which has become known as
‘social entrepreneurship’.
This idea of entrepreneurship driving innovation to create value — social and commercial — across the lifecycle of
organisations is central to this subject. Table 1.1 gives some examples.
In this book, we use this lens to look at managing innovation and entrepreneurship. We’ll use three core concepts:
innovation. As a process which can be organised and managed, whether in a start-up venture or in renewing a 100-
year-old business
entrepreneurship. As the motive power to drive this process through the efforts of passionate individuals, engaged
teams and focused networks
creating value. As the purpose for innovation, whether expressed in financial terms, employment or growth,
sustainability or improvement of social welfare.

TABLE 1.1 Entrepreneurship and innovation

STAGE IN START-UP GROWTH SUSTAIN/SCALE RENEW

LIFECYCLE OF
AN
ORGANISATION
 STAGE IN START-UP GROWTH SUSTAIN/SCALE RENEW
LIFECYCLE OF
AN
ORGANISATION

Creating Individual entrepreneur Growing the business Building a portfolio of incremental Returning to the radical frame-
commercial value exploiting new through adding new and radical innovation to sustain breaking kind of innovation
technology or market products/services or the business and/or spread its which began the business and
opportunity moving into new influence into new markets enables it to move forward as
markets something very different

Creating social Social entrepreneur, Developing the ideas Spreading the idea widely, Changing the system — and then
value passionately concerned and engaging others in a diffusing it to other communities acting as agent for the next wave
to improve or change network for change — of social entrepreneurs, engaging of change
something in their perhaps in a region or links with mainstream players like
immediate environment around a key issue public sector agencies

 Innovation: the clever country 1.2 Innovation isn’t easy! 

1.2 INNOVATION ISN’T EASY!
Learning objective 2
explain the difficulties in managing what is an uncertain and risky process

Coming up with good ideas is what human beings are good at — we have this facility already fitted as standard equipment in
our brains! But taking those ideas forward is not quite so simple, and most new ideas fail. It takes a particular mix of energy,
insight, belief and determination to push against these odds; it also requires judgement to know when to stop banging against
the brick wall and move on to something else.
It’s important here to remember a key point: new ventures often fail, but it is the ventures which are failures rather than the
people who launched them. Successful entrepreneurs recognise that failure is an intrinsic part of the process. They learn from
their mistakes, understanding where and when timing, market conditions, technological uncertainties, etc. mean that even a
great idea isn’t going to work. But they also recognise that the idea may have had its weaknesses but that they have not failed
themselves but rather learnt some useful insights to carry over to their next venture.

Innovation in action
Failure breeds success

Thomas Edison was a pretty successful entrepreneur with over 1000 patents to his name and the reputation for bringing
many key technologies into widespread use, including the phonograph, the electric telegraph and the light bulb; he also
founded the General Electric Company, which is still a major player today. He is famous for his attitude towards failure,
typified by the search for the right material to make the filament for his incandescent light bulb, where he explored over
1000 different options. He is reported as having said that the process did not involve failure so much as ‘the elimination of
a design that didn’t work, so we must be getting close’.

While the road for an individual entrepreneur may be very rocky with a high risk of hitting potholes, running into roadblocks
or careering off the edge, it doesn’t get any easier if you are a large established company. It’s a disturbing thought but the
majority of companies have a lifespan significantly less than that of a human being. Even the largest firms can show
worrying signs of vulnerability, and for the smaller firm the mortality statistics are bleak.
Many SMEs fail because they don’t see or recognise the need for change. They are inward looking, too busy fighting fires
and dealing with today’s crises to worry about storm clouds on the horizon. Even if they do talk to others about the wider
issues, it is very often to people in the same network and with the same perspectives, for example the people who supply
them with goods and services or their immediate customers. The trouble is that by the time they realise there is a need to
change it may be too late.
But it isn’t just a small firm problem. There is no guaranteed security in size or in previous technological success. Take the
case of IBM — a giant firm which can justly claim to have laid the foundations of the IT industry and came to dominate the
architecture of hardware and software and the ways in which computers were marketed. But such core strength can
sometimes become an obstacle to seeing the need for change — as proved to be the case when, in the early 1990s, the
company moved too slowly to counter the threat of networking technologies — and nearly lost the business in the process.
Thousands of jobs and billions of dollars were lost and it took years of hard work to bring the share price back to the high
levels which investors had come to expect.
One problem for successful companies occurs when the very things which helped them achieve success — their ‘core
competencies’ — become the things which make it hard to see or accept the need for change. Sometimes the response is ‘not
invented here’: the new idea is recognised as good but in some way not suited to the business.

Innovation in action
 The ‘not invented here’ problem

A famous example of ‘not invented here’ was the case of Western Union, which, in the 19th century, was probably the
biggest communications company in the world. It was approached by one Alexander Graham Bell, who wanted the
company to consider helping him commercialise his new invention. After mounting a demonstration to senior executives,
he received a written reply which said, ‘after careful consideration of your invention, which is a very interesting novelty,
we have come to the conclusion that it has no commercial possibilities … We see no future for an electrical toy.’ Within
four years of the invention, there were 50 000 telephones in the USA and within 20 years five million. Over the next 20
years, the company which Bell formed grew to become the largest corporation in the USA.

Sometimes the pace of change appears slow and the old responses seem to work well. It appears, to those within the industry
that they understand the rules of the game and have a good grasp of the relevant technological developments likely to change
things. But what can sometimes happen here is that change comes along from outside the industry — and by the time the
main players inside have reacted it is often too late.

Innovation in action
The melting of the ice industry
In the late 19th century, there was a thriving industry in New England based upon the harvesting and distribution of ice. In
its heyday, it was possible for ice harvesters to ship hundreds of tons of ice around the world on voyages that lasted as
long as six months — and still have over half the cargo available for sale. By the late 1870s, the 14 major firms in the
Boston area of the USA were cutting around 700 000 tons per year and employing several thousand people. But the
industry was completely overthrown by the new developments which followed from the invention of refrigeration and the
growth of the modern cold storage industry.
A case study of the ice industry is available on the Innovation Portal.

Of course, for others these conditions provide an opportunity for moving ahead of the game and writing a new set of rules.
Think about what has happened in online banking, call-centre-linked insurance or low-cost airlines. In each case, the existing
stable pattern has been overthrown, disrupted by new entrants coming in with new and challenging business models. For
many managers business model innovation is seen as the biggest threat to their competitive position, precisely because they
need to learn to let go of their old models as well as learn new ones. We also need to see that while for established
organisations these crises are a problem, they represent a rich source of opportunity for entrepreneurs looking to disrupt an
established order and create value in new ways.
In many cases the individual enterprise can renew itself, adapting to its environment and moving into new things. Consider
the example of the Stora company in Sweden: founded in the 13th century as a timber cutting and processing operation it still
thrives today — albeit in the very different areas of food processing and electronics.
All of these examples point to the same conclusion. Organisations need entrepreneurship at all stages in their lifecycle, from
start-up to long-lived survival. The ability to recognise opportunities, pull resources together in creative ways, implement
good ideas and capture the value from them are core skills.

 1.1 Innovation matters 1.3 Sources of innovation 

1.3 SOURCES OF INNOVATION
Learning objective 3
list some sources of innovation, both from within companies or industries and in the social environment

Most innovations result from methodically analysing seven areas of opportunity, some of which lie within particular
companies or industries, and some of which lie in broader social or demographic trends.8

Sources of innovation within companies or industries

Drucker9 identified four such areas of opportunity within a company or an industry:

1. Unexpected occurrences. Unexpected successes and failures are productive sources of innovation because most people
and businesses dismiss them, disregard them and even resent them.10 Many innovations are the result of unexpected
successes, particularly in the pharmaceutical industry. For example, the antibacterial effect of penicillin was discovered
accidentally by Alexander Fleming in 1928. The discovery of the Pfizer blockbuster Viagra was also an accident. In
1991, a group of scientists at Pfizer, led by Andrew Bell, David Brown and Nicholas Terrett, discovered a series of
chemical compounds that were useful in treating heart problems such as angina. The compounds were patented as
Sildenafil. In 1994, Terrett discovered during the trial studies of Sildenafil as a heart medicine that it also allowed men
to reverse erectile dysfunction. The drug acts by enhancing the smooth muscle relaxant effects of nitric oxide, a
chemical that is normally released in response to sexual stimulation.11
2. Incongruities. These occur whenever a gap exists between expectations and reality. For example, in 1971, when Fred
Smith proposed overnight mail delivery, he was told: ‘If it were profitable, the US Postal Office would be doing it.’12
It turned out Smith was right. An incongruity existed between what Smith felt was needed and the way business was
currently conducted — and Federal Express, the world’s first overnight delivery network, was born in the United
States.13
3. Process needs. These exist whenever a demand arises for the entrepreneur to innovate as a way of answering a
particular need. For example, eye surgeons long knew how to perform cataract surgery. An enzyme that made the
process easier had been known for decades, but was not usable because it was too hard to preserve. In the 1950s an
entrepreneur named William Conner figured out how to preserve the enzyme. He and a colleague set-up the Alcon
Prescription Laboratory (now Alcon Laboratories Inc.) to manufacture and market this new product.
4. Industry and market changes. There are continual shifts in the marketplace, which are caused by changes in consumer
attitudes, advances in technology and industry growth. Industries and markets undergo changes in structure, design and
definition. When market or industry structures change, traditional industry leaders often ignore the fastest growing
market segments.14 New opportunities rarely fit the way the industry has always approached the market, defined it or
organised to serve it. An example is found in the healthcare industry in South-East Asia, where private medical centres
are imitating five-star hotels to win a share of wealthy sick customers.

Sources of innovation in the social environment

Three additional sources of opportunity exist outside a company in its social and intellectual environment:

5. Demographic changes. Of the external sources of innovation opportunity, demographics are the most reliable.15
Census data, for instance, provide a precise picture of the actual demographic structure of a country, and from these
data it is relatively easy to extrapolate the future age structure. In Australia and New Zealand, two countries that have
integrated a large number of migrants over the past decades, ‘ethnic food’ is one of the fastest growing market
opportunities for entrepreneurs. Another demographic trend in the industrialised countries is the ageing population.
This creates many opportunities in the field of assistive technology.
6. Perceptual changes. Sometimes the members of a community can change their interpretation of facts and concepts,
and thereby open up new opportunities. What determines whether people see a glass as half full or half empty is mood
 rather than fact, and a change in mood often defies quantification.16 But it is not esoteric. It is concrete and it can be
tested and exploited for innovation opportunity. Perceptual changes can particularly affect dimensions, such as
acceptability, beauty, time and distance. For example, commuters living in suburbs of big cities often perceive a 50-
kilometre or one-hour journey to their workplace as acceptable, whereas residents in small towns would not.
7. New knowledge. Among history-making innovations, those based on new knowledge — whether scientific, technical
or social — rank high. Knowledge-based innovations differ from all others in the time they take, in their casualty rates,
and in their predictability, as well as in the challenges they pose to entrepreneurs.17 They have, for instance, the
longest lead time of all innovations. To become effective, innovation of this sort usually demands many kinds of
knowledge.18 Innovations in bioscience are a case in point. In recent innovations awards organised by The Economist,
the category receiving the largest number of nominations was bioscience.19 Interestingly, many of these could just as
easily have been classified under nanotechnology. Clearly, innovations in bioscience are built on the combination of
new knowledge from several fields.

 1.2 Innovation isn’t easy! 1.4 Different types of innovation 

1.4 DIFFERENT TYPES OF INNOVATION
Learning objective 4
discuss different innovation types

Ideas are not enough for innovation, let alone entrepreneurship, to occur. Many people who are full of ideas simply do not
understand how an organisation operates in order to get things done, especially new things. Too often there is an assumption
that creativity automatically leads to actual innovation, but this is not true. Once a business opportunity or idea has been
identified, it needs to be shaped and assessed, and eventually it has to materialise in a prototype, formula, patent or business
plan.
Entrepreneurship can occur with little, if any, innovation. Most of the ‘new’ products and services launched in the
marketplace, and the business ventures set-up to produce them, are more or less copycats. Thus, the presence of innovation is
viewed as a sufficient condition for entrepreneurship but not a necessary one.20 Moreover, newness or uniqueness of
innovation is a matter of degree, in terms of the tangible characteristics and the relevant market.
It is therefore important to understand that innovation is a multidimensional concept, and that it is not necessary to reinvent
the wheel to become an entrepreneur. For example, it is possible to innovate along several dimensions — product, service
and process. In addition, the extent of innovation can vary greatly. For example, technological product innovation can be
accompanied by additional managerial and organisational changes. This section discusses the various categories of
innovation.

Incremental versus disruptive (radical) innovation

When defined as an outcome, innovation is the tangible product, service or process that is adaptable or diffusable, meaning it
can be used in various contexts by different individuals. On a macro level, however, the change in condition, outcome or
relationship that results from the innovation process itself may be either incremental or disruptive.21 The characteristics of
incremental versus radical innovations are presented in table 1.2.

TABLE 1.2 Characteristics of incremental and disruptive innovation

INCREMENTAL INNOVATION DISRUPTIVE (RADICAL) INNOVATION

Steady improvements Fundamental rethink

Based on sustaining technologies Based on disruptive technologies

Obedience to cultural routines and norms Experimentation and play/make-believe

Can be rapidly implemented Need to be nurtured for long periods

Immediate gains Worse initial performance, potential big gains

Develop customer loyalty Create new markets

Incremental innovation
Incremental innovations are improvements of existing products that enhance performance in dimensions traditionally valued
by mainstream customers.22 They make existing products and services better. Such innovations include, for example, bigger,
more powerful mainframe computers. They usually come from tweaking existing designs and listening to big clients, who
usually just want steady improvements that yield higher margins. Incremental innovations use established technologies and
can be easily and rapidly implemented. Such innovations are a strong suit for established companies that continuously
improve their products. But they almost inevitably hit a point at which they offer more quality or features than customers
need, want or can afford. In pursuing higher margin business from demanding customers, established firms sacrifice the low
end. This creates openings for disruptive innovations, which usually debut at the bottom of the market, among new
customers.
Whatever the type of innovation, it remains fundamentally an application of knowledge. This notion lies at the heart of all
types of innovation, be they product-, service- or process-oriented and disruptive or incremental. Table 1.3 lists some
examples of incremental innovations with this central characteristic (application of knowledge) in mind.

TABLE 1.3 Types of incremental innovation

TYPE OF PRINCIPLE AND EXAMPLE

INNOVATION

Extension Improvement or new use of an existing product, service or process, such as the development of desktop, notebook and laptop
computers based on the mainframe.

Duplication Creative replication or adaptation of an existing product, service or concept. Duplication can take place across different markets
or industries, e.g. fast-food chicken outlets such as Chicken Treat or Red Rooster in Australia were adapted from the Kentucky
Fried Chicken model from the USA; or the franchise may be adapted to suit a variety of sectors such as petrol stations, cleaning
and childcare, with the concept having originated in the fast-food industry.

Synthesis Combination of an existing product, service or process into a new formulation or use, such as the fax (telephone + photocopier)
or the multi-purpose smartphone (telephone + camera + organiser + internet + music player + GPS).

Disruptive (radical) innovation

Conversely, disruptive innovations change the value proposition. Disruptive innovations, such as personal computers,
underperform existing products but they are also simpler, less expensive, more convenient, adequate and easier to use. They
cause fundamental changes in the marketplace. Such innovations are based on new technologies, and often present teething
problems that ruin the clients’ bottom line.23 Inevitably, breakthrough innovations require a foundational rethink. Sometimes
they come from dusting off ideas that failed to make it in the past, but more often they are caused by the outright
stubbornness of would-be entrepreneurs who refuse to abandon their pet ideas.
The process of making incremental improvements is far removed from creating game-changing innovation.24 Important as
they are, steady improvements to a company’s product range do not conquer new markets. Existing corporations, therefore,
face the difficulty of choosing between sustaining technologies, which deliver improved product performance, and disruptive
ones, which may initially result in a worse performance. This is what Christensen called the ‘innovator’s dilemma’.25 The
genuinely important breakthrough innovations built on disruptive technologies are initially rejected by clients who cannot
currently use them. This rejection can lead firms with a strong client focus to allow their most important innovations to
languish. The fatal flaw in these firms is their failure to create new markets and find new customers for these products of the
future.26 As they unknowingly bypass opportunities, they open the door for more flexible, entrepreneurial companies to
capitalise on the next great wave of industry growth. The transistor was a disruptive technology for the vacuum-tube industry
in the 1950s, just as the personal computer disrupted the typewriter industry in the 1980s.27
As shown in table 1.4, entrepreneurs seeking to create value through disruptive innovations can take one of three basic
approaches, each of which is suited to certain circumstances.

TABLE 1.4 Disruptive approaches

1. The back-scratcher: scratch an unscratched itch

What it is: Makes it easier and simpler for people to get an important job done
When it works best: When customers are frustrated by their inability to get a job done, and competitors are either fragmented or have a disability
that prevents them from responding
Historical examples: Federal Express, mobile phones
Current examples: Procter & Gamble Swiffer products, instant messaging technology
 2. The extreme makeover: make an ugly business attractive
What it is: Find a way to prosper at the low end of established markets by giving people good enough solutions at low prices
When it works best: When target customers don’t need and don’t value all the performance that can be packed into products, and when existing
competitors don’t focus on low-end customers
Historical examples: Nucor’s mini-mill, backpacker accommodation
Current examples: Budget airlines such as AirAsia, Jetstar Asia, Tiger Airways, Virgin Blue

3. The bottleneck buster: democratise a limited market

What it is: Expand a market by removing a barrier to consumption
When it works best: When some customers are locked out of a market because they lack skills, access or wealth. Competitors ignore initial
developments because they take place in seemingly unpromising markets.
Historical examples: Personal computers, Sony Walkman, eBay
Current examples: Blogs, home diagnostics, social networks such as Facebook or Twitter

Source: Adapted from S. D. Anthony & L. Gibson, ‘Mapping your innovation strategy’, Harvard Business Review, May 2006, p. 107. Copyright ©
2006 by the Harvard Business School Publishing Corporation; all rights reserved. Reprinted by permission of Harvard Business Review.

Cost innovation
Traditional thinking associates innovation with new product/service development or added functionality, for which customers
are expected to pay a premium. Although innovating to provide products of on-par or greater functionality at lower prices
seems counterintuitive, some savvy companies in emerging markets have done so, in order to attract value-conscious
consumers. This ‘value for money’ segment, which comprises people who ascribe importance to efficiency (doing the same
for less), effectiveness (doing more at the same cost) or economy (doing and spending less), is expected to grow in emerging
markets and developed countries alike.28
Products or services that in some aspects appear inferior, despite their greater affordability and ease-of-use, are cost
innovation strategies, disruptive to current offerings. Emerging giants initially relied on cheaper labour to produce low cost
products and services, but now others are using cost innovation to gain a competitive advantage. This capability not only
helps those entrepreneurs establish a stronghold in their home countries, but also allows them to crack the value-for-money
segments in developed markets.29
Cost innovation can be delivered in three ways:
Selling high-end products at mass-market prices. Consider Aravind, the world’s largest eye-hospital chain, based in
Madurai, India. Aravind’s founders used a pricing structure tiered so that wealthier patients were charged more (for
example, for better meals or air-conditioned rooms), allowing the firm to cross-subsidise care for the poorest. In
addition, the company benefits from economies of scale: its staff screens over 2.7 million patients a year via clinics in
remote areas, and refers over 285 000 of them for surgery at its hospitals.30 Aravind’s model does not just depend on
providing affordable services on a large scale, but on a clever combination of pricing, scale, technology and process.
Offering choice or customisation to value customers. China’s Goodbaby sells customers 1600 kinds of children’s
strollers, car seats, bassinets, baby walkers, high chairs, and tricycles — four times more than its rivals offer but at
comparable prices. The Shanghai-based company offers a wide range of products that meet practically every need,
from strollers that can handle uneven surfaces to those that fold away with a few simple movements. As a A$500
million company, Goodbaby can do this, in part, because it invests 4 per cent of its annual revenues in R&D, which is
twice the average for the toy industry.31
Turning niches into mass markets (see approach 3 in table 1.4). China’s Haier captured 60 per cent of the US wine-
refrigerator market in less than a decade by lowering prices so much that a small, under-guarded niche became a
volume business.

New product development

No product or brand remains the same. Markets are in a perpetual state of change, and organisations find it necessary to
enhance the product characteristics or product mix to meet the changing needs of their customers. The first stage of the
product life cycle involves new product development, commonly abbreviated to ‘NPD’. This is a crucial time for the
product as it is the stage at which the product benefits can be maximised and faults and problems minimised. There are also
several ways that a new product can be viewed depending on the organisation and the technology. What may be classified as
a new product includes:

1. new to the market — a new technology that has never been seen before
2. new to the company — a product already in the marketplace but this is the first time it has been produced by a certain
company
3. new to the product line — a product that is an extension of whatever the company currently produces
4. new to the product — modifications, enhancements and improvements to a specific product that will revitalise it and
move it into a growth stage in the product life cycle.

Although research and development can be expensive, the organisation should make the appropriate investment. Achieving
the organisation’s goals depends on successful new products. A poor or unappealing product will fail to generate profits and
may even damage the organisation’s reputation and brand. It is, therefore, extremely important to undertake research to test
the suitability of the new product with the target market in the current market environment.

 1.3 Sources of innovation 1.5 What do successful innovators

and entrepreneurs do? 
1.5 WHAT DO SUCCESSFUL INNOVATORS AND
ENTREPRENEURS DO?
Learning objective 5
understand the key practices of successful innovators and entrepreneurs

While most organisations have comparatively modest lifespans, some have survived at least one and sometimes multiple
centuries. Looking at the experience of these ‘100 club’ members — firms like 3M, Corning, Procter & Gamble, Reuters,
Siemens, Philips and Rolls-Royce — we can see that much of their longevity is down to having developed a capacity to
innovate on a continuing basis. They have learnt, often the hard way, how to manage the process of innovation and,
importantly, how to repeat the trick. Any organisation can get lucky once but sustaining it for a century or more suggests
there’s a bit more to it than that.
It’s the same with individuals: ‘serial entrepreneurs’ may start many different businesses and what they bring to the party is
an accumulated understanding of how to do it better. They have learnt and built long-term capability into a robust set of
skills.
Over the past hundred years, there have been many attempts to answer the question of whether we can manage innovation.
Researchers have looked at case examples, at sectors, at entrepreneurs, at big firms and small firms, at success and failure.
Practising entrepreneurs and innovation managers in large businesses have tried to reflect on the ‘how’ of what they do. The
key messages come from the world of experience. What we’ve learnt comes from the laboratory of practice rather than some
deeply rooted theory.
The key messages from this knowledge base are that successful innovators:

1. explore and understand the dimensions of innovation

2. manage innovation as a process
3. develop innovation capability
4. create an innovation strategy
5. build dynamic capability.

In the following sections we’ll explore each of these themes in a little more detail.

1. Explore and understand the dimensions of innovation

One approach to finding an answer to the question of where we could innovate is to use a kind of ‘innovation compass’
exploring different possible directions.
Innovation can take many forms but we can map the options along four dimensions, as shown in table 1.5.

TABLE 1.5 Dimensions for innovation32

DIMENSION TYPE OF CHANGE

Product Changes in the things (products/services) an organisation offers

Process Changes in the ways these offerings are created and delivered

Position Changes in the context into which the products/services are

introduced

Paradigm Changes in the underlying mental models which frame what the
organisation does
For example, a new design of car, a new insurance package for accident-prone babies and a new home-entertainment system
would all be examples of product innovation. And change in the manufacturing methods and equipment used to produce the
car or the home-entertainment system, or in the office procedures and sequencing in the insurance case, would be examples
of process innovation.
Sometimes the dividing line is somewhat blurred. For example, a new jet-powered sea ferry is both a product and a process
innovation. Services represent a particular case of this where the product and process aspects often merge. For example, is a
new holiday package a product or process change?
Innovation can also take place by repositioning the perception of an established product or process in a particular user
context. For example, an old-established product in the UK is Lucozade, originally developed as a glucose-based drink to
help children and invalids in convalescence. These associations with sickness were abandoned by the brand owner,
Beechams (part of GlaxoSmithKline), when it relaunched the product as a health drink aimed at the growing fitness market,
where it is now presented as a performance-enhancing aid to healthy exercise. In 2014, the brand was sold to Suntory for
around $1.35bn. This shift is a good example of ‘position’ innovation. In similar fashion Häagen Dazs created a new market
for ice cream, essentially targeted at adults, through position innovation rather than changing the product or core
manufacturing process.
Sometimes opportunities for innovation emerge when we reframe the way we look at something. Henry Ford fundamentally
changed the face of transportation not because he invented the motor car (he was a comparative latecomer to the new
industry) or because he developed the manufacturing process to put one together (as a craft-based specialist industry car-
making had been established for around 20 years). His contribution was to change the underlying model from one which
offered a hand-made specialist product to a few wealthy customers to one which offered a car for Everyman at a price he
could afford. The ensuing shift from craft to mass production was nothing short of a revolution in the way cars (and later
countless other products and services) were created and delivered. Of course, making the new approach work in practice also
required extensive product and process innovation, for example in component design, in machinery building, in factory
layout and particularly in the social system around which work was organised.
Examples of ‘paradigm’ innovation — changes in mental models — include the shift to low-cost airlines, the provision of
online insurance and other financial services and the repositioning of drinks like coffee and fruit juice as premium ‘designer’
products. They involve a shift in the underlying vision about how innovation can create social or commercial value. The term
‘business model’ is increasingly used and this is another way of thinking about ‘paradigm innovation’.
Paradigm innovation can be triggered by many different things: new technologies, the emergence of new markets with
different value expectations, new legal rules of the game, new environmental conditions (climate change, energy crises), etc.
For example, the emergence of internet technologies made possible a complete reframing of how we carry out many
businesses. In the past, similar revolutions in thinking were triggered by technologies like steam power, electricity, mass
transportation (via railways and, with motor cars, roads) and microelectronics. And it seems very likely that similar
reframing will happen as we get to grips with new technologies like nanotechnology or genetic engineering.

2. Manage innovation as a process

Rather than the cartoon image of a light bulb flashing on above someone’s head, we need to think about innovation as an
extended sequence of activities — as a process. Whether we are looking at an individual entrepreneur bringing their idea into
action or a multi-million-dollar corporation launching the latest in a stream of new products, the same basic framework
applies.
We can break it down to the four key steps we mentioned earlier:

1. recognising the opportunity

2. finding the resources
3. developing the idea
4. capturing value.

Figure 1.1 illustrates this model.

FIGURE 1.1 A model of the innovation and entrepreneurial process

1: RECOGNISING THE OPPORTUNITY

Innovation triggers come in all shapes and sizes and from all sorts of directions. They could take the form of new
technological opportunities or changing requirements on the part of markets. They could be the result of legislative pressure
or competitor action. They could be a bright idea occurring to someone as they sit, Archimedes-like, in their bathtub. They
could come as a result of buying in a good idea from someone outside the organisation. Or they could arise from
dissatisfaction with social conditions or a desire to make the world a better place in some way.
The message here is clear: if we are going to pick up these trigger signals then we need to develop some pretty extensive
antennae for searching and scanning around us — and that includes some capability for looking into the future.

2: FINDING THE RESOURCES

The trouble with innovation is that it is by its nature a risky business. You don’t know at the outset whether what you decide
to do is going to work out or even that it will run at all. Yet you have to commit some resources to begin the process. So how
do you build a portfolio of projects which balance the risks and the potential rewards? (Of course, this decision is even
tougher for the first-time entrepreneur trying to launch a business based on his or her great new idea — the choice there is
whether to go forward and commit what may be a huge investment of personal time, the mortgage, family life, etc. Even if
they succeed, there is then the problem of trying to grow the business and needing to develop more good ideas to follow the
first.)
So this stage is very much about strategic choices. Does the idea fit a business strategy, does it build on something we know
about (or where we can get access to that knowledge easily) and do we have the skills and resources to take it forward? And
if we don’t have those resources, which is often the case with the lone entrepreneur at start-up, how will we find and mobilise
them?

3: DEVELOPING THE IDEA

Having picked up relevant trigger signals, made a strategic decision to pursue some of them and found and mobilised the
resources we need, the next key phase is actually turning those potential ideas into some kind of reality. In some ways this
implementation phase is a bit like making a kind of ‘knowledge tapestry’, by gradually weaving the different threads of
knowledge (about technologies, markets, competitor behaviour, etc.) into a successful innovation.
Early on it is full of uncertainty but gradually the picture becomes clearer — but at a cost. We have to invest time and money
and find people to research and develop ideas and conduct market studies, competitor analysis, prototyping, testing, etc. in
order to gradually improve our understanding of the innovation and whether it will work. Eventually, it is in a form which
can be launched into its intended context — an internal or external market — and then further knowledge about its adoption
(or otherwise) can be used to refine the innovation. Developing a robust business plan which takes all of this into
consideration at the outset is one of the key elements in entrepreneurial success.
Throughout this implementation phase, we have to balance creativity — finding bright ideas and new ways to get around the
thousand and one problems which emerge and get the bugs out of the system — with control — making sure we keep to
some kind of budget on time, money and resources. This balancing act means that skills in project management around
innovation, with all its inherent uncertainties, are always in high demand! This phase is also where we need to bring together
different knowledge sets from many different people — so combining them in ways which help rather than hinder the
process and raise big questions around teambuilding and management.
It would be foolish to throw good money after bad, so most organisations make use of some kind of risk management as they
implement innovation projects. By installing a series of ‘gates’ as the project moves from a gleam in the eye to an expensive
commitment of time and money, it becomes possible to review and if necessary redirect or even stop something which is
going off the rails. For the solo entrepreneur it is in this stage that judgement is needed — and sometimes the courage to
know when to stop and move on, to let go and start again on something else.
Eventually, the project is launched into some kind of marketplace: externally, people who might use the product or service or,
internally, people who make the choice about whether to buy into the new process being presented to them. Either way, we
don’t have a guarantee that just because the innovation works and we think it the best thing since sliced bread they will feel
the same way. Innovations diffuse across user populations over time. Usually, the process follows some kind of S-curve
shape. A few brave souls take on the new idea and then gradually, assuming it works for them, others get on the bandwagon
until finally there are just a few diehards (laggards) who resist the temptation to change. Managing this stage well means we
need to think ahead about how people are likely to react and build these insights into our project before we reach the launch
stage — or else work hard at persuading them after we have launched it!

4: CAPTURE VALUE
Despite all our efforts in recognising opportunities, finding resources and developing the venture, there is no guarantee we
will be able to capture the value from all our hard work. We also need to think about, and manage, the process to maximise
our chances — through protecting our intellectual property and the financial returns if we are engaged in commercial
innovation or in scaling and spreading our ideas for social change so that they are sustainable and really do make a
difference. We also have an opportunity at the end of an innovation project to look back and reflect on what we have learnt
and how that knowledge could help us do things better next time. In other words, we could capture valuable learning about
how to build our innovation capability.

THE CONTEXT OF SUCCESS

It’s all very well putting a basic process for turning ideas into reality in place. But it doesn’t take place in a vacuum. It is
subject to a range of internal and external influences that shape what is possible and what actually emerges. This process
doesn’t take place in a vacuum; it is shaped and influenced by a variety of factors. In particular, innovation needs:
Clear strategic leadership and direction, plus the commitment of resources to make this happen. Innovation is about
taking risks, about going into new and sometimes completely unexplored spaces. We don’t want to gamble, simply
changing things for their own sake or because the fancy takes us. No organisation has resources to waste in that
scattergun fashion: innovation needs a strategy. But, equally, we need to have a degree of courage and leadership,
steering the organisation away from what everyone else is doing or what we’ve always done and towards new spaces.
In the case of the individual entrepreneur this challenge translates to one in which a clear personal vision can be shared
in ways which engage and motivate others to buy into it and to contribute their time, energy, money, etc. to help make
it happen. Without a compelling vision, it is unlikely the venture will get off the ground.
An innovative organisation in which the structure and climate enables people to deploy their creativity and share their
knowledge to bring about change. It’s easy to find prescriptions for innovative organisations which highlight the need
to eliminate stifling bureaucracy, unhelpful structures, brick walls blocking communication and other factors stopping
good ideas getting through. But we must be careful not to fall into the chaos trap. Not all innovation works in organic,
loose, informal environments or ‘skunk works’; indeed, these types of organisation can sometimes act against the
 interests of successful innovation. We need to determine appropriate organisation, that is the most suitable organisation
given the operating contingencies. Too little order and structure may be as bad as too much.
This is one area where start-ups often have a major advantage — by definition they are small organisations (often one-
person ventures) with a high degree of communication and cohesion. They are bound together by a shared vision and
they have high levels of cooperation and trust, giving them enormous flexibility. But the downside of being small is a
lack of resources, and so successful start-ups are very often those which can build a network around them through
which they can tap into the key resources they need. Building and managing such networks is a key factor in creating
an extended form of organisation.
Proactive links across boundaries inside the organisation and to the many external agencies who can play a part in the
innovation process: suppliers, customers, sources of finance, skilled resources and of knowledge, etc. Twenty-first-
century innovation is most certainly not a solo act but a multiplayer game across boundaries inside the organisation
and to the many external agencies who can play a part in the innovation process. These days it’s about a global game
and one where connections and the ability to find, form and deploy creative relationships is of the essence. Once again,
this idea of successful lone entrepreneurs and small-scale start-ups as network builders is critical. It’s not necessary to
know or have everything to hand but to know where and how to get it.
Figure 1.2 shows the resulting model: what we need to pay attention to if we are going to manage innovation well.

FIGURE 1.2 The resulting model: What we need to pay attention to if we are going to manage innovation well

3. Develop innovation capability

What are the actions involved in innovation and how can we use this understanding to help us manage the process better?
What comes into our minds when we think of innovation taking place?
One of the problems we have in managing anything is that how we think about it shapes what we do about it. So if we have a
simplistic model of how innovation works, for example that it’s just about invention, that’s what we will organise and
manage. We may end up with the best invention department in the world, but there is no guarantee that people will ever
actually want any of our wonderful inventions! If we are serious about managing innovation, we need to check on our mental
models and make sure we’re working with as complete a picture as possible. Otherwise, we run risks like those in table 1.6.
TABLE 1.6 The problem with partial models

IF INNOVATION IS ONLY …THE RESULT CAN BE

SEEN AS…

Strong R&D capability Technology which fails to meet user needs and may not be accepted: ‘the better mousetrap nobody wants’

The province of specialists in white Lack of involvement of others, and a lack of key knowledge and experience input from other perspectives
coats in the R&D laboratory

Meeting customer needs Lack of technical progression, leading to inability to gain competitive edge

Technological advances Producing products the market does not want or designing processes which do not meet the needs of the
user and are opposed

The province of large firms Weak small firms with too high a dependence on large customers

Breakthrough changes Neglect of the potential of incremental innovation. Also an inability to secure and reinforce the gains from
radical change because the incremental performance ratchet is not working well

Associated with key individuals Failure to utilise the creativity of the remainder of employees, and to secure their inputs and perspectives to
improve innovation

Internally generated The ‘not invented here’ effect, where good ideas from outside are resisted or rejected

Externally generated Innovation becomes simply a matter of filling a shopping list of needs from outside and there is little
internal learning or development of technological competence

CONFIGURING THE INNOVATION PROCESS: BUILDING CAPABILITY

Whatever their size or sector, all organisations are trying to find ways of managing this process of growth and renewal. There
is no right answer: every organisation needs to aim for the most appropriate solution for its particular circumstances. They
develop their own particular ways of doing things and some work better than others. Any organisation can get lucky once but
the real skill in innovation management is being able to repeat the trick. And while there are no guarantees, there is plenty of
evidence to suggest that firms can and do learn to manage the process for success, by consciously building and developing
their innovation capability.
These issues apply across the board, though solutions to them may take us in different directions depending on where we
start from. A start-up business may not need much in the way of a formal and structured process for organising and managing
innovation. But a firm the size of Nokia will need to pay careful attention to structures and procedures for building a strategic
portfolio of projects to explore and for managing the risks as the project moves from ideas into technical and commercial
reality. Equally, a large firm may have extensive resources to build a global set of networks to support its activities, whereas
a start-up may be vulnerable to threats from elements in its environment it simply didn’t know about, never mind being
connected to.
This core process runs through any successful innovation, from a lone entrepreneur right up to IBM or GlaxoSmithKline. Of
course, making the model work in practice requires configuring it for different situations, for example in a large company
‘recognising the opportunity’ may involve a large R&D department, a market research team, a design studio, etc., whereas all
of this could go on in a lone entrepreneur’s head. Finding the resources may involve bringing different departments together
in a large organisation, but a lone innovator will have to create networks. Attracting support may involve a lone entrepreneur
making a pitch to venture capitalists, whereas in a large organisation the business case may be put to a monthly project
portfolio meeting.
Allowing for the fact that we will organise and manage in different ways depending on different kinds of organisations, it is
still possible to identify some generic recipes or conditions that help the innovation process to happen effectively. But one of
the most important points to make at the outset is that organisations and individuals aren’t born with the capability to
organise and manage this process: they learn and develop it over time, and mainly through a process of trial and error. They
hang on to what works and develop their capabilities in that — and they try to drop those things which don’t work.
For example, successful innovation correlates strongly with how a firm selects and manages projects, how it coordinates the
inputs of different functions, how it links up with its customers, etc. Successful innovators acquire and accumulate technical
resources and managerial capabilities over time; there are plenty of opportunities for learning — through doing, using,
working with other firms, asking the customers, etc.—but they all depend upon the readiness of the organisation to see
innovation less as a lottery than as a process which can be continuously improved.
Another critical point to emerge from research is that innovation needs managing in an integrated way; it is not enough just
to be good at one thing. It’s less like running a 100-metre sprint than developing the range of skills to compete effectively in
a range of events in the pentathlon.

Innovation in action
Making ideas happen

If someone asked you, ‘When did you last use your Spengler?’ they might well be greeted by a quizzical look. But if they
asked you when you last used your ‘Hoover’, the answer would be fairly easy. Yet it was not Mr Hoover who invented the
vacuum cleaner in the late 19th century but one J. Murray Spengler. Hoover’s genius lay in taking that idea and making it
a commercial reality. In similar vein, the father of the modern sewing machine was not Mr Singer, whose name jumps to
mind and is emblazoned on millions of machines all round the world. It was Elias Howe, who invented the machine in
1846 and Singer who brought it to technical and commercial fruition. Perhaps the godfather of them all in terms of turning
ideas into reality was Thomas Edison, who during his life registered over 1000 patents. Products for which his
organisation was responsible include the light bulb, 35mm cinema film and even the electric chair. Many of the inventions
for which he is famous weren’t in fact invented by him — the electric light bulb, for example — but were developed and
polished technically and their markets opened up by Edison and his team. More than anyone else Edison understood that
invention is not enough — simply having a good idea is not going to lead to its widespread adoption and use.

4. Create an innovation strategy

Building a capability to organise and manage innovation is a great achievement, but unless that capability is pointed in a
suitable direction the organisation risks being all dressed up with nowhere to go! And for entrepreneurs starting a new
venture the challenge is even greater: without a clear sense of direction, a vision you can share with others to excite and
focus them, the whole thing may never take off.
We need to consider where and how innovation can be used to strategic advantage. Table 1.7 gives some examples of the
different ways in which this can be achieved, and you may like to add your own ideas to the list.

TABLE 1.7 Strategic advantages through innovation

MECHANISM STRATEGIC ADVANTAGE EXAMPLES

Novelty in Offering something no one else can Introducing the first (Walkman, fountain pen, camera,
product or dishwasher, telephone bank, online retailer, etc.) to
service offering the world

Rewriting the Offering something which represents a completely new product or Typewriters vs. computer word processing, ice vs.
rules process concept – a different way of doing things – and makes the old refrigerators, electric vs. gas or oil lamps
ones redundant

Reconfiguring Rethinking the way in which bits of the system work together (e.g. Zara and Benetton in clothing, Dell in computers,
the parts of the building more effective networks, outsourcing and coordination of a Toyota in its supply chain management
process virtual company)

The problem isn’t the shortage of ways of gaining competitive advantage through innovation but rather which ones to choose
and why. It’s a decision all organisations have to take, be it a start-up deciding the (relatively) simple question of go/no go in
terms of trying to enter a hostile marketplace with its new idea or a giant firm trying to open up new market space through
innovation. And it’s not just about commercial competition. The same idea of strategic advantage plays out in public services
and social innovation. For example, police forces need to think strategically about how to deploy scarce resources to contain
crime and maintain law and order, while hospital managements are concerned to balance limited resources against the
increasing demands of healthcare expectations.
Putting an innovation strategy together involves three key steps, pulling together ideas around core themes and inviting
discussion and argument to sharpen and shape them. These are:
Strategic analysis: what could we do?
Strategic selection: what are we going to do, and why?
Strategic implementation: how are we going to make it happen?
Let’s look at each of these in more detail.

Strategic analysis
Strategic analysis begins with exploration of innovation space: where could we innovate and why would it be worth doing
so? A useful place to start is to build some sense of the overall environment, to explore the current threats and opportunities
and the likely changes to these in the future. Typically, questions here relate to technologies, to markets, to underlying
political trends, to emerging customer needs, to competitors and to social and economic forces. It’s also useful to add to this
map some sense of who the players are in the environment: the particular customers and markets, the key suppliers and the
number and type of competitors.
Within this framework it’s also important to reflect on what resources the organisation can bring to bear. What are its relative
strengths and weaknesses and how may it build and sustain a competitive advantage?
(It’s important to remember that these are tools to help start a discussion — not accurate measuring devices. There are real
limitations to how much we can know about an environment which is complex, interactive and constantly changing, and
there are often wide differences about where the strengths and weaknesses actually lie.)
Having explored this environment, we need to understand the range of possibilities. Where can we innovate to advantage?
What kinds of opportunities exist for use to create something different and capture value from bringing those ideas into the
world?
We can think about strategy as a process of exploring the space defined by our four innovation types — the 4Ps mentioned
earlier. Each of our 4Ps of innovation can take place along an axis running from incremental through to radical change; the
area indicated by the circle in figure 1.3 is the potential innovation space within which an organisation can operate.
FIGURE 1.3 Exploring innovation space

Where it actually explores and why — and which areas it leaves alone — are all questions for innovation strategy. And for
new-entrant entrepreneurs this can provide a map of explored and unexplored territory, showing where there is open
opportunity, where and how to tackle existing players, etc. It also provides a useful map for social innovation: where could
we create new social value, where is there unexplored territory, where and how could we do things differently? Table 1.8
gives some examples of innovations mapped onto this 4Ps model.

Table 1.8 Some examples of innovations mapped onto the 4Ps model

INNOVATION TYPE INCREMENTAL: DO WHAT WE DO BUT BETTER RADICAL: DO SOMETHING DIFFERENT

‘Product’: what we offer Windows 7 and 8 replacing Vista and XP, essentially New to the world software (e.g. the first speech-
the world improving existing software recognition program)

CDs replacing vinyl records (essentially improving on Spotify and other music-streaming services (changing
storage technology) the pattern from owning to renting a vast library of
music)

Process: how we create Improved fixed-line telephone services Skype and other VOIP systems
and deliver that offering
Improved retailing logistics Online shopping
 INNOVATION TYPE INCREMENTAL: DO WHAT WE DO BUT BETTER RADICAL: DO SOMETHING DIFFERENT

Position: where we target Airlines segmenting service offering for different passenger Low-cost airlines opening up air travel to those
that offering and the story groups (e.g. Qantas Premium Economy) previously unable to afford it (e.g. Tiger Air; create
we tell about it new market and disrupt existing one)

Online support for traditional higher education courses University of Phoenix and others building large
education businesses via online approaches to reach
different markets

Paradigm: how we frame Dyson redefining the home appliance market in terms of iTunes platform (a -complete system of personalised
what we do high-performance engineered products entertainment)

IBM (from being a machine maker to a service and solution Linux, Mozilla, Apache (moving from passive users to
company, selling off its computer making and building up its active communities of users co-creating new products
-consultancy and service side) and services)

Strategic selection
The issue here is choosing out of all the things we could do which ones we will do — and why? We have scarce resources so
we need to place our bets carefully, balancing the risks and rewards across a portfolio of projects. There are plenty of tools to
help us do this, from simple financial measures like payback time or return on investment through to complex frameworks
which compare projects across many dimensions.
The challenge is for individuals and organisations to be aware of the extensive space within which innovation possibilities
exist and to try to develop a strategic portfolio which covers this territory effectively, balancing risks and resources. So how
can we choose which options will make sense for us? It’s helpful to consider two complementary themes in answering this
question:
What is our overall business strategy (where we are trying to go as an organisation) and how will innovation help us
get there?
Do we know anything about the direction we want to go in — does it build on something we have some competence in
(or have access to)?
Of course, competencies may become superseded by shifts in the technological area. Sometimes they can destroy the basis of
competitiveness (competence-destroying), but they can also be reconfigured to enhance a competitive position (competence
enhancing). A famous study by Tushman and Anderson gives a wide range of examples of these types of change.9
But it isn’t just technical knowledge. Google’s expertise is based not only on a powerful search engine but also on using the
data that helps it build to offer services in advertising. Major retailers like Tesco and Wal-Mart have rich and detailed
understanding of customers and their shopping preferences and behaviour.
Strengths can also come from specific capabilities, things which an organisation has learnt to do to help it stay agile and able
to move into new fields. Virgin as a group of companies is represented across many different sectors but the underlying
approach is essentially the original entrepreneurial one which Richard Branson used when setting up his music business.

Strategic implementation
Having explored what we could do and decided what we are going to do, the third stage in innovation strategy development
is to plan for implementation. Thinking through what we are going to need and how we will get these resources, who we may
need to partner with, what likely roadblocks may we find on the way — all of these questions feed into this step.
Of course, it isn’t a simple linear process. In practice, there will be plenty of discussion of these issues as we explore options
and argue for particular choices, but that’s the essence of strategy: a conversation and a rehearsal, imagining and thinking
forward about uncertain activities into the future.
To help do this we have a number of tools, again ranging from the simple to the complex. We could, for example, make a
simple project plan which sets out the sequence of activities we need to carry out to make our innovation come alive. That
would help us identify which resources we need and when and could also highlight some of the potential trouble spots so we
could think through how we would deal with them. Many tools add a dimension of ‘What if?’ planning to such project
models — trying to anticipate key difficulties and take a worst-case view so suitable contingency plans can be made.
It’s also worth thinking through and challenging the underlying strategic concept — the business case for doing whatever it is
we have in mind. Once again, building a business case or thinking through the underlying business model provides a
powerful way of making our assumptions explicit and opening them up for discussion and challenge.

5. Build dynamic capability

Most of the time innovation takes place within a set of rules of the game which are clearly understood, and involves players
trying to innovate by doing what they do (product, process, position, etc.) but better. Some manage this more effectively than
others do, but the rules of the game are accepted and do not change.
But occasionally something happens which dislocates this framework and changes the rules of the game. By definition, these
are not everyday events but have the capacity to redefine the space and the boundary conditions. They open up new
opportunities but also challenge existing players to reframe what they are doing in the light of new conditions. Taking
advantage of the opportunities — or seeing the threats early enough and doing something different to help deal with them —
requires an entrepreneurial approach which new entrants have but which may be difficult to revive in an established
organisation. So under these conditions we often see disruption of the old market and technological order and new rules of
the game.
The important message is that under such conditions (which don’t emerge every day) we need different approaches to
organising and managing innovation. If they try to use established models which work under steady-state conditions,
organisations are likely to find themselves increasingly out of their depth and risk being upstaged by new and more agile
players. The risk is clear if organisations fail to keep pace: there are plenty of examples of major corporations which began
with an innovative flourish but ended up beaten by their failure to innovate fast enough or in the right directions. The
examples of great photographic pioneers Kodak and Polaroid are graphic reminders that competitive advantage doesn’t
always last even if you are a major spender on R&D and have powerful marketing skills.
That raises a general point. We have spent a long time in this chapter talking about building innovation management
capability. But in a changing world we also need to be able to step back and review our position, looking at our capability
and fine-tuning it. There are some behaviours which we should keep on with, maybe increasing our commitment to them.
And there may be others which worked in the past but are no longer so relevant. Importantly, there will always be new tricks
to learn, new skills to acquire. (Think about the ways in which the internet has changed the innovation game, opening up
many more players, allowing rich links and connections, enabling knowledge flows. That simply wasn’t the case thirty years
ago and an organisation trying to manage innovation today using its recipe book from back then would be in deep trouble!)
This idea of reviewing and resetting our innovation management approaches is termed dynamic capability and building it is
a core theme which will run through the book.
Finally, it’s worth remembering some useful advice from an old but wise source. In his famous book The Prince Niccolò
Machiavelli gave a warning to would-be innovators:
It must be remembered that there is nothing more difficult to plan, more doubtful of success, nor more dangerous to management than the creation of
a new system. For the initiator has the enmity of all who would profit by the preservation of the old institution and merely lukewarm defenders in
those who gain by the new ones.

 1.4 Different types of innovation Summary 

SUMMARY
Learning objective 1: understand the meaning of innovation, six aspects of innovation, and innovation and
entrepreneurship
Innovation is about growth, about recognising opportunities for doing something new and implementing those ideas to
create some kind of value. It could be business growth; it could be social change. But at its heart is the creative human
spirit, the urge to make change in our environment. Innovation is also a survival imperative. If an organisation doesn’t
change what it offers the world and the ways in which it creates and delivers its offerings, it may well be in trouble.
And innovation contributes to competitive success in many different ways: it’s a strategic resource to getting the
organisation where it is trying to go, be it delivering shareholder value for private sector firms, providing better public
services or enabling the start-up and growth of new enterprises.
Innovation doesn’t just happen. It is driven by entrepreneurship. This powerful mixture of energy, vision, passion,
commitment, judgement and risk-taking provides the motive power behind the innovation process. It’s the same
whether we are talking about a solo start-up venture or a key group within an established organisation trying to renew
its products or services. Innovation is a complex process which carries risks and needs careful and systematic
management. Innovation isn’t a single event, like the light bulb going off above a cartoon character’s head. It’s an
extended process of picking up on ideas for change and turning them through into effective reality. The core process
involves four steps: recognising opportunities, finding resources, developing the venture and capturing value. The
challenge comes in doing this in an organised fashion and in being able to repeat the trick.
Learning objective 2: explain the difficulties in managing what is an uncertain and risky process
Organisations need entrepreneurship at all stages in their lifecycle, from start-up to long-lived survival. Many SMEs
fail because they don’t see or recognise the need for change. The ability to recognise opportunities, pull resources
together in creative ways, implement good ideas and capture the value from them are core skills. Successful
entrepreneurs recognise that failure is an intrinsic part of the process. They learn from mistakes, understanding when
timing, market conditions and so on mean that even a great idea isn’t going to work. But they also recognise that the
idea may have had its weaknesses but that they have not failed themselves but rather learnt some useful insights to
carry over to their next venture. Building a capability to organise and manage innovation is a great achievement, but
we also need to consider where and how innovation can be used to strategic advantage. Putting an innovation strategy
together involves three key steps: strategic analysis, strategic selection and strategic implementation.
Learning objective 3: list some sources of innovation, both from within companies or industries and in the social
environment
Innovation is the successful implementation of creative ideas within an organisation. Most innovative business ideas
come from methodically analysing several areas of opportunity, some of which lie within particular companies or
industries, and some of which lie in broader social or demographic trends. Innovation is a multidimensional concept.
When considering the extent of innovation, it is possible to distinguish between disruptive and incremental innovation.
Innovation can also concern different elements, such as a product, a service, a process or a combination of these.
Learning objective 4: discuss different innovation types
The successive stages of ideas generation (creativity), ideas evaluation (innovation) and ideas implementation
(entrepreneurship) can overlap and are not necessarily a linear process. These three stages essentially consist of
creating new knowledge, which is developed and formulated through different types of social network. However, a
good idea is not enough to start-up a business venture. The idea must be screened in order to identify significant
commercial opportunities, which will create value for the entrepreneur and the customer. The screening process to
establish the feasibility of the opportunity must address the product feasibility (is it real?), the market feasibility (is it
viable?) and the economic feasibility (is it worth it?).
Learning objective 5: understand the key practices of successful innovators and entrepreneurs
Innovation can take many forms but they can be reduced to four directions of change: product innovation (changes in
the products/services an organisation offers); process innovation (changes in the ways in which they are created and
delivered); position innovation (changes in the context in which products/services are introduced); and paradigm
innovation (changes in the underlying mental models which frame what the organisation does). Within any of these
dimensions innovations can be positioned on a spectrum from ‘incremental’ (doing what we do but better) through to
 ‘radical’ (doing something completely different). And they can be stand-alone (component innovations) or form part of
a linked ‘architecture’ or system which brings many different components together in a particular way.
Most of the time innovation takes place within a set of rules of the game which are clearly understood, and involves
players trying to innovate by doing what they do (product, process, position, etc.) but better. But occasionally
something happens which changes the rules of the game (e.g. when radical change takes place along the technological
frontier or when completely new markets emerge). When this happens, we need different approaches to organising and
managing innovation. If we try to use established models which work under steady-state conditions we find ourselves
increasingly out of our depth and risk being upstaged by new and more agile players. For this reason, a key skill lies in
building ‘dynamic capability’ (the ability to review and reset the approach which the organisation takes to managing
innovation in the face of a constantly shifting environment).

Discussion questions
1. Is innovation manageable or just a random gambling activity where you sometimes get lucky? If it is manageable, how
can firms organise and manage it — what general principles could they use?
2. ‘Build a better mousetrap and the world will beat a path to your door!’ Will it? What are the limitations of seeing
innovation simply as coming up with bright ideas? Illustrate your answer with examples drawn from manufacturing and
services.
3. What are the key stages involved in an innovation process? And what are the characteristic sets of activities which take
place at each stage? How could such an innovation process look for:
a. fast food restaurant chain?
b. an electronic test equipment maker?
c. a hospital?
d. an insurance company?
e. a new entrant biotechnology firm?
4. Fred Bloggs was a bright young PhD scientist with a patent on a new algorithm for monitoring brainwave activity and
predicting the early onset of a stroke. He was convinced of the value of his idea and took it to market having sold his car,
borrowed money from family and friends and taken out a large loan. He went bankrupt despite having a demonstration
version which doctors he showed it to were impressed by. Why might his failure be linked to having a partial model of
how innovation works — and how could he avoid making the same mistake in the future?
5. How does innovation contribute to competitive advantage? Support your answer with illustrations from both
manufacturing and services.
6. Does innovation matter for public services? Using examples, indicate how and where it can be an important strategic
issue.
7. You are a newly appointed director for a small charity which supports homeless people. How could innovation improve
the ways in which your charity operates?
8. Innovation can take many forms. Give examples of product/service, process, position and paradigm (mental model)
innovations.
9. The low-cost airline approach has massively changed the way people choose and use air travel — and has been both a
source of growth for new players and a life-threatening challenge for some existing players. What types of innovation
have been involved in this?
10. You have been called in as a consultant to a medium-sized toy manufacturer whose range of construction toys (building
bricks, etc.) has been losing market share to other types of toys. What innovation directions would you recommend to
this company to restore its competitive position? (Use the 4Ps framework to think about possibilities.)
11. Innovation is about big leaps forward, eureka moments and radical breakthroughs — or is it? Using examples from
manufacturing and services, make a case for the importance of incremental innovation.
12. Describe, with examples, the concept of platforms in product and process innovation and suggest how such an approach
could help spread the high costs of innovation over a longer period.
13. What are the challenges managers could face in trying to organise a long-term steady stream of incremental innovation?
 1.5 What do successful innovators
Endnotes 
and entrepreneurs do?
ENDNOTES
1. Rothwell, R. and P. Gardiner (1984) Design and competition in engineering. Long Range Planning, 17(3): 30-91.

2. Baumol, W. (2002) The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism, Princeton:
Princeton University Press.
3. Jones, T., D. McCormick and C. Dewing (2012) Growth Champions, Chichester: John Wiley & Sons Ltd.
4. Little, A.D. (2012) Global Innovation Excellence Survey, Frankfurt: ADL Consultants.
5. Drucker, P. (1985) Innovation and Entrepreneurship, New York: Harper & Row.
6. Schumpeter, J. (1943) Capitalism, Socialism and Democracy, New York: Harper.
7. Pinchot, G. (1999) Intrapreneuring in Action: Why You Don’t Have to Leave a Corporation to Become an Entrepreneur,
New York: Berrett-Koehler Publishers.
8. P.F. Drucker, ‘The discipline of innovation’, Harvard Business Review, August, 2002.
9. P.F. Drucker, see note 4.
10. Drucker, 2002, op. cit.
11. M. Bellis, ‘Viagra the patenting of an aphrodisiac’, Inventors, inventors.about.com.
12. D.F. Kuratko & R.M. Hodgetts, Entrepreneurship: A Contemporary Approach, Dryden Press, Fort Worth, 1998.
13. S. Gopalan, N. Pagiavlas & T. Jones, ‘Branding MBA programs: Are they sufficiently related to an institution's
strategy?’, SBANC Newsletter, Iss. 548, 2 December, 2008.
14. Drucker, 2002, op. cit.
15. ibid.
16. ibid.
17. T. Prestero, ‘Better by design: How empathy can lead to more successful technologies and services for the poor’,
Innovations Technology Governance Globalization, January, 2010.
18. Drucker, 2002, op. cit.
19. ‘Comeback kid?’, The Economist Science Technology Quarterly, 21 September 2002, p.3.
20. P. Sharma & J.J. Chrisman, ‘Toward a reconciliation of the definitional issue in the field of corporate entrepreneurship’,
Entrepreneurship: Theory and Practice, vol. 23, no. 3, 1999, p.11.
21. Brazael & Herbert, ‘Toward conceptual consistency in the foundations of entrepreneurship’, Paper presented at the
Annual Conference of the International Council for Small Business, 1997.
22. K. Sridhar, ‘Can organisations disrupt and expand from their core to sustain their operations?’, International Journal of
Services and Operations Management, vol. 8, no. 4, 2011.
23. N. Valery, ‘Leaps of faith’, The Economist, 18 February, 1999.
24. ibid.
25. C.M. Christensen, The Innovator’s Dilemma, Harvard Business Press, Boston, 1997.
26. ibid.
27. Valery, op. cit.
28. P.J. Williamson & M. Zeng, ‘Value-for-money strategies for recessionary times’, Harvard Business Review, March 2009,
pp. 66–74.
29. ibid.
30. The Economist, ‘Lessons from a frugal innovator’, 18 April, 2009, p. 63.
31. P.J. Williamson & M. Zeng, see note 27.
32. Francis, D. and J. Bessant (2006) Targeting innovation and implications for capability development, Technovation, 25:
171-83.

 Summary 2 Creativity, innovation, opportunities

and entrepreneurship 
 CHAPTER 2

Creativity, innovation, opportunities and entrepreneurship

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

2.1 understand the nature of creativity
2.2 understand the creative process
2.3 understand the components of creativity, use a series of creativity techniques, and identify factors influencing creativity
2.4 explain the link between creativity, innovation and entrepreneurship, and outline the steps for screening opportunities.

INTRODUCTION
Close your eyes and imagine someone being creative. What do you see? The chances are you have begun to picture an artist,
maybe a composer, perhaps a sculptor or a poet wrestling with his or her imagination? Maybe you have a mad scientist in
mind, a crazy white-haired professor who has questionable dress sense but a brilliant mind and is working out solutions to
the problems of the universe?
These are common pictures which remind us that we tend to think of creativity as something rather special, very important in
the worlds of art and science but somehow the province of exceptional and rare individuals working on their own. The reality
is a bit different: what we know about creativity is that everyone is capable of it and it can be developed and deployed in a
wide variety of ways. It’s at the heart of being human, something we have evolved over a long period of time.
Back in the early days it was a matter of survival: if we couldn’t think our way out of a problem (like an approaching
predator) then we wouldn’t be around for long! Dealing with the daily struggle to survive required us to be innovative and
the key to that was the ability to imagine and explore different possibilities. These days, we’re more concerned with creating
value, whether in a commercial or social sense, but the core skill remains one of finding, exploring and solving problems and
puzzles — and that’s where creativity comes in. Whether we are a solo start-up entrepreneur or a member of a team tasked
with helping the organisation to think outside the box, the main resource we need is the one we already have: creativity.
Just as entrepreneurship is crucial for the economy in general, innovation and creativity have become important tools for
managers who want to adopt an entrepreneurial approach. Promoting creativity and innovation is important for small and
medium-sized enterprises that want to maintain their competitive advantage. Creativity and innovation are the essence of
entrepreneurship and the engine of small business growth. It is the ability to innovate that determines much of what an
organisation is able to do. Innovation does make a huge difference to organisations of all shapes and sizes. The logic is
simple: if we don’t change what we offer the world (products and services) and how we create and deliver them, we risk
being overtaken by others who do. This chapter looks at the nature of creativity and explores how we can use our growing
understanding of the creative process to enhance our ability to be innovative in a variety of different contexts. It details the
three components of creativity, explains different creativity techniques and discusses the factors influencing creativity.

 Endnotes 2.1 The nature of creativity 

2.1 THE NATURE OF CREATIVITY
Learning objective 1
understand the nature of creativity

What is creativity?
The Oxford English Dictionary defines creativity as ‘the use of imagination or original ideas to create something’, and that’s
a pretty good starting point. Bright ideas are the fuel for innovation so understanding how we come up with them is worth
exploring. There’s been plenty of research in this direction and the good news is that we do have a growing understanding of
how it operates and how we can help it happen. In practice, we can see it as the ability to produce work that is both novel and
useful. Creativity is a combination of the following features.

1: Associations
We know, for example, that it involves the brain making associations, often between hitherto unconnected things. That’s why
daydreaming or coming up with ideas while we sleep is often an important part of the story; these are times when the
unconscious brain is able to relax and forge new and unexpected links.

Innovation in action
The innovator’s DNA

Research at Harvard Business School looking at the behaviour of 3000 executives over a six-year period found five
important ‘discovery’ skills for innovators:1
associating
questioning
observing
experimenting
networking.
The most powerful overall driver of innovation was associating — making connections across ‘seemingly unrelated
questions, problems or ideas’.

But it isn’t just wild ideas and apparently random connections. Creativity is the ability to produce work that is both novel and
useful. It’s a purposive activity, one with a target in mind. The journey to get there may require playfulness but there is a
serious goal at the end.

2: Incremental and radical

It’s also worth reminding ourselves of what we mean by ‘something new’. We can imagine degrees of novelty, running from
radically new insights, flashes of inspiration which are genuinely new to the world, through to much more basic
improvements to what we already have. As we saw in chapter 1, innovation maps onto this kind of spectrum and most of it
happens at the incremental end.
Creativity is about breaking through to radical new ideas, new ways of framing the problem and new directions for solving it.
But it’s also about the hard work of polishing and refining those breakthrough ideas, debugging and problem-solving to get
them to work. The pattern of innovation is one of occasional flashes of inspiration followed by long periods of incremental
improvement around those breakthrough ideas. Creativity matters throughout this process.
3: Divergent and convergent thinking
Many studies of creative thinking have looked at two different modes of thinking: convergent and divergent. Convergent
thinking is about focus, homing in on a single ‘best’ answer, while divergent thinking is about making associations, often
exploring round the edges of a problem. While there are some examples of problems which have a single ‘right’ answer and
need a convergent approach, most require a mixture of the two thinking skills. We need divergent thinking to open them up,
explore their dimensions and create new associations; and we need convergent thinking to focus, refine and improve the most
useful solution for a particular context.

4: Left and right brain thinking

Another key part of the puzzle lies in the way our brains operate. The brain is made up of two connected hemispheres and for
a long time neuroscientists have known that different parts of brain function relate to these different areas. Work originally
carried out by Nobel Prize winner Roger Sperry and colleagues back in the 1960s (and confirmed by more recent
neuroimaging techniques) shows that the left hemisphere is particularly associated with activities like language and
calculation. While our ‘left brain’ seems linked to what we might call ‘logical’ processing, the role of the ‘right brain’ was,
for a long time, much less well understood. Gradually it became clear that it is involved in associations, patterns and
emotional links; people with damage to the right hemisphere are often incapable of understanding humour or of feeling
moved by painting or music. Our ability to think in metaphors and to visualise and imagine in novel ways is strongly linked
to activity on this side of the brain.
It’s not a case of ‘creativity = right brain thinking’ but rather that we need to recognise that both hemispheres are involved
and they play different roles. This has important implications for developing the skills of creative thinking, as we’ll see later,
because we need to find ways to enable this interconnection between the two.

5: Pattern recognition
Creativity is particularly about patterns and our ability to see these. In its simplest form if we see a pattern, which we
recognise, we have access to solutions which worked in the past and which we can apply again. But sometimes it is a case of
recognising a similarity between a new problem and something like it which we have seen before. For example, Johannes
Gutenberg saw the connection between the way winepresses worked and his idea for the printing press. Alastair Pilkington
saw a link between the way fat floated on the surface of water and the way his company could make glass, eventually leading
to the revolutionary ‘float glass’ process with which most of the world’s windows are now made. And James Dyson applied
ideas about the large-scale industrial cyclones used to capture factory emissions to the world of domestic vacuum cleaners.

Innovation in action
Sticky success

It was during a flight in 1967 that Wolfgang Dierichs, a scientist working for the German company Henkel, had a flash of
creative insight. The company made a wide range of stationery products and one area in which he worked was in
adhesives. As he sat waiting for the plane to take off he noticed the woman next to him applying lipstick. His insight was
to see the potential of the lipstick tube as a new way to deliver glue. Put some solid glue in a tube, twist the cap and apply
it to any surface.
The company launched the ‘Pritt Stick’ in 1969, and within two years it was available in 38 countries around the world.
Today, around 130 million Pritt Sticks are sold each year in 120 countries and the product has sold over 2.5 billion units
since its invention.

Sometimes it is about finding a new pattern which makes sense. One of the challenges in creativity is that it sometimes
involves breaking rules, changing perspectives, seeing things differently. And this can set up tensions between the person
coming up with this new way of seeing and the rest of the world, who still have the old view.
That’s not always a comfortable position since it can involve going head to head with an established view of the world.
Those who hold it are likely to defend their view strongly. Being creative is often linked to breaking the rules and
challenging the conventional view — and it isn’t always popular. When Galileo, the astronomer, proposed a different view
for the way the sun and planets operated, he was imprisoned and threatened with death by the Inquisition. And in a version of
this which was not quite so life threatening, when Bob Dylan performed his new electric music at the Newport festival he
was booed off the stage. Not for nothing did successful entrepreneur James Dyson title his autobiography Against the odds.2
As the 16th-century writer Machiavelli put it:
It must be remembered that there is nothing more difficult to plan, more doubtful of success, nor more dangerous to management than the creation of
a new system. For the initiator has the enmity of all who would profit by the preservation of the old institution and merely lukewarm defenders in
those who gain by the new ones.
If we are to manage creativity effectively, we need to think about how to bridge these two worlds.

6: Individual and group creativity

So far we have been talking about individual creativity but it is also important to recognise the power of interaction with
others. We are all different in personality, experience and approach, and these differences mean we see problems and
solutions from different perspectives. Combining our approaches, sparking ideas off each other and building on shared
insights are all-powerful ways of amplifying creativity. The old proverb that ‘two heads are better than one’ is often true;
think of the many successful creative partnerships in the world of music or theatre, for example.

Innovation in action
The power of groups

Take any group of people and ask them to think of different uses for an everyday item — a cup, a brick, a ball, etc.
Working alone, they will usually develop an extensive list — but then ask them to share the ideas they have generated.
The resulting list will not only be much longer but will also contain much greater diversity of possible classes of solution
to the problem. For example, uses for a cup could include using it as a container (vase, pencil holder, drinking vessel,
etc.), a mould (for sandcastles, cakes, etc.), a musical instrument, a measure, a template around which one could draw, a
device for eavesdropping (when pressed against a wall) and even, when thrown, a weapon!
The psychologist J.P. Guilford classed these two traits as fluency — the ability to produce ideas — and flexibility — the
ability to come up with different types of idea. The above experiment will quickly show that, when working as a group,
people are usually much more fluent and flexible than any single individual. When working together, people spark each
other off, jump on and develop each other’s ideas, encourage and support each other through positive emotional
mechanisms like laughter and agreement — and in a variety of ways stimulate a high level of shared creativity.

 2 Creativity, innovation, opportunities

2.2 Creativity as a process 
and entrepreneurship
2.2 CREATIVITY AS A PROCESS
Learning objective 2
understand the creative process

It’s easy to see creativity as being that wonderful moment where we have a flash of inspiration. The light bulb goes on and
suddenly everything becomes clear. But research has shown it is not as simple as this; there is an underlying process which
starts a long way before that light bulb moment.3
It begins with our recognising we have a puzzle or a problem to solve. If it is something we have seen before, we can often
switch straight to applying a solution. But if it is something trickier, we need to explore it further. This can be frustrating; we
may wrestle with it for some time without coming up with any insight about possible solutions. Or we may try out various
ideas and realise they don’t or won’t work. Importantly, what’s going on here is a process of recognising and preparing the
problem.
We could give up on the struggle and switch off our attention — but the reality is that we don’t let the problem go. Our brain
continues to process and explore, trying out different connections, playing with different options. When we walk away from
the problem, or decide to sleep on it, we are not leaving it behind but rather passing the work of trying to solve it over to our
unconscious minds. This ‘incubation stage’ is important; as the name suggests, we are allowing something to develop and
grow.
At some stage, there is a moment when the insight is born. It may be that we wake up with a fresh idea in our head, or we
suddenly get that flash of inspiration. The ‘aha!’ moment is often accompanied by feelings of certainty; even if we can’t
explain why, we just know this is the right solution. There’s a flow of energy and a sense of direction to our thinking. The
idea may still need a lot of work to elaborate on and develop it but the underlying breakthrough has been made.
Figure 2.1 shows a model of this process.
FIGURE 2.1 A model of the creative process

This pattern can be seen in many accounts of creativity where people talk about how they came up with apparently radical
new solutions. And it’s a key resource for us in thinking about how we can build creativity. If it’s a process then we can map
the stages, understand what’s going on and provide some resources to help.

Innovation in action
Snakes on a bus

The 19th-century chemist Friedrich August Kekulé is credited with having unravelled one of the keys to the development
of organic chemistry, the structure of the benzene ring. This arrangement of atoms is central to understanding how to make
a range of chemicals, from fertilisers and medicines to explosives, and enabled the rapid acceleration of growth in the
field. Having wrestled for a long period with the problem, he eventually had a flash of inspiration on waking from a dream
in which he had seen the atoms dance and then, like a snake, begin eating its own tail. This weird dream picture nudged
him towards the key insight that the atoms in benzene were arranged in a ring.
He later reported on another dream which he had had while dozing on a London bus in which atoms were dancing in
different formations, which gave him further insight into the key components of chemical structure.

Sometimes this process takes place almost instantaneously; we recognise the problem and can retrieve a solution almost
simultaneously. But sometimes we need to work through the process in a more systematic fashion, allowing time for each
stage. We mentioned divergent and convergent thinking a little earlier and one way of seeing the creativity process is as a
mixture of divergent and convergent cycles. Figure 2.2 gives an illustration.
FIGURE 2.2 Cycles of divergence and convergence in creativity

We can link this to our earlier point about the two hemispheres of the brain. ‘Left brain’ thinking involves assembling facts
and processing them in a logical fashion, whereas the right hemisphere is about seeing patterns and making new associations.
Both are involved in these different stages of the creative process — the left side early on in preparing and recognising and
the right in the incubating and insight stages.
In practice, this means we need to find ways to engage both hemispheres and to practise skills and use tools to help us open
up and close down ideas around the core problem.

Recognition/preparation
Imagine we have a problem with a banging door. We can’t sleep at night because the door keeps banging and rattling in the
frame. We decide we need to fix the door, maybe even replace it, and so we get the carpenter in to look at it. He spends the
day, shaves and planes the wood, adjusts the hinges, tinkers with the latch. That night the problem comes again, waking us
up just as annoyingly. Eventually, we realise that the problem is not with the door at all but with the wind blowing through a
hole in the roof, swirling around the house. The answer lies in fixing the roof not in mending the door.
That’s a trivial example of problem recognition. Creativity starts with recognising we have a problem or puzzle to solve and
then exploring its dimensions. Working out the real problem, the underlying issue, is an important skill in arriving at a
solution which works. Redefining and reframing are key skills here, being able to see the wood for the trees, the underlying
pattern of the core problem.
There are several simple ways to develop skills around problem definition.
 Innovation in action
Five whys and a how

This simple but powerful tool can help strip away the apparent problem to get through to the root problem which is the
one we need to solve. For example, a big problem in UK hospitals at the moment is in waiting times and delays, putting
pressure on already scarce resources. Here's how the tool could be applied to help.
Apparent problem was that a patient arrived late in the operating theatre, causing a delay.
Why? — Because they had to wait for a trolley to take them from the ward to the theatre.
Why? — Because they had to find a replacement trolley.
Why? — Because the original trolley had a defect — the safety rail had broken.
Why? — Because it had not been regularly checked for wear and tear.
Why? — Because there was no organised system of checking and maintenance.
Arriving at this root cause — the real problem is in the lack of systematic maintenance — gives plenty of clues about the
‘how’, the potential solutions to the problem. Setting up a simple maintenance schedule could ensure that all trolleys were
regularly checked and available for use. This would mean future delays would be avoided, flow would improve and
overall system efficiency would be better. Importantly, if we had just focused on the apparent problem — a single broken
trolley — we would have solved that by repairing the trolley, but the underlying problem would mean it would happen
again.

Incubation
Sometimes redefining and exploring the problem is enough to lead to a solution — but very often we are left with a problem
and no obvious answer. Wrestling with it, pulling it into different shapes and trying to force fit it to something we’ve seen
before simply doesn’t work. This is where we need to let go with our conscious minds and allow the brain some time to play
around, to incubate. It needs to allow new connections to be made, and typical ways of helping this include relaxing, doing
something different, going for a walk, sleeping on the problem, etc. What’s going on underneath is a fascinating process of
association and connecting in ways which may appear to be illogical. Think about your dreams and the amazing and unlikely
events which take place in them; connections are established between random elements which simply wouldn’t normally be
linked. This is an important part of the unconscious creative process and one of the powerful ways of supporting this stage is
to give the brain some help in making new connections.
This also links with our earlier discussion of divergent and convergent thinking; divergence is very much about finding new
links and connections. To help with this we need to find ways to enable the right hemisphere of the brain to play a more
active role, to shut down temporarily the left brain with its logic and systematic approach and allow for new patterns and
associations to emerge.

Insight
The most common picture of creativity is the light bulb moment — and it’s an apt description for what it often feels like to
come up with a new insight. It’s not just the awareness of a solution; there is often a strong emotional charge, a deeps sense
of the answer, a certainty. According to the story, Archimedes was so excited about the flash of insight he had while sitting in
his bath tub trying to understand hydrodynamics that he jumped out and ran naked through the streets crying out ‘Eureka!’,
which, roughly translated, means ‘I have it!’
Interestingly, people describing such moments are often not entirely clear about the full extent of their solution, they just
‘know’ it is right and they then spend time (validation) tidying up the idea and building on their initial insight.
Sometimes their idea is half formed. It’s alive but hasn’t got a full shape yet. And so making it visible and available to others
is an important part of this stage and offers us another area where skills and tools may help. Even if the idea is only a few
scrambled words scribbled down on waking from a dream, or an outline sketch, or a key phrase, it may be enough to catch
the core idea and allow for its development.
Techniques like brainstorming make much of the act of writing down ideas, and variations on the theme use pictures and
sketches to capture the insights. Making ‘sculptures’ out of everyday items to represent elements in a different way and make
this available to others is another route. Within the field of design methods, many powerful tools and techniques are based on
the idea of helping people articulate what they can’t fully express — allowing for ‘visualising the invisible’.

Validation
This is the stage at which the idea, the core insight, becomes refined and developed. It involves trying the idea out —
prototyping — and using feedback from that to adapt and develop it. For example, the ‘lean start-up’ methodology for new
venture entrepreneurs places strong emphasis on the idea of designing experiments around a ‘minimum viable product’
(MVP). The idea is to use the MVP as a probe, a prototype around which we can gather information to help refine and focus
the initial insight. Central to the approach is the idea of the ‘pivot’ — not changing direction completely but rotating around
the core idea to find the most suitable configuration which works.
Prototyping can be done in various ways and forms the core of design methods aimed at bringing new ideas into widespread
use. A key point here is that this represents the end of one cycle and the beginning of the next. As we saw earlier, creativity is
a process of alternately opening up and closing in on the core solution. By sharing the original idea we can explore its
different dimensions from many perspectives and open up the idea for further development.

Innovation in action
Striking a light

Although creativity is often pictured as a flash of inspiration, the reality is that it is a lot of hard work, building on that
insight and improving and debating with yourself about the idea to make it work. For example, Thomas Edison, when
working to develop the light bulb, spent weeks in the laboratory trying to find the right material for the filament for his
incandescent bulb, experimenting and learning about the core idea. His painstaking work (some reports suggest he tried
over 10 000 different materials) led to the famous phrase attributed to him that ‘genius is one per cent inspiration, ninety-
nine per cent perspiration!’

Developing personal skills

So far, we’ve been looking at thinking skills and some tools to help develop these. But creativity is also about motivation and
communication. We need to feel comfortable about taking the risk of trying out something new or trusting our intuition. For a
few people, creativity is their way of life. They are constantly challenging and questioning, but for most people there is an
element of self-imposed limitation to it. Am I allowed to think this way? What if my idea is wrong? Will I look/sound foolish
for suggesting this? Can I trust my instincts which are leading me to think in this way?
Building confidence in our own ideas and then developing skills in communicating them and handling the feedback we get
on them is another area where we can develop our creative capabilities. Successful entrepreneurs are not just able to come up
with creative insights; they are also resilient in the face of feedback, using this to help shape and adapt their ideas. They have
a strong sense of vision and can communicate and engage others in sharing that insight. And they are skilled at ‘pitching’:
communicating the core idea to others in ways which get past their critical comments and engage their interest (and
hopefully their resource support).
One key point is to understand the nature of the creative process as we have described it and to recognise that it isn’t entirely
rational, that emotions, intuitions and odd insights are a valuable part of it, and that ideas which emerge can be useful
stepping stones or valuable in their own right. ‘If it’s worth thinking, it’s worth saying’ is a useful motto. But understanding
the process also reminds us of different kinds of thinking associated with different stages — from divergent activities
opening our minds to new connections through to convergent thinking helping us focus in and whittle many wild ideas down
to the ones with real potential value. We need to develop the flexibility in our thinking to deal with these different stages in
creativity.

Developing group-level creativity

Creativity is something we are all capable of; we can all come up with novel and useful ideas on our own. But working
together with others can amplify that process, leading to more ideas and more different insights, which can lead to novel
solutions. People differ in their experience, their personality and their perspectives on the world, and this diversity is a rich
resource for helping creativity to happen. Think about creative partnerships in the musical world like Lennon and
McCartney, Rogers and Hammerstein, Rice and Lloyd Webber, the Gershwin brothers. Look at the world of theatre and film
and see how much success is the product not of a lone genius but of a team of co-creators front and back stage who help
make it happen. Look at business ventures and very often you'll find a team — Eric Schmidt and Sergei Brin (Google), Bill
Gates and Paul Allen (Microsoft), Andy Grove and Gordon Moore (Intel).
So there’s a lot to be said for working with others and there's plenty of research to support the potential of doing so. But it’s
not as easy as it looks. There are many downsides to working in a group, as table 2.1 shows. Social pressures can act as a
damper on individual sparks of ideas. Diversity can lead to conflict. Simply throwing people together does not make them a
team and the wrong mix can easily lead to the whole performing much less well than the sum of the parts.

TABLE 2.1 Advantages and disadvantages of group-level creativity

ADVANTAGES DISADVANTAGES

Diversity — more different ideas ‘Groupthink’ — social pressures to conform

Volume of ideas — ‘many hands make light work’ Lack of focus — ‘too many cooks spoil the broth’

Elaboration — multiple resources to explore around the problem Group dynamics and hierarchy

Rich variety of prior experience Political behaviour, people following different agendas

 2.1 The nature of creativity 2.3 Components of creativity and

creativity techniques 
2.3 COMPONENTS OF CREATIVITY AND CREATIVITY
TECHNIQUES
Learning objective 3
understand the components of creativity, use a series of creativity techniques, and identify factors influencing creativity

Creativity is the process through which invention occurs — the facilitative process by which something unique comes into
existence. Garnering the rewards from innovation begins with creative ideas.4 It is therefore not surprising that successful,
innovative companies systematically encourage the development of ideas. Those ideas are then screened to see whether they
lead to a potential innovation. Experience shows that entrepreneurial companies need to generate hundreds of ideas to end up
with four plausible programs for developing new products, and four development programs are the minimum to obtain just
one winner. Therefore, it is crucial to create a corporate culture that allows ideas to blossom. ‘You have to kiss a lot of frogs
to find a prince,’ said Art Fry,5 the inventor of Post-It notes at 3M. ‘But remember, one prince can pay for a lot of frogs.’

The three components of creativity

Creativity is usually associated with the arts and is seen as the expression of highly original ideas. In business, originality is
not enough. To be creative, an idea must also be appropriate — that is, useful and actionable. In the end, it must fulfil a need
in the marketplace and generate profit. To most people, creativity refers to the way people think. Thinking imaginatively is
certainly one part of creativity, but knowledge and motivation are also crucial.6

1: Creative thinking skills

Creative thinking refers to how people approach problems and solutions — their ability to combine existing ideas and
knowledge in new formations.7 The skill itself depends on personality, as well as on how a person thinks and works. People
are more creative if they feel comfortable disagreeing with others; that is, if they try out solutions that depart from the status
quo. As for working style, people are more likely to achieve creative success if they persevere with a difficult problem.
Indeed, plodding through long dry spells of tedious experimentation increases the probability of truly creative
breakthroughs.8 So, too, does a work style that uses ‘incubation’, which is the ability to set aside difficult problems
temporarily, work on something else, and then return later with a fresh perspective.
Further, personality is strongly influenced by cognition, the mental activity by which an individual is aware of and knows
about his or her environment, including such processes as perceiving, remembering, reasoning, judging and problem solving.
Creative thinking is based on the same kinds of cognitive processes that we use in ordinary, everyday thought — retrieving
memories, forming mental images, and using concepts.9

2: Knowledge
Expertise or knowledge encompasses everything a person knows and can do. This knowledge can be acquired in different
ways: through formal education, practical experience or interaction with other people. Knowledge constitutes what Simon
called his ‘network of possible wanderings’,10 the intellectual space that he uses to explore and solve problems. The larger
this space, the better.

3: Motivation
Knowledge and creative skills are a person’s raw material — the person’s natural resources. However, a third factor —
motivation — dictates what people will actually do.11 Scientists can have outstanding educational credentials and a great
ability to generate new perspectives on old problems. But if they lack the motivation to do a particular job, they simply will
not do it; their expertise and creative thinking will either be wasted or applied to a different pursuit. However, all forms of
motivation do not have the same impact on creativity.12 In fact, there are two types of motivation — extrinsic and intrinsic.
Extrinsic motivation originates from outside a person, whether the motivation is a ‘carrot’ or a ‘stick’.13 If the manager
promises to reward employees financially if a project succeeds, or threatens to fire them if it fails, employees will certainly
be motivated to find a solution. However, this sort of motivation ‘makes’ employees do their jobs in order to get something
desirable and to avoid something painful. The most common extrinsic motivation that managers use is money, which does
not necessarily stop people from being creative. But in many situations it does not help either, especially when it makes
people feel they are being bribed or controlled. More importantly, money by itself does not make employees passionate about
their jobs.
Conversely, passion and interest — a person’s internal desire to do something — are what intrinsic motivation is all about.
When people are intrinsically motivated, they work solely for the challenge and satisfaction of it.14 Consequently, people
will be most creative when they feel motivated mainly by the interest, satisfaction and challenge of the task itself and not by
external pressure.

Creativity techniques
Several techniques can be used to get the initial ‘creative spark’, and most can also be used to fine-tune an entrepreneurial
opportunity during the innovation stage. Among the most popular creativity techniques are problem reversal, forced analogy,
attribute listing, mind maps and brainstorming.

1: Problem reversal
The problem reversal technique is based on the premise that the world is full of opposites.15 Any attribute, concept or idea
is meaningless without its opposite. The great Chinese thinker Lao Tzu stressed the need for the successful leader to see
opposites all around. For example, he noted the importance of action through inaction (wu wei), of letting go and not
resisting nature’s way of achieving balance.16 As a result, his philosophy maxims were often expressed as opposites: ‘Be
upright without being punctilious. Be brilliant without being showy.’ All behaviour consists of opposites. To stimulate our
creativity, we have to learn to see things backwards, inside out and upside down.
State the problem in reverse. Change a positive statement into a negative one. For example, if you are trying to
improve customer service, list all the ways one could make customer service bad. People are often pleasantly surprised
at some of the ideas they come up with.17
Figure out what everybody else is not doing. For example, Apple did what IBM did not — it was the first computer
manufacturer to provide a graphical user-interface. Japanese car manufacturers made small, fuel-efficient cars, whereas
American car manufacturers focused on large cars.
Change the direction or location of perspective. For example, examine a particular problem or question from the
perspectives of the producer, distributor and client. Similarly, the problem may be different if people are city dwellers
or country dwellers or from different nations.
Turn defeat into victory. If something turns out badly, think about the positive aspects of the situation. One of the most
popular products ever developed by 3M, the Post-It note, came about because a 3M engineer took some glue that did
not stick properly and put it on small, colourful pieces of paper. This glue was originally considered an innovation
failure.

2: Forced analogy
Forced analogy is a useful and light-hearted way of generating ideas. This technique takes a fixed element, such as the
product or some idea related to the product, and forces it to take on the attributes of another unrelated element. This forms
the basis of a free flow of associations from which new ideas may emerge. One should evaluate the value of the ideas only
after the process is complete.18
Forcing relationships is one of the most effective methods of generating new solutions and new insights. A helpful way of
developing the relationships is to have a selection of objects or cards with pictures to help develop ideas. Choose objects or
cards at random and explore what relationships you can force. Use mind-mapping to record the attributes, and then
investigate aspects of the challenge at hand. For example, Olson19 described the problem of examining a corporate
organisational structure by comparing it with a matchbox. This comparison is summarised in table 2.2.
TABLE 2.2 Forced analogy between a matchbox and a corporation

ATTRIBUTES OF A MATCHBOX ANALOGY WITH THE CORPORATION

Striking surface on two sides The protection an organisation needs against strikes

Six sides Six essential organisational divisions

Sliding centre section The heart of the organisation should be ‘slidable’ or flexible

Made of cardboard Inexpensive method of structure, disposable

3: Attribute listing
Attribute listing ensures that all possible aspects of a problem have been examined. List all the major characteristics or
attributes of a product, object or idea. Then, for each attribute, list ways each of the attributes could be changed. After all the
ideas are listed, evaluate each idea — bringing to light possible improvements that can be made to the design of the product.
Consider the following situation: a person in the business of making torches is under pressure from competitors and needs to
improve the quality of the product. As table 2.3 shows, by breaking down the torch into its component parts — casing,
switch, battery, bulb and weight — and by studying the attributes of each component, it is possible to develop ideas on how
to improve each one.20

TABLE 2.3 Attribute listing — improving a torch

FEATURE ATTRIBUTE IDEAS FOR IMPROVEMENT

Casing Plastic Metal

Switch On/off On/off low beam

Battery Power Rechargeable

Bulb Glass Plastic

Weight Heavy Light

Attribute listing is a very useful technique for quality improvement of complicated products, procedures or services. It can be
used in conjunction with some other creative techniques, especially idea-generating ones such as brainstorming.21 This
allows the entrepreneur to focus on one specific part of a product or process before generating ideas.

4: Mind maps
The human brain is very different from a computer. Whereas a computer works in a linear fashion, the brain works
associatively as well as linearly — comparing, integrating and synthesising as it goes. Association plays a dominant role in
nearly every mental function, and words themselves are no exception. Every word and idea has numerous links attaching it to
other ideas and concepts. Mind maps are an effective method of note-taking and useful for the generation of ideas by
association.22 Mind mapping (or concept mapping) involves writing down a central idea, and thinking up new and related
ideas that radiate out from the centre. By focusing on key ideas written down in your own words, and then looking for
branches out and connections between the ideas, knowledge is mapped in a manner that helps you understand and remember
new information.23
To make a mind map, start in the centre of a page with the main idea and work outwards in all directions, producing a
growing and organised structure composed of key words and key images.24 Mind maps are a way of representing associated
thoughts with symbols rather than with extraneous words — the mind forms associations almost instantaneously, and
‘mapping’ allows us to record ideas more quickly than if we were expressing them using only words or phrases.25 Because
of the large amount of association involved, mind maps can be very creative, tending to generate new ideas and associations
that have not been thought of before. Every item in a map is, in effect, the centre of another map.26
The creative potential of a mind map is useful in brainstorming sessions. Start with the basic problem as the centre, and
generate associations and ideas from it in order to arrive at a large number of possible approaches. By presenting thoughts
and perceptions in a spatial manner and by using colour and pictures, a better overview is gained and new connections can be
seen.27

5: Brainstorming
The term brainstorming has become a commonly used generic term for creative thinking. More concisely, brainstorming is
the generation of ideas in a group based on the principle of suspending judgement — a principle that has proved to be highly
productive in individual effort as well as group effort. The ‘generation’ phase is separate from the ‘judgement’ phase of
thinking.28
Brainstorming works best when a group of people follows four rules:
Suspend judgement. When ideas are suggested, no critical comments are allowed. All ideas are written down.
Evaluation is reserved for later — people have usually been trained to be so instantly analytical and practical in their
thinking that this is very difficult to do, but it is crucial. To create and criticise at the same time is like watering
seedlings while pouring weedkiller onto them at the same time.
Think freely. Every idea is accepted and recorded. Freewheeling, untamed thoughts are fine, as are improbable and
seemingly unthinkable ideas. In each session, there should be some ideas so extraordinarily far-fetched that they make
the group erupt with laughter. Remember that practical ideas often come from impractical or impossible ones.29
Encourage people to build on the ideas of others. Improve, modify, build on the ideas of others. Identify what is
positive about the idea just suggested. How can it be made to work? What changes would make it better or even
wilder? This is often referred to as piggybacking ideas.30
Quantity of ideas is important. Concentrate on generating a large stock of ideas so that they can be refined later on.31
There are two reasons for wanting a lot of ideas: (1) the mediocre, obvious, usual, stale, unworkable ideas often come
to mind first, so the first ten ideas probably won’t be innovative and fresh32; (2) the larger your list of possibilities, the
more you will have to choose from, adapt or combine. Some brainstormers aim for a fixed number, such as 20 or 30
ideas, before quitting the session.

Factors influencing creativity

The traditional psychological approach, which focuses on the characteristics of creative people, contends that the social
environment can influence both the level and the frequency of creative behaviour.33 The encouragement of creativity,
autonomy, resource availability, workload pressures and mental blocks are important factors to consider in this respect. Since
creativity, innovation and entrepreneurship can also take place in an established organisation, these factors should be of
prime interest to managers who want to promote an entrepreneurial spirit.34

1: Encouragement of creativity
Encouragement of the generation and development of ideas appears to operate at three major levels within organisations:
Organisational encouragement plays an important role, and several aspects are perceived as operating broadly across
the organisation — such as encouragement of risk-taking and of idea generation, valuing innovation from the highest
to the lowest level of management, and fair, supportive evaluation of new ideas.35
Encouragement from supervisors indicates that project managers or direct supervisors can promote creativity. Open
supervisory interactions and perceived supervisory support operate on creativity largely through the same mechanisms
that are associated with fair, supportive evaluation; under these circumstances, people are less likely to experience the
fear of negative criticism that can undermine intrinsic motivation.36
Encouragement of creativity can occur within a group itself, through diversity in team members’ backgrounds, mutual
openness to ideas, constructive challenging of ideas, and shared commitment to the project.

2: Autonomy
Creativity is fostered when individuals and teams have relatively high autonomy in the day-to-day conduct of work, and a
sense of ownership and control over their own work and their own ideas.37 In addition, people produce more creative work
when they perceive themselves as having a choice in how to go about accomplishing the tasks they are given.

3: Resources
It is generally admitted that resource allocation on a project is directly related to the project’s creativity levels. Apart from the
obvious practical limitations that extreme resource restrictions place on what can be accomplished, perceptions of the
adequacy of resources may affect people psychologically by affecting their beliefs about the intrinsic value of the projects
they have undertaken.

4: Pressures
The evidence that exists about pressures suggests seemingly paradoxical influences. Some research has found that, although
extreme workload pressures can undermine creativity, some degree of pressure can have a positive influence if it is perceived
as arising from the urgent, intellectual, challenging nature of the problem itself.38 Similarly, time pressure is generally
associated with high creativity in scientists involved in research and development, except when that pressure reaches an
undesirably high level. Thus, two distinct forms of pressure can be identified: excessive workload pressure and the pressure
of challenge. The former is likely to have a negative influence on creativity, whereas the latter will have a positive influence.
‘Creativity loves constraints’ is one of Google’s operating mantras, driving innovation in new directions. A powerful
principle — as long as we recognise that it involves a balancing act. Constraints provide pressure, but too much pressure can
be dangerous. Urgent projects can become unstoppable; the tragic disaster in 1986 when the Challenger space shuttle
exploded shortly after launch is a powerful reminder of this. In many ways it mirrored an earlier aviation disaster. In 1930 the
airship R101 on its maiden voyage crashed into a hillside in France killing all on board. Like the Challenger, the R101
project was high-profile and driven by a sense of urgency, always in the public eye, being rushed along by high profile
leaders pushing for success. Just as the faulty O-ring seals in the Challenger’s engines were known about but brushed aside
by project managers driven by the urgency of the shuttle launch, so the R101 engineers could not get their doubting voices
heard. As the novelist Nevil Shute (who worked in the industry) commented in his autobiography Slide rule, ‘it was
impossible for them to admit mistakes without incurring discredit far exceeding their deserts, for everybody makes mistakes
from time to time. Surely no engineers were ever placed in so unhappy a position.’
What we’re looking for is the ‘sweet spot’ (see figure 2.3) between having enough constraints to provide the pressure to
innovate, and so many constraints that our attempts to innovate are hindered. Too many resources, and we can relax, work in
our comfort zone, draw on variations on established themes and try to make them work; too few and we become paralysed.
FIGURE 2.3 The ‘sweet spot’ in crisis-driven innovation

What innovation management lessons can we take from this?

Create the challenge. Build a compelling vision, something to engage the energy.
Construct the sense of crisis. Construct the sense of crisis. Bring the constraints to the fore and demand a solution in
spite of them.
Coach the team. Many famous crisis innovation teams have leaders — like Kelly Johnson — whose roles are working
as coaches, challengers and guides.
Cultivate the team. Diversity helps, so teams can draw on different core knowledge as well as on different
personalities, perspectives and angles.
Enable co-operation. Networking can often fill much of the resource gap. For example, 3M’s famous ‘bootlegging’
model is at heart a social process, depending on the community from which entrepreneurs can beg, borrow and
otherwise pull together the resources they need.

5: Mental blocks
In addition to organisational constraints, creativity can be impeded at the individual level because of various mental blocks.
Prejudice and functional fixedness are two examples of mental blocks.
Prejudice stems from the preconceived ideas we have about things. These preconceptions generally block us from enacting a
vision beyond what we already know or believe to be achievable, and thus inhibit the acceptance of change and progress.39
Consider the problem of how to connect sections of aeroplanes with more ease and strength than by using rivets. A modern
solution is to glue the sections together. Most people would probably not think of this solution because of the prejudice about
the word and idea of glue. But there are many kinds of glue, and the kind used to stick plane parts together makes a bond
stronger than the metal of the parts themselves.
Sometimes we see an object only in terms of its name, rather than in terms of what it can do. This type of mental block is a
functional fixedness. Consider the case of shopping centres. Traditionally, these were considered to be places where people
went to buy something specific, until it was discovered in the mid-1990s that many people go shopping for entertainment.
There is also a functional fixedness when it comes to people’s roles. Think how most people would react if they saw their
dentist mowing their lawn, or their car mechanic on a television show promoting a book. In Australia, Australia Post uses its
dense logistics network throughout the country to deliver products other than mail — it also delivers groceries and organic
fruit and vegetables that have been ordered online through various companies, including Only Australian Groceries, Coles
Online and Ecofy.

What would you do?

Weighing in with creativity

You have just come across an Australian health survey with findings that indicate 19 per cent of males and 22 per cent
of females aged 25 years or over are obese, and an additional 48 per cent of males and 30 per cent of females are
overweight. Further research suggests that obesity has become the number one public health issue in Australia and in
many other industrialised countries. According to the World Health Organisation ‘obesity has reached epidemic
proportions globally, with more than 1 billion adults overweight — at least 300 million of them clinically obese — and
is a major contributor to the global burden of chronic disease and disability’.40
The conditions of overweight and obesity are defined as the excessive accumulation of body fat, which is often classified
using the body mass index (BMI), a weigh-for-height index. Whereas a BMI of 18.5–24.9 is considered to be a healthy
weight range, BMIs of 25 and 30 or more are considered overweight and obese respectively. Both of these conditions
expose individuals to a greater risk of health problems, including diabetes, cardiovascular disease, musculoskeletal
disorders and some forms of cancer.
Various discussions with health experts made you aware that effective weight management for individuals involves a
range of long-term strategies. These include prevention, weight maintenance and weight loss, and you sense that each of
these areas represent a huge number of entrepreneurial opportunities.

Questions

1. Use two creativity techniques to generate new ideas in the area of weight maintenance. What ideas can you
identify?
2. Which of the ideas that you identified has the potential to generate a sustainable profit? Why?
3. To what extent do obesity prevention, weight maintenance and weight loss relate to each other? Use a mind
map to show the relationships.

It’s easy to think that innovation is about resources — throw enough money, smart minds and clever technology at the
problem and the answer will surely follow. But the history of ideas suggests there is another pathway. Sometimes the very
absence of resources is what galvanises innovation. Think about these examples:
In 1943, at the height of World War II, a small team at Lockheed’s Burbank factory were given the apparently
impossible task of designing and building a jet aircraft within six months. They’d never built a jet before so there were
no designs to work from, the technology was unknown, the only engine was in the UK and wouldn’t be available to
them to experiment with until near the end of the project, and the factory was already working flat-out on producing
bombers for the war effort. Kelly Johnson was the manager appointed to run this project and one of his first tasks was
to rent a circus tent because there was no space available for his team to work in! Time was of the essence — the
Germans had been working on jets since 1938 and were already flying their Messerschmidt 262 fighters in Europe.
Despite all these barriers, his ‘skunk works’ team achieved their target with weeks to spare, producing and safely
flying the Shooting Star.
Toyota wasn’t always the great car-maker we know today. Back in the post-war years Japan’s slow and painful
recovery was hampered by resource shortages, its physical infrastructure still severely damaged and skilled labour
 desperately scarce. All of this on an island which had to import most of its key industrial resources. The stuttering
local car market was small and fragmented; under such conditions it was impossible to run a car factory in the
profligate style associated with mass production. Constraints forced experiments towards a radically different approach
emphasising reduced waste at every stage. From these unhappy beginnings (and a long learning process) the idea of
‘lean’ was born, one which went on to become one of the most powerful process innovations of the twentieth century.
It’s not just in the world of manufacturing — back in the 1970s Dr Govindappa Venkataswamy began his search to try
and bring safe, low-cost eye care to the poor of India. The cataract operation he pioneered was simple enough to
perform technically; the innovation challenge he faced was doing so in a resource-constrained context. Lack of skills
and facilities was a factor, but more significant was a lack of money: the average cost of cataract treatment was around
$300, far beyond the means of poor village folk trying to subsist on incomes of less than $2/day. His Aravind Eye
System borrowed ideas from the world of fast food and essentially shifted the model of surgery to one similar to
manufacturing — in the process cutting the average cost to $25 and delivering it using largely unskilled labour trained
in narrow focused areas. Forty years later, millions of people around the world owe their sight to his innovation; his
ideas influenced Devi Shetty and others to pioneer similar approaches to operations as complex as heart bypass
surgery, again massively lowering the costs without compromising on safety.
And think about the world of the arts. Each season the Royal Shakespeare Company faces the challenge of short time
scales and the need to find something new in a 400-year-old repertoire limited to 37 plays — all of which have already
been performed thousands of times before. Despite this, they can still push the edges of the audience’s experience.
In all of the above cases, a shortage of resources — including time, money, infrastructure and materials — forced a different
mind-set. A lack of available resources, rather than hindering creativity and innovation, can trigger a different kind of search
for solutions, one with a number of important characteristics:
Ends rather than means drive innovation. The presence of a challenging vision compels innovation, even if the ways
of reaching the goal are unclear.
Extensive search. Because the normal pathways may be blocked, the search for solutions pushes out into new and
unfamiliar territory.
Reframing. One powerful exploration tool is to work at a higher level of abstraction, bridging between different worlds
to find solutions to similar problems (e.g. Aravind’s leap between the worlds of healthcare and fast food).
Creatively combining. Improvising solutions from what is available can often result in novel configurations. The
French word ‘bricolage’ helpfully describes this process which is one of the core elements in the entrepreneur’s mind-
set.
Experimental learning. Improvising and building on what emerges can enable fast learning from early prototyping.
Tolerance of imperfection. Rather than planning the innovation from the outset, the journey is one of stepping-stone
jumps, improving as the design takes shape and often building in key elements of the user experience into the process.
A 1960s novel (made into a successful movie in 2004), The Flight of the Phoenix, provides a good example of the way this
story unfolds. A plane crashes in the Mongolian Desert and some people survive. They have little food and water, they are
miles from anywhere, the radio is (of course) broken and the sun is beating down. It doesn’t take long to set up the drama:
they are trapped; and, unless they come up with a radical solution fast, they will all die. Plenty of room for arguments,
romance and other dramatic devices — but at its heart the story is about creativity under constraints. One of the survivors has
a background in aeronautical engineering, enough of the plane remains intact so that parts could be bolted together to make a
crude airframe, one of the engines is undamaged and there are enough drops of fuel left to give them one shot at flying their
‘Phoenix’ out of the desert and to safety. It’s a story of improvisation, inspiration, occasional violent arguments which trigger
new insights — and it has a more or less happy ending!
Research on creativity lends support to this model. Studies at the University of Amsterdam(1) concluded that obstacles and
constraints may actually help the creative process.41 Using different kinds of barriers and constraints, the studies found that
participants began to search more widely in their problem solving behaviour — as if the limitations trigger an ‘if obstacle,
then start global processing’ response.
It’s not enough just to have the search behaviour — we also need perseverance. The University of Amsterdam studies found
the global search effect particularly powerful when used by individuals who were naturally inclined to stay engaged and
finish on-going activities. We have plenty of role models in the world of innovation which remind us of this — for example,
Thomas Edison trying hundreds of possible solutions before he found a filament for his light bulb and James Dyson
struggling through 5 years and 5000 prototypes for his cyclone vacuum cleaner.

 2.2 Creativity as a process

2.4 Linking creativity, innovation

and entrepreneurship 
2.4 LINKING CREATIVITY, INNOVATION AND
ENTREPRENEURSHIP
Learning objective 4
explain the link between creativity, innovation and entrepreneurship, and outline the steps for screening opportunities

While still oversimplified, figure 2.4 is a representation of the links between creativity, innovation and entrepreneurship as a
process model. It can be regarded as a logically sequential (though not necessarily continuous) process that can be divided
into a series of interdependent stages. The overall process can be thought of as a complex set of communication paths over
which knowledge is transferred. These paths include internal and external linkages. At the centre of the model, innovation
represents the firm’s capabilities and its linkages with both the marketplace and the science base.42 As shown in figure 2.4,
the entrepreneurial process is influenced by two main factors. On the one hand, the unsatisfied needs in the marketplace are
one source of opportunity for developing and commercialising new products or new services (pull factors). On the other
hand, technological progress, such as powerful computers, microscopes, digital networks and scanners, combined with the
advance of science produce knowledge at an exponential rate (push factors). New knowledge can be a formidable source of
opportunity for people who are able to use this knowledge to answer needs that are often unformulated.

FIGURE 2.4 A process model of creativity, innovation and entrepreneurship

Many people see the successive stages of ideas generation (creativity), ideas evaluation (innovation) and ideas
implementation (entrepreneurship) as being distinct and separate. In fact, these stages can overlap, and entrepreneurship is
not necessarily a linear process. Two important concepts are developed in this section:
It is shown that these three stages essentially consist of creating new knowledge.
It is suggested that this knowledge is developed and formulated through different types of social network.

Knowledge development during the entrepreneurial process

What creativity, innovation and entrepreneurship all have in common is that they are concerned with knowledge
development. In other words, the creativity–innovation–entrepreneurship process is like an assembly line of knowledge and
ideas. Knowledge is an intangible commodity, but it lies at the core of the three stages.
During the creativity stage, knowledge is present in an exceptionally raw form. It might just consist of ideas and sketches
drawn on a piece of paper. During the innovation stage, knowledge is further refined, and the initial idea should pass the
‘feasibility test’. At this stage, knowledge is often codified, for instance in the form of a formula or patent. However, the best
patent does not constitute a finished product. For this we need an entrepreneur who is able to organise and coordinate
resources to manufacture and market the product that integrates the patented technology. During the entrepreneurship stage,
knowledge is embedded in the product or service marketed. It is the extent to which the entrepreneur can generate, explain
and protect this knowledge that will ensure the firm has a competitive advantage.
Therefore, the development and deployment of unique resources and distinctive skills are necessary for achieving
organisational survival, profitability and growth. Such resources and skills are also referred to as competencies, which must
be sustained by continuous learning.43 Knowledge constitutes the essence of competencies, and the way organisations create
new knowledge is intrinsically related to the creativity–innovation–entrepreneurship process.
In the case of established organisations, the crucial role that corporate entrepreneurship activities play in the creation of
knowledge has been recognised.44 Formal and informal corporate entrepreneurship activities can enrich a company’s
performance by creating new knowledge that becomes the basis for building new capabilities or revitalising existing ones.
Indeed, some of the most important contributions of corporate entrepreneurship may lie in the development of critical
capabilities that are much needed for the creation and commercialisation of new knowledge-intensive products, processes or
services.

Developing and disseminating knowledge through social networks

Social networks are the catalyst for the development and dissemination of knowledge, both for emerging and established
organisations. Would-be entrepreneurs’ personal networks — the set of people to whom they are directly linked — affect
their access to social, emotional and material support.45 Network relationships and contacts are basic to (1) identifying
opportunities and (2) obtaining the knowledge and resources required to exploit opportunities. Regardless of their abilities,
would-be entrepreneurs who are low on the socioeconomic scale and who possess poor networking skills may find
themselves cut off from emerging opportunities and critical resources.
Social networks can be characterised by three main features: their diversity, their affective or emotional strength, and their
structural equivalence — that is, the degree to which actors in the network have similar/dissimilar social relationships.
Diversity arises from the various characteristics (in terms of age, gender, ethnicity, education and occupation) of the people
forming the network. Diversity in network ties, for example, is essential for would-be entrepreneurs, as it widens the scope of
information about potential innovations, business locations, assistance schemes and sources of capital. Therefore, a network
of uniform or similar ties will be of limited value to an entrepreneur.46
The relationships between the people in the network can be strong, weak or indeterminate/fluctuating.47 The most durable
and reliable relationships in personal networks are strong ties, which are usually of long duration. Strong ties are built on
mutual trust and are not governed by short-term calculations of self-interest.48 Weak ties, on the other hand, are superficial or
casual and normally involve little emotional investment. Weak relationships are typically of shorter duration and contact is
less frequent. The loosest ties — fluctuating ties — can best be described as contacts. This type of network relationship is
created for pragmatic purposes with strangers with whom the individual has generally had no previous contact.

Screening opportunities
The creativity–innovation–entrepreneurship process essentially entails identifying and evaluating opportunities. During this
process, business ideas will be assessed to determine if they represent an entrepreneurial opportunity — a situation where
sustainable value and wealth can be created. There are many different tools available for evaluating entrepreneurial
opportunities, most of which have been developed by venture capitalists and business consultants. One such tool is depicted
in figure 2.5. The process consists of a series of strict filters that are first used to screen for opportunities in order to identify
those that offer a significant, commercial viable potential to be exploited. Versions of the screen, sometimes known as the
Schrello screen or the R-W-W (‘real, win, worth it’) screen have been circulating since the 1980s, and have been used by
large corporations to assess business potential and risk exposure in their innovation portfolio.49 Any tool that aims to assess
an opportunity should address three critical issues:
 Product feasibility — Is it real? Can the product be made or service delivered using currently available, or at least
feasible, technology?
Market feasibility — Is it viable? Does anyone want it? Has the product any features that someone values and would
be ready to pay for?
Economic feasibility — Is it worth it? Can the product be developed, manufactured and distributed while generating a
profit?

FIGURE 2.5 Feasibility analysis: structured process to screen opportunities

Is it real? Establishing the novelty, patentability and technical feasibility

The first step of the process consists of determining the novelty, the patentability and the technical feasibility of the product
or service delivery. Typically, about 50 per cent of opportunities would not pass this filter because the innovation is not
genuinely novel, it cannot be patented or the entrepreneur does not own the technology; someone else, somewhere else, has
already disclosed and/or patented it.

Is it novel?
Quite a few ‘inventions’ are not novel — findings in one field turn out to be well known in another, a situation not helped by
specialist scientific jargon and acronyms. Many would-be entrepreneurs are in fact reinventing the wheel. An initial search
on the internet might quickly reveal that an invention is not novel, since most leading scientific groups these days use the
internet extensively to post details about themselves and their work. It is also easy to conduct a patent search via the websites
of the main patent registration authorities in the world, such as the US Patent and Trade Mark Office (www.uspto.gov) and
the European Patent Office (www.european-patent-office.org).

Is it patentable?
A patent is a right granted for any device, substance, method or process that is new, inventive and useful. Double-checking
that the ‘innovation’ meets these basic requirements can potentially save a lot of work. Although commissioning a patent
search costs money, it is not prohibitively expensive, although the use of a professional patent lawyer is recommended.
Other new and useful innovations such as artistic creations, mathematical models, plans and schemes are not patentable, but
can be protected by other intellectual property rights. Trademarks, copyrights and design rights may, therefore, have a
valuable role, and should be included in the search at this stage. In any case, if the innovation is not patentable, a clear
concept of the product or the service must be laid out.

Is it technically feasible?
How do you find out whether a product idea is feasible? One way is to conduct a peer review. Under suitable non-disclosure
agreements, opinions should be sought from other leading professional scientists in the relevant technical field. They should
also be able to inform you of any rival technologies. In addition, the development of a product prototype is recommended at
this stage. Prototyping can help identify technical challenges and provide useful insight into possible manufacturing
challenges for subsequent mass production.

Is it viable? Showing the superiority of the product and market interest

The question of product viability is the point at which 30 per cent of ‘innovations’ fail. Cases of scientific fraud are few but
do occur. More frequently there are misinterpreted results or, quite simply, a better product already exists.

Is it better than rival products?

An internet search should now be conducted using a search engine such as Google. Again, a skilled search will swiftly lead
to the discovery of existing products if they are available. Separate searches should be conducted for each application of the
technology, and they should be carried out in two ways: first, for the exact product, and second, for products that perform the
same function. Which offers commercial benefit? Which is faster, cheaper and easier? Note that there are three types of
commercial advantage: (1) the saving of time in comparison to existing products (time to market or to money); (2) the saving
of money in comparison to existing products; or (3) the enabling of future, valuable products of a type not currently
available. Potential applications can be dismissed because the technical advantages do not translate into commercial
advantages. ‘Smaller is only better if smaller is needed.’
Remember that the market is indifferent to how the technology works, instead buying the benefits that technology can
provide. Through close examination of rival technologies, it is possible to determine which technical attributes are
advantages. A good rule of thumb is that the new technology should have at least one feature that promises to be ten times
better than its rivals, and this should be quantifiable in a definite measure, such as dimension, speed, time, range or
availability.

Does somebody want to buy it?

The next filter aims to check that there are indeed potential buyers — whether individuals or companies — willing to adopt
and pay for the commercial advantages. These buyers should then be contacted to verify that they would value the offered
advantages if the development proved successful, and to determine what they would require in order to make such a decision.
There is no greater reassurance of the viability of a novel technology than potential customers who clearly state that they
would like to obtain, and are willing to pay for, the commercial advantages that the technology could offer.
It is not necessary to consider every potential customer at this stage; only a few ‘lead buyers’ should be contacted. Note that
any ‘not interested’ answer from a potential buyer is only on behalf of that buyer alone — this individual does not speak for
the industry as a whole or all existing rivals. Again, it is worth checking why an offer has been rejected, as this allows any
perceived or actual inadequacies to be addressed. Therefore, it is more effective at this stage to take a qualitative approach
that involves contacting key potential customers to seek their opinions and discuss the product offering in detail.

Do we have superior resources?

After establishing that the offering can win, the entrepreneur must determine whether or not the company’s resources,
management and market insight are better than those of the competition. If not, it may not be possible to sustain advantage,
no matter how good the product.

Is it worth it? Showing a positive return

Will the product be profitable at an acceptable risk? Few products launch unless the entrepreneur — or the top management
in the case of a large company — is confident that the forecasted return is greater than costs. A successful launch requires
projecting the timing and amount of capital outlays, marketing expenses, costs, and margins; and applying time to breakeven,
cash flow and other financial performance measures. The business plan is the document that provides an overview on the
economic feasibility of the project. It involves planning resources and developing a budget, which is then compared with the
end-point value (the sales projections derived from a market survey) to ascertain the true market size that can realistically be
captured.
What is the market size and attributes?
Would the market size and attributes lead to the advantages actually being paid for? In other words, are the applications
viable or would the market either ignore their benefits (as nice but not needed) or wish to absorb the benefits (taking them if
offered but not paying for them)? To find this out, questions must be asked about the size of the markets, the openness of the
markets to new products or attributes, and the rate and direction of change in the markets. The result of this inquiry helps to
identify potential market segments, determine paths to the market and ultimately generate sales projections.

 2.3 Components of creativity and

Summary 
creativity techniques
SUMMARY
Learning objective 1: understand the nature of creativity
The dictionary defines creativity as ‘the use of imagination or original ideas to create something’; in practice, we can
see it as the ability to produce work that is both novel and useful. It is a combination of thinking skills including
associating, pattern recognition, and divergent and convergent thinking. Its application can range from incremental to
radical, from simple problem-solving to breakthrough insights.
Learning objective 2: understand the creative process
Although often portrayed as a flash of inspiration, creativity actually follows a process of recognition/preparation,
incubation, insight and validation/refinement. Developing creativity is less about injecting something new than in
creating enabling conditions to support a natural process. At the individual level, thinking skills can be enhanced
through the use of techniques aimed at developing new ways of dealing with the core process. Group-level creativity
recognises the potential of diversity and interaction and tools to support this include those which enable ‘creative
collisions’. Brainstorming is the best known but there are many others; developments in information technology
provide new ways of bringing groups together.
Learning objective 3: understand the components of creativity, use a series of creativity techniques, and identify
factors influencing creativity
Within every individual, creativity is a function of three components: creative thinking skills, knowledge and
motivation. Several techniques can be used to obtain the initial ‘creative spark’. Among the most popular creativity
techniques are problem reversal, forced analogy, attribute listing, metaphorical thinking, mind maps and
brainstorming. At the same time, several factors can influence creativity. Encouragement, autonomy, resource
availability and workload pressures are important factors in this respect.
Some amazing innovations have been born of a lack of resources, rather than of abundance. Constraints on resources
— be they financial, infrastructure, materials or time — can alter innovators’ search for solutions in the following
ways: changing the focus to ends rather than means driving innovation; abandoning traditional pathways in favour of
new and unfamiliar territory; reframing the problem; creatively combining; experimental learning; and tolerating
imperfection. As innovators we should look for the ‘sweet spot’ between having enough constraints to provide the
pressure to innovate, and too many constraints which will stifle the innovation process.
Learning objective 4: explain the link between creativity, innovation and entrepreneurship, and outline the
steps for screening opportunities
Innovation is the successful implementation of creative ideas within an organisation. Most innovative business ideas
come from methodically analysing several areas of opportunity, some of which lie within particular companies or
industries, and some of which lie in broader social or demographic trends. Innovation is a multidimensional concept.
When considering the extent of innovation, it is possible to distinguish between disruptive and incremental innovation.
Innovation can also concern different elements, such as a product, a service, a process or a combination of these. The
successive stages of ideas generation (creativity), ideas evaluation (innovation) and ideas implementation
(entrepreneurship) can overlap and are not necessarily a linear process. These three stages essentially consist of
creating new knowledge, which is developed and formulated through different types of social network.
A good idea is not enough to start-up a business venture. The idea must be screened in order to identify significant,
commercial opportunities, which will create value for the entrepreneur and the customer. The screening process to
establish the feasibility of the opportunity must address the product feasibility (is it real?), the market feasibility (is it
viable?) and the economic feasibility (is it worth it?).

Review questions
1. What are the different components of creativity?
2. What are the factors that can affect creativity?
3. What are the different sources of innovation?
4. What do creativity, innovation and entrepreneurship have in common?
5. What are the key steps to screening an opportunity?
Discussion questions
1. Can everyone learn to be creative?
2. How can entrepreneurs evaluate the potential return of an innovation?

 2.4 Linking creativity, innovation

Endnotes 
and entrepreneurship
ENDNOTES
1. Christensen, C., J. Dyer and H. Gregerson (2011) The Innovator’s DNA, Boston: Harvard Business School Press.
2. Dyson, J. (1997) Against the Odds, London: Orion.
3. Sternberg, R. (1999) Handbook of Creativity, Cambridge: Cambridge University Press.
4. D. Brazael & T. Herbert, ‘Toward conceptual consistency in the foundations of entrepreneurship’, Paper presented at the
Annual Conference of the International Council for Small Business, 1997.
5. ‘Leaps of faith: A survey of innovation in industry’, The Economist, 20 February 1999, pp. 12–16.
6. T. Amabile, ‘How to kill creativity’, Harvard Business Review, September–October 1998, pp. 77–87.
7. ibid.
8. ‘Why are you “just too afraid”?’, VA Biz Connection, 30 January, 2012.
9. T. Ward, R. Finke & S. Smith, Creativity and the Mind, Plenum Press, New York, 1995.
10. H. Simon, Administrative Behavior, Free Press, New York, 1997.
11. Amabile, op. cit.
12. T. Amabile, Creativity in Context: Update to the Social Psychology of Creativity, Westview, Boulder, CO, 1996.
13. ibid.
14. ibid.
15. C. Thompson, What a Great Idea!, Harper Perennial, New York, 1992.
16. The Economist, ‘The art of making money’, 5 April, 2001.
17. Andalusian Institute of Technology, ‘Guidelines for implementation — EVA guidelines’, 25 March, 2010, www.iat.es.
18. Summer Institute for Engineering and Technology Education, ‘Introduction to engineering design and problem solving’,
University of Arkansas, 1995.
19. R. Olson, The Art of Creative Thinking, Harper Collins, New York, 1986.
20. R. Harris, Techniques for Creative Thinking, self-published, 1998, p. 11.
21. Harris, op. cit., p. 10.
22. T. Buzan, Mind Maps at Work, Penguin Book, New York, 2005.
23. ‘Mind mapping’, http://writingwithict.webs.com.
24. ‘What is mind mapping?’, Online learning centre, 2012, http://olc.spsd.sk.ca.
25. I. Gogorici, ‘Mind mapping — Using your mind’s eye for better management of projects and everyday life’, TEBA, June,
2012.
26. P. Kendiri, ‘Inspiration 5.0 Pro’, 2011, http://jtp.ipgkti.edu.my.
27. ‘Mind Maps’, University of Wollongong, 2002, www.ouw.edu.au.
28. ‘Creative problem solving for managers’, Clear Vision, n.d., http://cvlearn.com.
29. ‘Thinking outside the box’, St. Michael’s College School, 2009.
30. ibid.
31. ibid.
32. F. Wouters, ‘Brainstorming and other cool stuff’, 31 October, 2011, http://it2servu.be.
33. T. Amabile, R. Conti, H. Coon, J. Lazenby & M. Herron, ‘Assessing the work environment for creativity’, Academy of
Management Journal, vol. 39, no. 5, 1996, pp. 1154–84.
34. M. Li, ‘The impact of the national culture on team learning’, 4th International Conference on Wireless Communications
Networking and Mobile Computing, October, 2008.
35. M. West, ‘Twelve steps to heaven: Successfully managing change through developing innovative teams’, European
Journal of Work and Organizational Psychology, vol. 13, no. 2, 2004.
36. D. Wang & Y. Hong, ‘Work support and team creativity: The mediating effect of team psychological safety’, IEEE 17th
International Conference on Industrial Engineering and Engineering Management, 2010.
37. K. Dewerrinck, ‘Empowerment and control dynamics in service contexts: Conceptual exploration and empirical
validation of the impact on frontline employee affect and performance’, dissertation, Ghent University, 2005.
38. T. Amabile, C.N. Hadley & S.J. Kramer, ‘Creativity under the gun’, Harvard Business Review, Special Issue, August
2002, pp. 52–63.
39. St. Michael’s College School, op. cit.
40. World Health Organization, ‘Obesity and overweight’, WHO, www.who.int.
41. J. Marguc J, J. Förster & G.A. Van Kleef. (2011). ‘Stepping back to see the big picture: when obstacles elicit global
processing’. Journal of Personality and Social Psychology. vol. 101, no. 5, pp. 883–901.
42. P. Trott, ‘Innovation and market research’, In L.V. Shavinina (Ed.), International Handbook on Innovation, Elsevier
Science, Oxford, 2004.
43. S.A. Zahra, A.P. Nielsen, P. Anders & W.C. Bogner, ‘Corporate entrepreneurship, knowledge, and competence
development’, Entrepreneurship: Theory and Practice, vol. 23, no. 3, 1999.
44. S. Zahra, A. Nielsen & W.C. Bogner, ‘Corporate entrepreneurship, knowledge and competence development’,
Entrepreneurship Theory and Practice, vol. 23, no. 3, 1999, pp. 169–89.
45. H.E. Aldrich, Organizations Evolving, Sage Publications, London, 1999, p. 68.
46. M. Granovetter, Getting a Job: A Study of Contacts and Careers, University Press, Cambridge, MA, 1974.
47. Aldrich, op. cit.
48. B. Urban, ‘Entrepreneurial networking differences: An ethnic in-group and out-group analysis’, SA Journal of Industrial
Psychology, vol. 37, no. 1, 2011.
49. G. Day, ‘Is it real? Can we win? Is it worth it? Managing risk and reward in an innovation portfolio’, Harvard Business
Review, December 2007, pp. 110–20.

 Summary Part 2 Marketing 

 PART 2
Marketing
3 Marketing, the environment and market analysis
4 Identifying customers
5 Elements of the marketing mix

 Endnotes 3 Marketing, the environment

and market analysis 
 CHAPTER 3

Marketing, the environment and market analysis

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

3.1 provide an overview of marketing, the marketing process, and the exchange of value
3.2 describe the marketing environment and the purpose of environmental analysis
3.3 explain the factors at work in the organisation’s internal environment
3.4 understand the importance of the different micro-environmental factors
3.5 outline the different types of macro-environmental forces
3.6 understand the components of marketing planning.
Do you see what I see?
For many, marketing has a bad reputation. It is important for any aspiring marketing professional to understand the views
of marketing that are widely held in the broader community. Marketing is viewed by many people as an evil force; for
some, it is viewed as a business function that causes people to buy many things they don’t really need with money they
don’t have. For others, the marketing function is blamed for flawed products that are sold in the marketplace. Finally,
others are concerned about the messages that are communicated by marketers. Many marketing messages include false or
overstated claims, and others fail to include complete information — leaving consumers largely in the dark about the
(short and long) effects of a product. These are but a few of the concerns expressed by members of the broader
community about the marketing profession.
Let’s take a brief look at alcohol. Australia, like many developed nations, has a drinking problem, with an estimated cost
to the community of $36 billion a year1 and consequences for society that include alcohol-related violence, the harmful
effects of chronic disease or accident or injury.2 According to the Australian Institute for Health and Welfare, 1 in 5
Australians aged 14 years or older consumed alcohol at a level that put them at risk of harm from alcohol-related disease
or injury over their lifetime.3 Australian research shows that many Australian adults are not adequately informed, and
many do not enjoy alcohol responsibly as a result.4 UK statistics reported in 2011 demonstrate that industry-funded
efforts to promote safer drinking (US$ 104 million) are greatly out-gunned by alcohol advertising (US$ 4.9 billion).5 As a
result, young people are 239 times more likely to see an alcohol advertisement than an advertisement promoting safe
drinking (moderate drinking or abstinence).

Society as a whole is demanding that marketers work for the benefit of all of society and minimise any adverse effects of
marketing activities. Marketing is becoming a discussion between marketers, customers and society that seeks to
negotiate the best possible value for all the stakeholders in the marketing process. At this point in time, it is important —
more than ever before — for marketers to fully understand the products they are marketing and the possible social and
economic consequences of the misuse of products. For marketing’s reputation to improve, the number of socially
responsible messages will need to increase (remember, only 1 in every 239 messages about alcohol promotes safe
drinking). To achieve a long and fulfilling career in marketing, it is best to align with socially responsible organisations
that have the broader community interests and not purely profit motives at heart. Many examples where marketing is
contributing positively to society can be found. It is surely best to market a product or service that is needed, improves
health and contributes positively to society.
 Question
Find one marketing message that concerns you. Why is this message concerning?

INTRODUCTION
Through accident or intent, the most successful businesses throughout history have been those built around and focused on
making their customers happy — and doing it better than their competitors can. Every person, thing and process within a
market-oriented organisation strives to create value for the organisation’s customers. It is the creation of a mutually
beneficial exchange of value between one party and another that is the purpose of all marketing efforts.
Recognising the importance of a market orientation to success, this chapter introduces the concept of marketing as a
philosophy of how to do business. It explores the formal definition: ‘the activity, set of institutions, and processes for
creating, communicating, delivering and exchanging offerings that have value for customers, clients, partners and society at
large’6 and explains how this definition reflects the reality of marketing today.
A lot of people have the misconception that marketing is purely about selling. Marketing is most definitely not well
described as ‘the art of selling products to customers’. Not-for-profit organisations, community groups, governments and
even individuals use marketing practices. For example, the Council of Australian Governments (COAG) Healthy
Communities Initiative is an Australian government initiative that aims to reduce the prevalence of overweight and obesity
within target populations. The target populations consist of individuals at high risk of developing chronic disease and who
are not predominantly in the paid workforce. For more information about the campaign, go to www.healthyactive.gov.au.
Marketing, done well, is an approach to business that influences and informs every activity of the business or organisation.
As you read through this chapter, think about how the ideas discussed can be applied to the things you encounter in your
everyday life. You will realise that there are some common elements to each instance of marketing, such as product, price,
promotion, place (distribution), people, processes and physical evidence. How these factors come together to provide a
complete marketing experience is what differentiates one marketing effort from another; successful organisations from failed
ones; and having loyal, satisfied customers from having no customers at all.

 Part 2 Marketing 3.1 What is marketing? 

3.1 WHAT IS MARKETING?
Learning objective 1
provide an overview of marketing, the marketing process, and the exchange of value

Marketing is everywhere and much of what you do every day is in some way affected by it. Marketing is an evolving
discipline and each marketer will have their own take on exactly what it is. Some people — mistakenly — think that
marketing is selling; some that marketing is advertising; and some that it is making sure your business is listed at the top of
every Google search that in some way relates to your product. No doubt, you already have your own ideas about what
marketing is.
The most recent formal definition of marketing is:
the activity, set of institutions, and processes for creating, communicating, delivering and exchanging offerings that have value for customers, clients,
partners and society at large.7

Figure 3.1 expands on this definition and begins to explain what each part of it means.

FIGURE 3.1 Marketing defined

The definition refers to ‘activity, set of institutions and processes’, recognising the broad scope of marketing — that it is not
just a function that exists as a ‘marketing department’ within an organisation, and that marketing is about much more than
advertising.
‘Creating, communicating, delivering and exchanging offerings that have value’ recognises that marketing must involve an
exchange that benefits both the customer who buys the product (a good, service or idea) and the organisation that sells the
product (a good, service or idea).
‘Customers, clients, partners and society at large’ recognises that organisations need to conduct their marketing in such a way
as to provide mutual benefit, not just for the users of their products, but also for partners in the supply chain, and that
marketers must consider their impact on society. Marketing brings many benefits to societies, including employment and the
creation of wealth. With careful planning, some marketing activities can be good for customers, people in the supply chain
and the environment. Consider McDonald’s — one of many major coffee purchasers that changed their coffee buying
practices in 2008. Today, McDonald’s serves only Rainforest Alliance coffee. Rainforest Alliance coffee guarantees farms
that meet specific and holistic standards balancing all aspects of production — including protecting the environment, the
rights and welfare of workers, and the interests of coffee growing communities.8 Marketers must be aware of the impact that
products and services sold have on society — and they must work towards minimising the negative impacts and maximising
the positive impacts. This is referred to as corporate social responsibility or sustainability. Corporate social responsibility is a
commitment to behave in an ethical and responsible manner, to ‘minimise the negative impacts and maximise the positive
impacts’.9
Marketing is a relatively new discipline, which came into its own in the 1960s. Many of the ideas that underpin marketing
theories draw on other disciplines, including psychology, sociology, economics and management. Many definitions of
marketing have been proposed over the years and marketing, like any new discipline, continues to evolve today. Figure 3.2 in
the teal box below describes how our understanding of marketing has changed in recent history, including the increasing
importance of service-dominant logic in the progression of marketing thinking.
TRADE
Throughout history people have exchanged what they have for what they have wanted. While some core marketing ideas
(such as mutually beneficial exchange) were at play, formal definitions of marketing did not exist.

LATE 1800S/EARLY 1900S

As technology and infrastructure were developed and built, businesses were able to produce greater volumes of an ever-
increasing range of products. Demand for these goods was strong. Marketing at this time could best be described by the
concept of a ‘production orientation’. Marketers’ offerings were largely determined by what could be made, and what
people bought was largely determined by what was available. This is summed up in the famous quotation of Henry Ford,
‘Any customer can have a car painted any colour that he wants so long as it is black.’ (Black paint dried faster than any
other colour, so it was the most efficient colour to produce.)

1930S
As competition increased, companies could no longer rely on consumers to want and buy everything they could make.
This led to the ‘sales orientation’, which focused on increasing profits through advertising and one-to-one selling.
Consider the American Marketing Association marketing definition in 1935: ‘Marketing is the performance of business
activities that direct the flow of goods and services from producers to consumers.’10

MID TO LATE 1900S

In the second half of the 20th century, customers had so many products to choose from that they could not buy them all.
When they did want to buy a particular product, they could choose from many similar items. In a new era of increased
competition, businesses realised that customers would not automatically buy any product that a business happened to
devise. The approach to marketing changed to a ‘market orientation’ in which businesses worked to determine what
potential customers wanted and then made products to suit. Marketing became mainstream business practice. Successful
businesses in the late 1900s were those that adopted a market orientation throughout their operations and responded to the
market’s needs and wants.

THE 2000s
Today businesses are increasingly faced with not only satisfying customer wants but ensuring they are socially
responsible corporate citizens. Businesses face well-informed customers with an enormous number of competing
products vying for their attention. Marketers have broadened the concept of market orientation to view the market as not
just their customers, but also broader society. This view is reflected in marketers’ consideration of issues such as the
sustainability of their products and the benefits their products might bring to society generally. This is known as a
‘societal market orientation’. Examples of a societal market orientation in action include supermarkets offering to pack
groceries in reusable bags, potato chip marketers developing chips cooked in lower-cholesterol oils and health clinics
offering free vaccinations. Companies with a societal market orientation have practices and policies that seek to minimise
their negative impact on society and maximise their positive impact.

WHERE NOW/WHERE NEXT?

The most recent advancement in marketing is the idea of service-dominant logic. service-dominant logic represents a
move away from a goods-dominant mentality. Marketing inherited a model of exchange from economics, and traditional
definitions of marketing refer to the exchange of ‘goods’, or manufactured output. Examples include cars, orange juice,
tennis rackets — the list goes on. The traditional or goods dominant logic focused on tangible resources (things that you
can see and touch), embedded value and transactions. Over the past several decades, as technology has improved and
goods can be rapidly copied by competitors, new perspectives have emerged. In 2004, Steve Vargo and Robert Lusch
published a paper in the Journal of Marketing introducing the idea of service-dominant logic. This idea has rapidly
gained popularity in marketing worldwide.
 Service-dominant logic focuses on intangible resources, the co-creation of value, and relationships. Today the dominant
logic for marketing is that service provision, rather than a traditional goods focus, is fundamental to marketing exchange.
Service-dominant logic embraces concepts of value-in-use and the co-creation of value, rather than the value-in-exchange
and embedded-value concepts that were characterised in more traditional marketing. Thus, instead of firms being
informed to market to customers, they are instructed to market with customers, as well as other value-creation partners in
the firm’s value network. Companies following service-dominant logic have co-created product flavours, improved
software, advertisements and marketing campaigns with their customers. In 2012, the Stand For Japan contest initiated by
the Japanese agency Asatsu-DK (ADK) was created and implemented to source insights from foreigners about what they
see as truly unique to Japanese culture. Some of the artwork and videos were later exhibited at the underground square of
Tokyo Station from July to October 2012, and at Ad:Tech in Tokyo on 7 November 2012.11

FIGURE 3.2 The evolution of marketing

As you study this course you will develop a deeper understanding of just what is meant by each component of the definition
that we have described and, more importantly, your own understanding of what marketing is. Most importantly, though, you
will understand that for successful organisations marketing is a philosophy or a way of doing business.

The marketing approach to business

Marketing is an approach to business that puts the customer, client, partner and society at the heart of all business decisions.
Marketing requires customers to be at the core of business thinking. Rather than asking which product should we offer,
marketers who adopt best practice marketing thinking ask which product would our customers value or like us to offer.
We are using the word ‘business’ in a broad sense. Remember that marketing is used by:
small businesses and large multinational corporations
businesses selling goods and businesses selling services
for-profit and not-for-profit organisations
private and public organisations, including governments.
As mentioned previously, it is important to recognise that marketing is not just about selling products to customers. In fact,
for many organisations, that is not what marketing is about at all. Think about the following examples. They all involve
marketing.
Cancer is a leading cause of death in Australia. An estimated 120 710 new cases of cancer will be diagnosed in Australia in
2013, with that number set to rise to 150 000 by 2020. One in two Australian men and 1 in 3 Australian women will be
diagnosed with cancer by the age of 85. Cancer Council Australia, a leading not-for-profit organisation, and its members
undertake a broad range of activities, including funding cancer research in Australia. In 2011, the Cancer Council granted
more than $50 million to fund cancer research, and the organisation provides evidence-based up-to-date information to
patients and healthcare professionals. Other activities include marketing a range of skin care products and raising funds to
support cancer patients.12
Breast cancer is a major health issue, being the second most common cause of cancer-related death in Australian women. In
2013, 2862 Australian women died from breast cancer. The lifetime risk of women developing breast cancer before the age
of 75 years is 1 in 11. In June 1990, the ministers responsible for health in all states and territories joined the federal
government in jointly funding a national mammography screening program. The national program now known as
BreastScreen Australia was established in 1991, and is recognised as one of the most comprehensive population-based
screening programs in the world. BreastScreen Australia is targeted specifically at well women without symptoms aged 50–
69, although women aged 40–49 and 70 years and older are also able to seek screening. Today, BreastScreen Australia
operates in over 500 locations nationwide via fixed, relocatable and mobile screening units. Screening has increased
significantly since commencement of BreastScreen Australia in 1991, with a total of 1.6 million women screened across
Australia in 2007–08. Of these women, 1.2 million (78 per cent) were in the screening program target age group of 50–69
years. The program’s aim is to achieve a participation rate of 70 per cent among women in the target age group. As of 2013,
the program was screening 54.9 per cent of women in this age group.13
In 2011, a research report uncovered that consumers love their large, sleek, flat-screen televisions, but are becoming
increasingly frustrated with their dusty and dirty screens. The 2012 Australian Marketing Institute (AMI) Brand
Revitalisation Award Winner Kimberley-Clark launched Viva TV & Computer Wipes in response.14 The wipes are cleaning
products that have been specially designed to safely remove dust, dirt, fingerprints and marks from a range of multimedia
screens — from TVs and computers to phones and tablet. It was the first TV screen cleaning product made available in
Australian supermarket cleaning aisles. At the time of winning the AMI award, the brand was forecast to deliver $4 million
to the cleaning category in its first 12 months.15
Marketing is a science, a learning process and an art. Marketers need to learn what customers, clients, partners and society
want. This is an ongoing process as customer preferences are continually evolving. Customers’ needs and wants change with
each product purchased, magazine read, conversation had or television program watched. Marketers must use information to
maintain their understanding. Marketers must be creative and able to develop new ideas. Markets are cluttered and there are
many options available to consumers. The best marketers are able to offer something that is unique or special to consumers.
In January 2013, Maria Sharapova — ranked second worldwide in women’s tennis — launched a line of premium sweet and
sour lollies called ‘Sugarpova’. With 12 flavours and lollies shaped as high heels, purses and tennis balls, Sugarpova is a
premium lolly brand with a story about reward for success. The brand story is that Sharapova was awarded a lollipop after a
good practice. It seems this is a product range that has been created specifically with girls in mind, with more than 1 million
bags predicted to sell worldwide in 2013. Sharapova has a long history of working with brands — she’s been the face of
brands like TAG Heuer, Samsung, Evian and Head — and she has worked closely with Nike and Cole Haan to design
product lines for their brands. Her choice to align with a lolly was immediately criticised as irresponsible and inappropriate,
with a whopping 21 grams of sugar per serving (five pieces). Following the launch, there were many questions about whether
lollies were the kind of thing sport stars should be promoting. In late 2013, Sharapova announced that she planned to
officially change her name to ‘Sugarpova’ for the two-week duration of the US Open, so that commentators would be
required to refer to her by the brand name.16
Mobile technology has opened up a huge opportunity for companies to collect information and data. Marketers can use
‘active’ data collection — asking mobile users to answer surveys or ‘like’ something on Facebook — or they can collect
‘passive’ information. Our devices are collecting data about us all the time. The GPS feature on most smartphones offers one
example. Apps such as FourSquare or our navigation apps track our whereabouts passively, and this information can be used
by marketers to track the habits of consumers.

The marketing process

The marketing process involves understanding the market to create, communicate and deliver an offering for exchange. The
marketing process is an ongoing cycle and often marketers will be undertaking multiple tasks simultaneously. However,
when you start your first marketing job, you will have to start with ‘understanding’, and, for this reason, we will look at the
marketing process sequentially. Marketers start by understanding the consumers, the market and how they are currently
situated. This may involve undertaking some market research to gain insights into a problem the marketer currently faces or
reviewing sales data to understand how the company is currently performing. Marketers need to undertake a situation
assessment to understand how their company is positioned relative to the competition.
The understanding phase of the marketing process involves an analysis and assessment of the marketing environment and
markets (local and/or international), as well as consumer and business buying behaviour. Marketers must start by
understanding the situation they currently face, including both internal and external factors, in order to create a solution to
meet the needs and wants of customers. Marketers use market research to understand consumer motivations, abilities and
opportunities to act. For example, wine marketers can access market insight reports from a market research company, such as
the Nielsen Company, in order to understand which wines they should range in their stores, how their wines should be
branded and which consumers they should target with promotions. For example, a recent Nielsen report revealed that buyers
of New Zealand wine are:
more likely to be in their thirties
more likely to live in metropolitan areas
more likely to have a household income of over A$100 000 per annum
more likely to experiment within the wine category
less likely to be brand loyal.17
Armed with this knowledge, marketers would understand that placing several varieties under one umbrella brand might be
the best way to generate brand loyalty for New Zealand wines in Australia, and they could take steps to create, communicate
and deliver such an offering to the market.
Let’s take another example to illustrate the marketing process. Imagine that a food marketer, based on research and an
understanding of current trends, determines that his company needs to create a new flavour of yoghurt in order to maintain or
grow sales in this product category in the dairy aisles of supermarkets relative to competitors. Once testing and creation of
the new flavour variant is complete, the food marketer needs to communicate the offering to the market. This could be
achieved, perhaps, via mass media advertising and/or a point-of-sale campaign, in order to change the way a group of target
customers think and purchase. The food marketer must constantly ensure their product is delivered and available at a time
and place that is convenient for the customer. The new flavour yoghurt variant in this example has therefore progressed from
the food marketer’s initial understanding of market requirements through the production process and distribution chain —
ultimately ending up on supermarket shelves, with target customers hopefully being fully aware of the new product offering.
Marketers need to constantly monitor and understand their effectiveness in all aspects of this process, as this cycle is
ongoing. Figure 3.3 visually represents these four broad components of the marketing process and the interrelationships
between each.

FIGURE 3.3 The marketing process involves understanding, creating, communicating and delivering an offering for
exchange of value.

It is important to note that delivery in the process outlined in figure 3.3 is also concerned with quality and satisfaction.
Marketers need to ensure the offering (product, service or idea) satisfies the customer. Customers want products and brands
that are reliable and services that fulfil promises. Many companies track quality to ensure they are delivering a product that is
consistent, and which meets consumers’ expectations. Marketers that are able to consistently satisfy their customers can
build loyalty and, in turn, this can lead to word-of-mouth. It is commonly accepted in marketing that keeping customers loyal
is cheaper than gaining new customers and that brands with a loyal base of customers have a value that is an asset for a
company. For this reason, branding is studied by many marketing academics to understand how to build and maintain brands.
Spotlight: USM Events and the multi-sport market
Timo Dietrich, Griffith University
USM Events has over 30 years of experience in managing triathlon and multi-sport events. Founded in 1982 with the
legendary Noosa Triathlon, USM Events has grown into an international company that develops and manages mass-
participation sporting events throughout the Asia–Pacific region. The company manages 18 events; attracts 50 000
competitors each year; and operates from four offices based in Melbourne, Brisbane, Noosa and Auckland.
Recent decades have seen a massive increase in the triathlon customer base, along with other endurance sports such as
running and swimming. Since their beginnings in the early 1980s, triathlons have blossomed, with a range of events
hosting over 200 000 participants in 2012, and Australian running events are now seeing participation numbers over 85
000 at some events. Going forward, there is a great opportunity to produce multi-sport events that cater for a wider
audience. As the industry of multi-sport has grown, so has the knowledge base of customers participating in these events.
Today, customers have the luxury to choose an event that best fits their interests.

USM recognised that it would need to expand its product offerings to maintain its leadership position in the Australian
and New Zealand market. As a result, in 2012 the integration of the highly successful Ironman and Ironman 70.3 events
into USM’s portfolio was announced. The appeal for USM of adding events stemmed from opening up the multi-sport
world to a larger customer base. Most Ironman festival weekends feature a pinnacle triathlon event, five kilometre fun
runs, one kilometre ocean swims and children-only events. This allows triathlons to be introduced to participants in a fun
manner, and provides opportunities for the entire family to get involved on race weekend.
One of the key success factors for USM Events is a young and dynamic team that is close to its stakeholders and listens to
the market forces. Stakeholder insights are important, as they enable USM to competitively and strategically align itself
with the needs and expectations of participants, spectators, officials and event partners. The company places high priority
on listening to what its customers would like out of a multi-sport event. For example, online surveys are emailed out after
every event to provide participants the chance to critique the event. Local surf clubs, sponsors and sporting communities
are consulted in each event market to ensure the existing stakeholders are satisfied with the event production.18

Question
Visit the USM Events website (www.usmevents.com.au). In terms of what you have read in the chapter so far,
how would you describe USM Events’ approach to business and the marketing process?
The exchange of value
The aim of marketing is to develop mutually beneficial exchanges. Consider this example. A customer buys an 84 inch, ultra
high-definition 3D television for $15 999. The retailer and manufacturer receive money for the purchase and clear one stock
unit, which contributes to their profits. The customer receives their much-wanted television, which they hang on their wall at
home. The customer enjoys better quality sound and picture and a more aesthetically pleasing television, along with many
other benefits. Both parties have received a benefit and both parties had to give something up to receive something in return.
To be considered a successful marketing exchange, the transaction must satisfy the following conditions:
two or more parties must participate, each with something of value desired by the other party
all parties must benefit from the transaction
the exchange must meet both parties’ expectations (e.g. quality, price).
Once again, exchange can occur for all different types of organisations: large and small, for-profit and not-for-profit, and
private and public. Consider the following examples of exchange:
Electricity is sold to an electricity retailer. A wholesaler sells electricity to an electricity retailer for $40 per megawatt hour.19 Wholesale electricity
prices are impacted by weather, demand for power by manufacturers, energy use levels by households and electricity supply. The electricity retailer
operates a network that is used to supply and sell electricity to households and/or manufacturers for a profit.
Sales of Snickers bars surged globally from $3.3 billion in global sales in 2011 to $3.6 billion for 2012, capturing a 1.8 per cent share of the global
candy market, according to Euromonitor. The brand — supported by the BBDO developed ‘You’re not you when you’re hungry’ advertising
campaign that first featured Betty White being crash-tackled in a Super Bowl advertisement — has brought Snickers back to the top of consumers’
minds.20

Both parties need to feel the exchange will leave them better off. Without this, exchange will not take place. Think about our
first example again. The customer was quite happy to spend $3299 on a 127 centimetre, 3D television because the benefits
received (3D picture, sound and aesthetics) outweighed the cost of purchasing the television. Further, the retailer only sold
the television because it could make a profit that could be paid to the business’s owners. Exchange is a value-creating process
because it leaves both parties better off.
Like exchange, value is a core marketing concept. Value is a customer’s overall assessment of the utility of an offering based
on perceptions of what is received and what is given.21 Some marketers view this simply as a ratio between quality and
price. This is the economic view of value. According to this view, value is a comparison between what a customer gets and
what a customer gives; in other words, the benefits a customer receives from a product in relation to its price. Other
marketers view value as unique and determined by the beneficiary. According to this view, value is idiosyncratic,
experiential, contextual and meaning laden. When value is viewed this way, it is not thought of in terms of one transaction.
Rather, value is thought of in a way that helps to promote customer loyalty and to consider the lifetime value of the customer
to the firm.
The idea that value is a ratio between quality and price is a simple view of value to help you to understand the concept.
Marketers know that the idea of value is more complicated. Value refers to the ‘total offering’. This includes all aspects, from
the reputation of the organisation to how the employees act, the features of the products, the after sales service, quality and
price. Most companies have competitors and value is relative to the competition as the competing offerings influence how a
customer perceives value. For example, say two different brands of diet yoghurt are available for purchase this week at Coles
Online Supermarkets. Nestlé Diet Apricot Yoghurt 2 × 200 gram packs sell for $2.58 while Yoplait Forme Yogurt Banana
Honey 2 × 175 gram packs sell for $2.91. It is likely that Nestlé will be perceived as offering more value with a cheaper price
and larger pack size than Yoplait.
Value evolves continually. Value changes with each purchase, experience and conversation that a person has. For example, a
student purchases a laptop online and tells her friend that by purchasing online she saved $100. Her friend had purchased the
same model laptop at the recommended retail price at a department store near campus. She chose the department store
because it was convenient and she does not have a credit card. While she was happy with her purchase at the time because it
was quick and convenient, she no longer feels satisfied with her purchase because her perception of value has changed.
Going back to the yoghurt example, the Nestlé yoghurt was on sale this week. It usually retails for $3.15. The Yoplait
yoghurt may now be perceived to be better value.
Value means different things to different people. Value is unique for each individual.22 Some customers perceive value when
there is a low price while others perceive value when there is a balance between quality and price.23 Going back to the flat
screen television example used earlier, the customer paid $3299 for a 127 centimetre, 3D television. Another person might
think that $3299 is an outrageous price for a television. It is clear then that value is a matter of individual perception. This is
where marketing becomes a little more complicated, because marketers have to understand the perceptions of the market.

The market
A market is a group of customers with different needs and wants. Markets cover varying groups of customers from
geographic markets (e.g. the Malaysian market), product markets (e.g. the smartphone market) and demographic markets
(e.g. seniors), to name a few.
Markets can also cover different types of customers. Remember from our definition of marketing that marketing is aimed at
‘customers, clients, partners and society at large’. The term ‘customer’ is used most frequently in this text to help you to
better understand marketing because you are a customer. You are a customer who buys goods and services for your own and
maybe others’ use and you are already able to understand marketing from a customer’s point of view. Our aim in this text is
to teach you to understand marketing from a marketing organisation’s or manager’s point of view. While there are different
groups that marketers cater to, the underlying principles of marketing remain the same.
Different marketers have to market to different groups. Some have to market to customers or consumers, others market to
businesses or clients, while other marketers have to consider the needs and wants of society in general. The group that the
marketer has to market to is the focus of all marketing activities.
Successful marketers are those who view their products in terms of meeting customer needs and wants. For example, a
company that operates vending machines that serve hot drinks should view its business as one that quenches people’s thirst,
warms them when out on chilly winter nights and gives them a caffeine boost when they are feeling tired; not as a business
that places machines on train station platforms and mixes lukewarm water with powdered flavouring in a cardboard cup.
We will now discuss each group — customers, clients, partners and society — in turn.

Customers
Customers are those people who purchase products for their own or someone else’s use, while consumers are people who
use the good or service. For example, a mother buys hair shampoo and conditioners for her own use. Her two children also
use the hair shampoo and conditioner when they need to wash their hair. The children use or consume the products but they
did not purchase them.

Clients
In the general sense, the word ‘client’ is often used as a synonym for ‘customer’, especially with regards to professional
services such as those provided by lawyers, accountants and architects. In the formal definition of marketing, however,
clients refers specifically to ‘customers’ of not-for-profit organisations or social marketers (i.e. those seeking to encourage
social changes), thus serving as a differentiator from customers of businesses. ‘Customers’ of Medicare, Centrelink or a
public hospital and the viewers of anti-drug advertisements are all examples of clients.

Partners
Partners are organisations or individuals who are involved in the activities and processes for creating, communicating and
delivering offerings for exchange. For example, a partner may be an advertising consultant who is hired to develop marketing
communications to raise awareness for a sports club that wants to recruit new players for next year. A partner might be a
supplier of raw materials or a retailer in the distribution channel. Thinking back to our flat screen television example,
partners of the flat screen television manufacturer would include the retailer who sells the flat screen televisions to customers
and the manufacturing company that supplies television screens to the television manufacturer. Marketers need to understand
how their partnership will benefit the partner. For example, say a wine marketer wants retailers to stock their new wine.
Before agreeing to stock the new range of wine, the retailer needs to be convinced by the wine marketer that including this
wine in their product range will benefit their business.

Society
Society is a body of individuals living as members of a community. A society is a highly structured system of human
organisation for large-scale community living that normally furnishes protection, continuity, security and an identity for its
members. Marketers must understand the needs of the societies in which they operate. For example, Toyota developed the
Prius (a hybrid car that generates its own electrical power, thus reducing the amount of petrol it consumes) in response to
growing concerns about the environmental impact of cars. Successful marketers demonstrate an awareness of community
concern about the natural environment, responsible use of resources, sustainable practices and social equity. Studies suggest
that companies that demonstrate social responsibility have higher profits and market capitalisation.24
Spotlight: Telstra: the challenge of delivering value over time
Marketing is an approach to business that puts the customer at the heart of all business decisions. The world is rapidly
changing, placing many businesses at risk as customers adapt to advancing technology. Telstra is one major Australian
business that needs to undergo a rapid transformation to remain as relevant to customers today as it was in the 1990s
when every Australian house had a fixed Telstra telephone line.
Telstra shareholders face a problem. With industry competition increasing and technologies rapidly evolving, Telstra’s
ability to continue delivering its 28-cent-per-share dividend is under threat. When the company was floated in 1997, it
enjoyed a near monopoly of the Australian telecommunications industry. Much has changed since. The mobile business,
once Telstra’s dominant business, is characterised today by cut-throat competition. Alan Kohler sums up the challenges
facing Telstra well.
One of my daughters moved out last week. The little house she’s now living in doesn’t have the phone on and she and her housemate have
absolutely no intention of putting it on.

The rise of mobile, coupled with an evolving, more web-like TV market, will present a vastly different communications
landscape. Rising to the challenge will entail many changes to old business processes and networks for companies such as
Telstra. Forecasts suggest that by 2017, 85 per cent of the world will be covered by 3G mobile internet, and half will have
4G coverage. Three billion smartphone users will contribute to data traffic that’s 15 times heavier than today’s. The trend
is clear. Communication technologies are moving almost exclusively to the internet. Landlines are steadily being replaced
by VoIP services and mobiles, and online TV streaming is gaining ground.
Rather than text or call, research by Nielsen shows that younger users increasingly communicate online through
Facebook and Twitter. This has already eroded Telstra’s pricing power. Text messages, once charged at 25 cents a pop, are
now effectively free on most mobile plans.25

Question
How can Telstra deliver value to customers while increasing shareholder value?
Concepts and applications check
Learning objective 1 provide an overview of marketing, the marketing process, and the exchange of value
1.1 Find an example of marketing in action and analyse the extent to which you think the marketer has adopted ‘marketing thinking’.
1.2 Find an example of a socially responsible company. Explain why you feel this company is socially responsible.
1.3 Find an example of a company that is co-creating with customers. Explain why you feel this is an example of co-creation.
1.4 Define marketing in your own words. How has your understanding of marketing changed after reviewing the first part of this
chapter?
1.5 Explain how marketing can be used by not-for-profit organisations. Discuss an example in your answer.
1.6 Provide three examples of products for which the customer may not necessarily be the consumer. Briefly outline how this would
affect the marketing of each product.
1.7 In your own words, define ‘value’.
1.8 Our perceptions of value are constantly changing. Describe the last time that your perception of value changed for mobile phone
packages (either pre-paid or plan). To answer this question you might want to describe your most recent mobile phone plan, the
factor(s) that led to your change in perception and how your perception changed.
1.9 You are applying for a graduate marketing job. How is a graduate marketing job mutually beneficial (for you and your new
employer)?
1.10 Go to the Apple website. Print a picture and the specifications of the latest iPad or iPhone release. Interview two people,
showing them the information you have obtained and the picture. What are their perceptions of value? Do they view value as an
economic function, or is value viewed differently?

 3 Marketing, the environment

3.2 The marketing environment 
and market analysis
3.2 THE MARKETING ENVIRONMENT
Learning objective 2
describe the marketing environment and the purpose of environmental analysis

In addition to understanding the needs and wants of their customers and clients, and balancing these against the organisation
needs, marketers need to understand the wider environment in which they operate. They need to understand their products in
light of what competitors currently offer and what they expect to offer in future. Marketers cannot expect to succeed by
devising one strategy and sticking with it; nor will they succeed by simply copying a competitor. In many ways, then,
marketing can be likened to a game of sport. Like a sports team, organisations need to develop and implement a strategy to
win, and they must be prepared to change their strategy to outfox their competition. Again like a sport, if you are ten points
behind at half-time, there is little point carrying on with the same approach. If you are ten points ahead, you need to ensure
you maintain and increase that margin. To achieve this, marketers need to understand and be attuned to their customers and
society at large. Marketers need to plan and think of ways to stay one step ahead of the competition. Apple might be a good
example of a company that can do this. Can you think of another?
As one means of staying ahead of the competition, marketers need to keep their ‘fingers on the pulse’. To better meet
customer needs — and to devise ways they can convince employees and/or partners to change if necessary — marketers need
to understand both who they are competing with, and what barriers to change currently exist in their own organisation and in
partner organisations.
This chapter is about understanding the environment in which organisations exist. In addition to their own internal
environment, organisations operate within a micro environment (comprising the various players in the industry such as
suppliers and competitors) and a macro environment (comprising broader forces such as social values and laws). Marketers
must be able to analyse the environment in which they operate to obtain a comprehensive understanding of the situation they
face. This understanding, together with management’s objectives, is used by marketers to formulate a strategy to compete in
the marketplace.
The marketing environment refers to all of the internal and external forces that affect a marketer’s ability to create,
communicate, deliver and exchange offerings of value. The factors and forces within the marketing environment can be
classified as belonging to the internal environment, the micro environment, and the macro environment (see figure 3.4). The
internal environment refers to the organisation itself and the factors that are directly controllable by the organisation. The
micro environment comprises the forces and factors at play inside the industry in which the marketer operates. Micro-
environmental factors affect all parties in the industry, including suppliers, distributors, customers and competitors. The
macro environment comprises the larger-scale societal forces that influence not only the industry in which the marketer
operates, but all industries. Macro-environmental factors include political forces, economic forces, sociocultural forces,
technological forces, environmental forces and legal forces. This macro-environmental framework has been called the
PESTEL (for political, economic, sociocultural, technological, environmental, legal) framework. Micro-environmental and
macro-environmental forces are outside of the organisation and, while they can be influenced, they cannot be directly
controlled.
FIGURE 3.4 The marketing environment

Marketers seek to monitor, understand, respond to and influence their environment. This is a complex task and encompasses
all of marketing. Environmental analysis is an analytical approach that involves breaking the marketing environment into
smaller parts to better understand it. This chapter introduces key considerations for an environmental analysis in order to
provide you with insights into some of the things that effective marketers need to understand.
Spotlight: Looking for a clean solution
A party work report delivered by outgoing premier Wen Jiabao on 5 March 2013 demonstrated a clear awareness among
China’s leaders that the country faces major challenges. The Chinese economy was portrayed as favouring inefficient
state enterprises over the private sector; favouring economic growth over population health; and facing in many industries
what Wen termed ‘blind expansion’ that has led to overcapacity, pollution and financial risks.
One example of expansion in China is the building of coal-powered energy plants, which are the most polluting of all
power stations. The World Resources Institute identified that China was planning to build a further 363 plants over 12
months. The capacity of the new plants adds approximately 500 GW to global greenhouse gas emissions — the
equivalent of adding 50 per cent more to China’s current state.26
Given that reports of hazardous and harmful smog levels in large Chinese and other Asian cities are increasing in
frequency, the addition of new coal-powered energy plants is concerning. In February 2013, Beijing residents were urged
to stay indoors as pollution levels soared in China’s capital. According to global news reports, a thick blanket of smog
covered large swathes of China, causing residents to dig out face masks. This was not the first occasion of intense smog
during the 2012–13 winter period. In this particular instance, the United States embassy’s air quality index reading for
Beijing hit 516 at 6 am, signalling air quality worse than the highest classification of ‘hazardous’.27
While China grapples with balancing economic growth with the needs of its people, an issue for many Chinese
households is reducing exposure to PM2.5 air pollution. PM2.5 air pollution refers to particles that can penetrate deep
into human tissue, causing serious health problems.28 Particles in the PM2.5 size range are commonly present in air and
may be drawn into the body with every breath. In the lungs, particles can have a direct physical effect and can be
absorbed into the blood. Airborne particles, not only the PM2.5 fraction, may also be deposited in the mouth, throat or
nose and be ingested. Companies such as Sharp and Panasonic have been experiencing rapid growth in China by selling
electronics that help purify the air. Sales of Sharp’s air purifiers — which China certifies ‘remove 99 per cent of PM2.5’
— tripled in January 2013 compared with the same month of 2012.29

Questions

1. From the brief overview of the marketing environment provided in the chapter so far, outline some factors
that you believe would particularly affect Sharp air purifiers. Categorise these factors as being part of
Sharp air purifiers’ internal, micro or macro environment.
2. Why would environmental analysis be useful for a company like Sharp?
Concepts and applications check
Learning objective 2 describe the marketing environment and the purpose of environmental analysis
2.1 Describe the factors in the marketing environment.
2.2 Which environmental factors can an organisation control or influence?
2.3 Name the six key forces in the PESTEL model of the macro environment.
2.4 What is an environmental analysis and why is it important to marketing?

 3.1 What is marketing? 3.3 Internal environment 

3.3 INTERNAL ENVIRONMENT
Learning objective 3
explain the factors at work in the organisation’s internal environment

The internal environment refers to the parts of the organisation: the people and the processes used to create, communicate,
deliver and exchange offerings that have value. The internal environment is directly controllable by the organisation. A
thorough understanding of the internal environment ensures that marketers understand the organisation’s strengths and
weaknesses. Strengths and weaknesses are internal factors that positively and negatively affect the organisation’s ability to
compete in the marketplace. Typically marketers seek to minimise weaknesses and maximise strengths.
The most successful organisations are those with a market orientation. This means that all parts of the organisation are
focused on creating and delivering value for the market. While this may seem simple, it is often very difficult in practice.
Organisations consist of people, groups, departments and complex interrelationships. At times these can work against each
other, rather than with each other. In reality, the internal environment of any organisation is affected by the personal and
political natures of the people who make it up. It is important to be aware that as organisational complexity increases, so does
the potential for conflict. Marketers need to understand the parts of the organisation and the processes that are in place. The
main parts of a typical organisation include:
senior management — responsible for making decisions about the overall objectives and strategy of the organisation.
middle management — typically responsible for a department or a geographic region. Middle management makes
decisions about the overall objectives and strategy of the department or geographic region for which they have
responsibility. Their aim is to make sure the objectives for their department or region are aligned with the objectives of
the organisation as a whole.
functional departments — organisations can be structured around functional departments and/or regions. If you are a
business student you will study many of these functions during your degree. Functional departments may include:
– marketing
– sales
– research and development
– customer service
– distribution/logistics
– manufacturing
– finance
– human resources
– administration.
Functional department managers make decisions about the overall objectives and strategy of their department. Their
aim is to make sure the objectives for their department are aligned with the broader objectives of the organisation and
to manage their departments to ensure the departmental objectives are achieved.
employees — employees are responsible for carrying out the work required to meet departmental objectives. Most
corporations talk about their people being ‘their most important asset’. Employees are also the ‘face’ of the
organisation and marketers need to understand and manage the attitudes and behaviours of employees who come into
contact with customers and clients.
external vendors (outsourcing) — organisations often outsource functions and roles if they can be done more
efficiently by specialist external providers. This represents a shift of the function from the internal environment to the
micro environment and thus reduces the level of control. The organisation doing the outsourcing must, however,
manage the service relationship with the external provider, and so outsourced functions still very much affect the
organisation’s internal environment. An organisation needs to ensure that the outsourced services remain consistent
with its own objectives and do not adversely affect its market perception. This does not always occur, however, as
Telstra discovered when one of its offshore information technology vendors, Satyam, was engulfed in a corporate fraud
 scandal. The India-based company overstated its cash reserves by $1 billion. The scandal, along with performance
issues, led to the cancellation of Telstra’s $32 million contract with the company.30
The structure of any organisation can be summarised in an ‘organisation chart’. Most large organisations have a formal chart
that illustrates the relationships between different parts of the organisation and the management hierarchy, but even the
smallest businesses can be charted. Figure 3.5 is an extract of a typical example. An organisation chart can be a very useful
tool to help analyse the internal environment. It gives an indication of the focus of the organisation’s operations, how
different areas relate to each other and where the power rests in the organisation.

FIGURE 3.5 An example of an organisation chart (extract)

Marketers need to understand the objectives for each part of the organisation and how the objectives are being met. They
need to understand whether the objectives align between the various parts of the organisation and whether the objectives are
consistent with the overall marketing goals of the organisation. Employees are individuals and may perceive objectives
differently. Consider the following case.31 Senior management in two Australian financial institutions each decided to shift
the emphasis of financial service staff from a service focus to a sales focus. Under this new strategy employees were given
new titles. According to management, employees who previously had a service role were now called ‘sales consultants’ or
‘sales officers’. Employees resisted the management initiative, however, and continued to refer to themselves as ‘customer
service officers’. One employee commented:
Basically I still think of myself as a customer service officer because I would rather service customers than sell them products. I think it is a much
nicer title.

For many of the employees, their identification as caring service people had developed early in their careers, and they were
unwilling to make a transition from service to sales. Resistance to management’s objectives from the employees would have
reduced the ability of the organisation to meet its objectives.
To be successful, all of the parts of the internal environment should work together towards one common goal. This is most
likely to occur when each person and department understands their contribution and the contribution of other departments.

Internal marketing
Internal marketing is a cultural framework and a process to achieve strategic alignment between front-line employees and
marketing. More specifically, internal marketing is a collection of activities, processes, policies and procedures that treat
employees as members of an internal market who need to be informed, educated, developed and motivated in order to serve
clients more effectively. Companies that provide and practise internal marketing are more likely to satisfy their employees. In
turn, satisfied employees are more likely to deliver to a customer’s satisfaction and be more productive. Research suggests
that if carried out effectively, internal marketing would be expected to positively influence employee attitudes and
behaviours.
Internal marketing is practised in three main ways. First, the primary role of internal marketers is to manage internal
communications to ensure that employees’ actions are aligned with company goals (internal communications). Second,
internal marketing managers use market research to understand employees’ needs and demands (internal market research).
Then, they provide the training needed by employees to reach the company’s goals. The three activities assist marketers to
ensure that all members understand their role in creating, communicating, delivering and ultimately exchanging offers that
have value for the target audience.
The marketing department is best positioned to understand what customers value. It is the marketing department’s role to
collaborate with the human resources department to ensure that all members within an organisation understand their role in
creating, communicating, delivering and exchanging offerings that have value. It is then up to the other departments to use
their own expertise to deliver that value.
With the increasing focus on a market orientation in many organisations, marketers have generally gained more influence
and have been allocated more resources for their activities in recent decades. With this, however, has come an increasing
expectation of results and an increasing need for marketers to be able to demonstrate and quantify their achievements.
Marketing, like all other parts, processes and people in an organisation, must work to achieve the overall organisational
objectives and must always demonstrate how it does so.
In many organisations, the severe squeeze on profits brought about by the global financial crisis resulted in tighter marketing
budgets (particularly in the areas of new product development and advertising) and even more pressure for marketers to
justify their organisation’s investment in marketing. In general, during economic downturns, organisations tend to make
drastic cuts to marketing budgets.32 Marketing is viewed by many organisations largely as a cost, rather than as an
investment. However, companies choosing to grow their marketing investment in economic downturns fare much better
when economic recovery commences. Some companies were too swift to let staff go in the recent downturn in Australia,
making it subsequently difficult to attract good staff when the economy recovered. Whatever the economic conditions,
marketing can help influence consumer behaviour, set prices effectively, create value for marketing expenditure and take
advantage of emerging opportunities.
It should be clear from the previous discussion that the internal environment is not an isolated entity. Much of what happens
in an organisation’s internal environment is affected by what happens in the less controllable external environment.
The external environment is concerned with things that are outside of the organisation. The external environment
encompasses the people and processes that the organisation cannot directly control. Marketers can only seek to influence the
external environment. For example, movie studios cannot prevent people from copying or file-sharing movies and TV shows
with their friends. They do, however, lobby governments to introduce legal penalties for doing so, and they include warnings
about piracy on DVD and Blu-ray packaging, and on the films themselves. Hence, they cannot control the factors in their
external environment, but they do seek to influence them. The process of outsourcing (transferring an internal function to an
external provider) has gone through waves of popularity over the past few decades. It represents a blurring of the line
between the internal and external environment.
A thorough understanding of the external environment ensures that marketers understand the opportunities and threats that
may arise. Opportunities and threats are external factors that positively and negatively affect the organisation’s current and
future ability to successfully serve the market. Typically marketers seek to make the most of the opportunities identified and
minimise the threats arising in the external environment. The external environment includes the micro environment and the
macro environment. We will look at each in turn to provide you with an understanding of the types of external factors that
marketers need to understand.
Spotlight: Please hold
Call centre customers get frustrated at the long waiting times, hang ups, automated responses and lack of information.
How many times have you been left on hold for more than 20 minutes by leading service providers? While it is easy to
criticise call centres as consumers (given that we all have a horror story or two to share), it is a different case when you
are a marketer for a call centre. As marketers we need to not only understand the customer’s experience — we need to
experience working in a call centre to understand the technical support and training required for the teams operating in
that environment.

Picture a call centre. The employees are under pressure to answer calls within the shortest number of rings; answer each
call in the correct way (‘Good morning, my name is … how can I help? Can I have your account number?’); ask the right
questions; listen; provide the right answers or advice (sometimes within a tight timeframe); log the conversation on an
ever-slow computer system; be polite; and close the call. This list is an over-simplified view of the call centre process that
employees are meant to adhere to hundreds of times each day.
Now, think about the environment that call centre employees are working in. Employees work in a small, open space with
noise all around them. Their calls are monitored for training and quality assurance processes. There might even be a
screen installed by management on the wall to constantly display call volume and response time data. All of these things
make it hard to concentrate, and the big screens remind employees there are more angry customers waiting. How can you
motivate employees to deliver a quality service experience in this environment?

Question
Ray White real estate offers a Concierge service (see www.raywhiteconcierge.com.au), which has been designed
to take the hassle out of moving house. With just one phone call, they take care of everything — including
arranging all connections and disconnections, insurance and even home loans for people selling or buying their
home through Ray White. Imagine you are the marketing manager for Ray White Concierge’s call centre.
Name one thing you could do to improve the service experience for a consumer.
Concepts and applications check
Learning objective 3 explain the factors at work in the organisation’s internal environment
3.1 How can a marketing manager motivate an employee to deliver improved customer service?
3.2 Find your bank’s annual report to shareholders (usually available in the investor section of its corporate website), and locate the
bank’s objectives for the next financial year. Were the behaviours of the staff who provided you with service consistent with
management’s objectives? If so, how were they consistent? If not, what improvements are needed for management’s objectives
to be reached?
3.3 Find an organisational chart for a business. Identify the areas of possible conflict that may arise from the structural organisation
of the business. You should consider the number of different levels of management, the number of different departments and the
number of employees in the organisation. How can marketers ensure that all employees understand their contribution and the
contribution of other departments to providing value to customers and clients?
3.4 Outsourcing leads to improved service delivery — true or false? Search the internet and find an example from Qantas airlines to
defend your point of view.

 3.2 The marketing environment 3.4 Micro environment 

3.4 MICRO ENVIRONMENT
Learning objective 4
understand the importance of the different micro-environmental factors

The micro environment consists of customers, clients, partners and competitors. Unlike the internal environment, the micro
environment is not directly controllable by the organisation. The organisation can, however, exert some influence on the
customers, clients, partners, competitors and other parties that make up its industry. For example, a recent survey by
CHOICE found that 60 per cent of Jetstar customers were satisfied with the airline. Jetstar’s customer relationship
management has been overhauled and call centre practices have been changed, allowing the airline to cut complaint
resolutions from 90 to 10 days; also, instead of having to make a formal complaint in writing, customers can now do it over
the phone. While Jetstar can’t directly control a customer, it can influence satisfaction by improving its complaint handling
procedures.33
In one way or another, all of the factors in the micro environment affect the marketer. In analysing the micro environment,
marketers need to consider customers and clients; partners, including suppliers; and competitors. We will discuss each of
these in turn next.

Customers and clients

Marketers must understand the current and future needs and wants of their target market. They must:
understand what their customers value now
be able to identify any changes in customer preferences
be willing and able to respond to changes
anticipate how needs and wants might change in the future
be able to influence customer preferences.
Consider, for example, how downsizing products (a macro-environmental factor) has affected customers and clients (in the
micro environment). Marketers that can respond to these trends in order to satisfy changing consumer preferences will view
this as an opportunity and tailor their marketing mix accordingly. Consumer behaviour is explained in detail later in the text.
In the business-to-business market (i.e. where businesses market their products to other businesses), marketers need to be
similarly aware of the current and future needs of their target market. For example, changes in economic conditions (another
macro-environmental factor), such as movements in interest rates, will likely have an impact on business investment and
spending patterns. Astute marketers keep abreast of such developments, assess their likely impact and implement marketing
strategies accordingly.

Partners
Marketers need to understand their partners, how each partner’s processes work and how their partnerships benefit each
party. Partners include the following.
logistics firms. Logistics is the term used to describe all the processes involved in distributing products; it includes
storage and transport.
financiers. Financiers provide financial services such as banking, loans and insurance, and the financial system’s
infrastructure facilitates electronic payment transactions with partners and customers.
advertising agencies. Small businesses tend to devise their own advertisements, often with the help of the publication,
radio station or other medium they are advertising with. Larger businesses can hire the services of advertising
agencies. When they do so, they put an enormous amount of faith in the agency to attract the attention of potential
customers and encourage them to actually engage in a marketing exchange with the organisation.
retailers. Retailers are the businesses from which customers purchase goods and services. Many retailers, such as
corner shops and supermarkets, sell mainly products made by others. Other businesses make and retail their products,
 particularly small boutique businesses, service businesses and businesses with an online shop.
wholesalers. Wholesalers are an intermediary acting between the producer and the retailers to provide storage and
distribution efficiencies to both.
suppliers. Suppliers provide the resources that the organisation needs to make its products. Suppliers are a crucial
business partner and they must be monitored for continuity of supply and price.
While the word ‘partner’ suggests a mutually beneficial relationship, there are also many risks involved in working with
partners and often the balance of power between partners can be skewed towards one at the expense of the other. For
example, Woolworths and Coles often sell Coca-Cola at a loss during price promotions. They do this because Coca-Cola
specials draw customers to the store and these customers often then purchase other products as well. The Coca-Cola
Company does not need to discount Coca-Cola in order to sell it and so does not offer a rebate to the supermarkets when they
put it on special. This is rare in the food retailing business. Marketers need to know the missions and strategies of their
partners. Ideally their strategies should be aligned and complementary. Marketers need to understand their partners’ cost
structure to enable them to price their offerings appropriately. Marketers need to understand how partners promote their
offerings, if at all.

Suppliers
Marketers need to know their existing and potential suppliers’ costs, availability, time frames and planned innovations to
determine how they can best create value. They also need to know and manage the risks involved in their dependency on
their suppliers. Organisations need to be aware of and pre-empt any problems (e.g. labour strikes and stock shortages) with
the supply of the resources they need to ensure they can fulfil demand. In summary, marketers must identify, assess, monitor
and manage risks to supplies and risks to the price of supplies.

Competitors
The most successful businesses throughout history have been those built around and focused on making their customers
happy — and doing it better than their competitors can. To succeed, marketers must ensure their offerings provide their target
market with greater value than their competitors’ offerings. Marketers seek to understand their competitors’ marketing mix,
sales volumes, sales trends, market share, staffing, sales per employee and employment trends. They do this through casual
and formal analysis.
Spotlight: Woolworths and Coles killing the competition
The Australian grocery market is a mature market and one of the most concentrated grocery sectors in the world. Two
major grocery chains, Woolworths and Coles, dominate the market, together accounting for 80 per cent market share of
an industry valued at $80 billion. To put this into context, in the United Kingdom, the two major chains of Tesco and
Sainsbury have 48 per cent market share; and the United States equivalent supermarket chains have a 20 per cent share.
Woolworths and Coles are opening stores in growth areas and rural centres — killing off competition, obliterating local
small business, and leaving many independent and smaller retailers fighting for survival. At present, Coles and
Woolworths plan to expand store floor space by more than 5 per cent a year in coming years — a rate almost three times
that of Australia’s current levels of population growth — suggesting that any gains made by Coles and Woolworths are at
the expense of small, independent retailers.

In 2012, Master Grocers Australia, an association representing independently operated supermarkets and liquor stores,
released a report titled Let’s have fair competition. Master Grocers Australia says Coles and Woolworths are saturating
the market and opening oversized and unprofitable supermarkets to squeeze out local competition in growth areas and
rural centres, leaving no room for independently owned supermarkets to continue operations. Among the stores, both
opened and proposed, identified as ‘oversized’ by the Master Grocers are:
Seville (population 1800), a proposed 3100-square-metre Woolworths store plus 17 shops
Koo Wee Rup (population 2803), a 2660-square-metre Woolworths store
Bright (population 2100), a 2383-square-metre Woolworths store plus liquor store.
If the claims are true that stores are oversized and unprofitable, the independently owned supermarkets simply cannot
compete. The report called for the Australian Consumer and Competition Commission (ACCC) to investigate, and for
changes in laws to protect smaller competitors in the Australian grocery industry.34

Questions
Imagine you are the marketing manager for an independent supermarket in a town such as Seville or
Bright. From a marketing perspective, how would you attempt to beat larger competitors like Coles and
Woolworths?
Concepts and applications check
Learning objective 4 understand the importance of the different micro-environmental factors
4.1 What aspects of competitors’ operations must an organisation understand as part of its micro-environmental analysis?
4.2 What risks are involved in entering an oligopoly market?
4.3 An organisation cannot directly control its micro environment. It can, however, exert influence. Look at the 2012 Master Grocers
Australia report (Let’s have fair competition). Describe one way that independent retailers were trying to influence their
environment in 2012.

 3.3 Internal environment 3.5 Macro environment 

3.5 MACRO ENVIRONMENT
Learning objective 5
outline the different types of macro-environmental forces

The organisation itself and all of the forces within the micro environment operate within a larger environment known as the
macro environment. The macro environment encompasses the factors outside of the industry that influence the survival of
the organisation. In practice, the macro environment can be at any geographic level including local, state, country or regional
(e.g. the Asia–Pacific or the European Union).
In some cases it is possible for marketers to influence macro-environmental factors. However, these factors will always
remain beyond a marketer’s control. For example, a company can lobby government to reduce the tax on wine, but they
cannot directly control the rate set by the government.
Failure to plan based on emerging trends can lead to business closure. Effective marketers continually monitor the
environment, adapting and changing offers where necessary in response to changes in the macro environment.
News services, business and investment media, libraries, the internet and industry associations are all avenues to inform
marketers of developments in the macro environment. Key environmental factors that marketers need to consider when
analysing the marketing environment include political, economic, sociocultural, technological, environmental and legal
forces. (This view of the macro environment is commonly abbreviated to ‘PESTEL’.) The key considerations are
summarised in figure 3.6 and each factor is discussed in the following sections.
FIGURE 3.6 The macro environment

Economic factors are the focus of economics courses and students intending to major in marketing should seek to take an
introductory economics course if it is not a core degree requirement. An understanding of the political environment is also
encouraged. Students intending to major in marketing should seek to take one course in politics and law to gain a broad
understanding of the political and legal environments. Students choosing to continue in marketing studies will explore
sociocultural factors in detail in consumer behaviour courses.
Political forces
Political forces describe the influence of politics on marketing decisions. Politics is directly relevant to the marketing
organisation through:
lobbying for favourable treatment at the hands of the government
lobbying for a ‘light touch’ approach to regulation
the very large market that the government and its bureaucracy comprise
the ability of political issues to affect efforts at international marketing.
Many organisations, particularly smaller ones, monitor political issues, but do not actively engage in politics. Larger
organisations, or the bodies created to represent smaller ones, can engage directly in politics by seeking to influence
lawmakers. Every time there is a federal election, the sources of large donations to one or other of the major political parties
become headline stories in the media. Organisations can also campaign for legal or policy changes that can have a
fundamental impact on their operating environment. The extensive changes to Australia’s workplace relations system made
by the federal government in recent years are an example of how political forces can change an organisation’s operating
environment.
It is worth noting too that political parties, governments and the public service themselves undertake a lot of marketing
activities. For example, the federal government’s Department of Foreign Affairs and Trade runs advertising campaigns and
maintains its www.smarttraveller.com.au website to inform Australians travelling overseas about laws, customs, health issues
and other matters that might affect their travel decisions.

Economic forces
Economic forces refer to all of those factors that affect how much money people and organisations can spend and how they
choose to spend it. The obvious components of this are income, prices, the level of savings, the level of debt and the
availability of credit.
Economic forces and conditions can change quickly and dramatically, and marketers can find themselves facing a very
different economic environment within a short period of time. Currency fluctuations, for example, affect the prices of exports
and imports. A devaluation of the Australian dollar makes exports cheaper and imports more expensive. The reverse applies
when the currency appreciates on international markets (i.e. exports become more expensive and imports cheaper). Interest
rates are another economic force. Increases or decreases in interest rates can have a significant impact on both consumer and
business confidence, and subsequent spending and investment patterns. The global financial crisis served to highlight an
important aspect of the macro environment: it is made up of global forces that are beyond the control of any individual
organisation or even government.

Sociocultural forces
Sociocultural forces is a term used to describe the social and cultural factors that affect people’s attitudes, beliefs,
behaviours, preferences, customs and lifestyles. They comprehensively and pervasively influence the value people put on
different product offerings. ‘Demographics’ describe statistics about a population. A population can be characterised by its
demographic characteristics: age, gender, race, ethnicity, educational attainment, marital status, parental status and so on.
These characteristics influence the behaviour of society as a whole and the individuals within it. Changes in demographic
characteristics should be expected to result in changes in the behaviour of individual consumers and society generally.
One of the sociocultural themes to become a key issue for marketing organisations over the past couple of decades is the
natural environment. Society (particularly the younger members of society) has become more and more concerned about the
sustainability of humankind’s lifestyle — the effect our activities have on the world that supports us. Think about how many
issues related to the natural environment appear in the headlines every day: sustainability, corporate social responsibility,
global warming, pollution, deforestation, salinity and carbon trading. Marketers need to be aware of these issues and
society’s expectations of how businesses and other organisations need to respond. Some marketing organisations have
already capitalised on the growing environmental concern of society; others have responded to it; others are slow to respond
and potentially risk destroying their businesses.

Technological forces
It is important, when considering technological forces, not to fall into the trap of viewing technology just in terms of iPhones,
satnavs and hybrid-electric cars. Rather, technology is a broad concept based on finding better ways to do things. That is, the
electronic gadgetry of a satnav device is not really the technology; the technology is that a satnav is a better way (than a map)
to navigate to your destination.
Technology is advancing at an unprecedented rate. Our daily lives are touched by technology almost all of the time. It is
similarly common to be touched by technological change. Think about how often you change to a newer, better, brighter
model of mobile phone (or at least how often you would like to). While email, Web 2.0, mobile phones, mobile internet and
e-commerce are an everyday part of your life, they all represent major technological changes that your lecturers have had to
learn to adapt to (with varying degrees of success!).
In a wired world, we are connected most of the time, be it to the internet via a PC, laptop or mobile phone, to our friends via
Twitter, or to our work via a BlackBerry device. Never before have marketers been able to interact with the market as often,
as intimately, and as extensively as they can today. For example, it is reasonably common today for a survey to pop up online
seeking your feedback when you first enter a website.
Technology does not just change the expectations and behaviours of customers and clients. Technological change can have
huge effects on how suppliers work. Today manufacturers, suppliers and distributors are likely to be in constant electronic
exchange with marketing organisations, ensuring stock levels are automatically monitored and maintained, tracking goods in
transit down to the nearest kilometre. Increasingly the customer can see how many goods are in stock or how long they will
have to wait to have an item delivered. Consider the efficiencies brought about by electronic payment systems. How many
more shoes can Mathers sell given a customer can whip out a credit card to purchase a pair that take their fancy, rather than
have to go to a bank, fill out a paper form, stand in line and be handed some crumpled paper currency to carry back to the
shop?
Technology, while enabling many advances, can also pose a threat to marketers. Kodak, long-established as a leading
photography brand, suffered massive downsizing and its business was severely threatened by the advent of digital cameras in
the 1990s. The mass market for photographic film disappeared in a few short years.

Environmental forces
Environmental forces is a term used to describe the environmental factors that affect individuals, companies and societies.
There is a wide range of environmental factors that companies need to be mindful of, including ecological and environmental
aspects such as weather, climate and climate change. For example, natural disasters can directly impact companies. Consider
the 2011 and 2013 Queensland floods, which closed flood-affected businesses for periods of time and impacted the
profitability of insurance companies. Consider Jellyfish, a restaurant located on flood-affected Eagle Street Pier, whose
business was closed for weeks following the January 2011 flood that affected Brisbane; Suncorp Metway, who received over
4500 claims in the week following the January 2013 flood35 or the small business in Gympie that had been flooded up to 4
times in just over 2 years. Environmental factors can have more influence in certain industries, and marketers need to be
mindful of the factors likely to influence their particular industry (e.g. tourism, farming and insurance). Growing awareness
of the potential impacts of climate change is affecting how companies operate and the products they offer, both creating new
markets and diminishing or destroying existing ones.

Legal forces
Laws and regulations are intimately tied to politics. Elected officials and the bureaucracy that works for them are ultimately
responsible for making legislation; that is, for creating and changing laws. Regulations are made under conditions established
by legislation and tend to deal with more minor or more specific issues than legislation. They are by no means unimportant.
Laws and regulations govern what marketing organisations can and cannot legally do. They spell out their obligations to
consumers, partners, suppliers, government authorities and society as a whole. The most significant laws and regulations fall
into the following categories: privacy, fair trading, consumer safety, prices, contract terms and intellectual property.
In a bid to forestall legal regulation, many industries have adopted codes of conduct as a self-regulatory device. Self-
regulation is usually cheaper, and more attuned to industry needs and actual practice. For example, Australian advertisers
established the Advertising Standards Bureau to establish and uphold certain standards in advertising.
As mentioned earlier in the chapter when describing the impact of political forces on an organisation’s macro environment,
larger organisations (and industry lobby groups) can attempt to influence government lawmakers. An example of this
occurred in 2011, when a group of high-profile Australian retailers (such as David Jones, Myer, Harvey Norman and Target)
banded together in an orchestrated advertising campaign. This campaign was designed to highlight what Australian retailers
perceived as an inequity in the market, where offshore retailers are not required by the Commonwealth Government to pay
import duty or GST (goods and services tax) on sales to Australia under the value of $1000. The group of Australian retailers
(which employ Australians and are required to pay 10 per cent GST on all purchases) argue that this inequity places them at a
price disadvantage compared to offshore online retailers. The Commonwealth Government countered by saying it wouldn’t
be pressured into making a decision; while local consumer advocacy group CHOICE argued that the Australian retailers’
campaign was motivated by self-interest, and would only result in higher prices for local consumers.36

Macro-environmental complexity
There are numerous ways to view the macro environment. The PESTEL framework we have outlined in this section of the
chapter is just one. It is intended to help focus on some particular issues of importance for marketers, but it must be
remembered that none of these factors act in isolation. Rather, they are all interdependent, and a change in one will almost
always have consequences for the others. For example, the development of internet technology created a need for new laws
to regulate online conduct; an entire online economy developed; the provision of internet infrastructure and the regulation of
internet content has become a major political issue; the nature of relationships and how people spend their days has been
fundamentally changed by the online world.
Let’s consider another example. Over the past two decades, the world as a whole has become more aware of the need to
minimise the impact of human behaviour on the natural environment. Amid warnings from scientists of global warming,
pollution, the exhaustion of fossil fuels and the extinction of flora and fauna species, individuals, businesses and
governments have begun to give much more weight to the need for business activities to be responsible and sustainable.
Options put forward to encourage such behaviour include proposals for emissions trading schemes and/or carbon taxes. New
Zealand introduced a government-run emissions trading scheme in 2008, while Australia introduced a carbon tax on 1 July
2012, with a cost initially set at $23, increasing gradually until 2015. The role of carbon taxes continues to be debated across
the globe, and many in the general population hold conflicting views. Emissions trading schemes and carbon tax proposals
are designed to encourage market forces to reduce carbon pollution, which is one of the main contributors to global warming.
In 2013 it is estimated that 33 countries and 18 sub-national jurisdictions will have a carbon price in place. According to the
Climate Commission report titled Critical decade: international action on climate change, these schemes cover around 850
million people, or 30 per cent of the global economy, and around 20 per cent of global emissions.37
Emissions trading schemes and carbon tax proposals are generally based on the theory that the price of products that generate
more carbon pollution will increase as a result of the scheme/proposal, reducing demand; whereas carbon-friendly products
will fall to be relatively low in price, increasing demand. Over time, those producers that are larger greenhouse gas emitters
will be less able to compete in the market with those who can produce in a more carbon-friendly manner.
Spotlight: Spending is going online
Many older Australians will remember shopping in suburban strips. This is now a distant memory, with shopping centres
(like Westfield) becoming the favoured retail landscape over the past few decades. Today, statistics show the proportion
of Australians spending money in bricks and mortar shops is declining. Consider Dayle who went to the Mountain Design
shop to look at travel backpacks ahead of her eight week trip to Europe. Dayle tried on the various backpacks in the store
before deciding on the backpack that best suited her needs. She then went home and spent time surfing the internet,
finding the backpack online for $150 cheaper than the in store retail price. She went ahead and ordered the backpack
online, which was delivered free of charge to her front door 48 hours later.

The retail landscape in Australia (and around the world) is changing dramatically. More than half of Australian shoppers
aged over 15 now shop online, causing major concern to traditional bricks and mortar Australian retailers.
PricewaterhouseCoopers and Frost & Sullivan research shows that online shopping in Australia increased 17.9 per cent in
2012 to reach $16 billion. To put this into perspective, retail spending in Australia in January 2013 was estimated by the
Australian Bureau of Statistics to be $21.5 billion in a single month. Of even greater concern to Australian retailers,
growth in internet sales is expected to continue, and it is predicted to grow to $26.9 billion by 2016 at a compound annual
growth rate of 14.1 per cent. This is much higher than Australia’s average retail growth — which, according to the
Australian Bureau of Statistics, is 2.5 per cent.
A key point to note is that the PricewaterhouseCoopers and Frost & Sullivan report excluded spending on such items as
travel and accommodation, event ticketing, financial services products and media downloads (such as Apple’s iTunes
store). This suggests that the true figure of Australian online spending is much higher, and that the retail landscape is
shifting.38

Question
Identify as many macro-environmental forces as possible that would impact Lorna Jane (a fitness clothing
retailer), and categorise them under the PESTEL model.
Concepts and applications check
Learning objective 5 outline the different types of macro-environmental forces
5.1 Identify six macro-economic factors and explain their relevance to marketers.
5.2 You are a marketer for Salt, a resort at Kingscliff in New South Wales. Identify two environmental and two political trends that
will affect your business in the next financial year.
5.3 You are marketing new houses and understand that the trends towards environmentalism and smaller families are beginning to
reduce demand for large homes. How would you respond to these changes?
5.4 Identify two major consumer laws in your country. Explain their relevance to marketers.
5.5 The Australian Competition and Consumer Commission and the Commerce Commission are key regulatory bodies in Australia
and New Zealand respectively. Choose one and locate a recent decision made. How did this decision impact a company?

 3.4 Micro environment 3.6 Situation analysis, organisational

objectives and the marketing plan 

3.6 SITUATION ANALYSIS, ORGANISATIONAL OBJECTIVES
AND THE MARKETING PLAN
Learning objective 6
understand the components of marketing planning

Situation analysis
Before marketers can create an offering for exchange they must understand their current position or situation. Situation
analysis involves assessing the current situation in order to clearly state where the company is now. Together with
organisational objectives, situation analysis is used as the platform for marketing planning, as illustrated in figure 3.7.

FIGURE 3.7 Marketing planning

Consider the following example. A marketer is informed by top management that their objective for the next financial year is
to achieve the number two position in terms of market share for a product that was launched 12 months ago (it is currently at
number four out of six products in the market). Since the launch the product has achieved 17 per cent market share. To gain
the number two position, the marketer needs to increase market share by a further 10 per cent, to achieve a total of 27 per
cent market share. If successful, the marketer will receive bonuses. In practice, where competition exists, this is a difficult —
but not impossible — objective to achieve. The marketer needs to gain a comprehensive understanding of the current
situation, viewed through the eyes of customers, clients, partners and the society at large, in order to develop a marketing
plan to reach the target.
Marketers need to be able to analyse their current situation, understanding not only their own business, but also their
competitors’ businesses and the marketing environment. As stated earlier, situation analysis leads to an assessment of where
we are now. In addition to giving consideration to trends in the internal and external marketing environment, marketers must
understand their past performance. Figure 3.839 outlines key factors that should be evaluated in a thorough situation analysis.
FIGURE 3.8 The situation analysis

SWOT analysis
A multitude of factors are likely to impact a business. When marketers conduct a situation analysis, they will always find that
there are more factors that need attention than they can possibly address within the constraints of the available time, money
and other resources. Marketers need to be able to isolate the key, or most important, factors that need to be addressed to
continue to compete effectively in the market. For example, while a garden nursery will identify that drought and
government-imposed water restrictions will both have a large impact on its business, government-imposed water restrictions
that do not allow people to water outdoor plants will have a more immediate impact. Marketers need to be able to prioritise
or rank the factors to determine which factors will be used to inform their decision making. Factors included in a situation
analysis are expected to have an immediate and sufficiently large impact on the business. A situation analysis must use
insights from customers, partners, suppliers and other areas of the organisation.
Situation analysis involves identifying the key factors that will be used as a basis for the development of marketing strategy.
Marketers must be able to understand the current opportunities that are available in the market, the main threats that business
is facing and may face in the future, the strengths that the business can rely on and any weaknesses that may affect the
business performance. Not surprisingly the method used to identify these factors is known as a SWOT analysis. SWOT is
short for strengths, weaknesses, opportunities and threats.
Strengths are those attributes of the organisation that help it achieve its objectives: competitive advantages and core
competencies. Weaknesses are those attributes of the organisation that hinder it in trying to achieve its objectives. Strengths
and weaknesses are considered to be internal factors and therefore directly controllable by the organisation. Opportunities
are factors that are potentially helpful to achieving the organisation’s objectives. Note the emphasis on the word ‘potentially’
in the previous sentence. Opportunities are only of benefit if the organisation responds effectively to them. Opportunities are
factors that are beyond the organisation’s direct control, though the organisation may be able to have some influence over
them. Threats are factors that are potentially harmful to the organisation’s efforts to achieve its objectives. Like
opportunities, threats are beyond the organisation’s direct control, but require an effective response by the organisation.
Opportunities and threats can arise from many different factors in the organisation’s environment.
A SWOT analysis is often used to help frame marketing thinking. A SWOT analysis can help marketers to identify ways to
minimise the effect of weaknesses in their business, while maximising their strengths. Ideally, marketers will seek to match
their strengths against market opportunities that result from competitors’ weaknesses or voids. A potential framework for
conducting a SWOT analysis, along with key factors to be considered, is outlined in figure 3.9.

FIGURE 3.9 A potential framework for a SWOT analysis

Figure 3.10 shows a very basic example of a SWOT analysis for a retail shop. This SWOT analysis, combined with an
evaluation and understanding of the effectiveness of past marketing and business approaches, provides the retail shop with
the information it needs to consider possible actions. For example, given its strengths, the retailer could concentrate its
marketing efforts on current customers, adjusting stock on hand to meet current customer needs. This strategy would reduce
stock costs, increase cash flow and improve business performance. However, given one of its identified threats is the trend
towards increased competition, it may also consider the possibility of adding a second, high-traffic location to counter the
competitors’ moves. Further, the SWOT analysis identified an increase in leisure time and a change to working hours. The
retail shop could consider changing opening hours to grow retail shop revenue. These are just three possible responses to the
strengths, weaknesses, opportunities and threats identified. There are many others that would need to be considered. Armed
with this SWOT information, the organisation can begin to shape its marketing plan.
FIGURE 3.10 An example of a SWOT analysis for a retail shop

Marketing metrics
Marketing metrics are measures that are used to assess marketing performance. The Australian Marketing Institute offers a
framework to guide marketers’ choice of metrics. The framework’s underlying principles are that metrics should be linked to
strategy and should include, as a minimum, four key elements: return on marketing investment, customer satisfaction, market
share in targeted segments and brand equity.
To give you an idea of the many different ways that marketers can measure performance, key marketing metrics are
summarised in figure 3.11.41
FIGURE 3.11 Best practice marketing metrics

It is important to remember that there is no one best marketing metric. In practice, different strategies require different
metrics and marketers need to select metrics accordingly. For example, Kellogg’s objective was to revamp the way it used
trade promotions in its overall marketing strategy. In trade promotions, manufacturers such as Kellogg’s make payments
known as rebates to grocers to display, advertise and offer reduced prices on certain products at specified times. Kellogg’s
knew almost nothing about the effectiveness of the thousands of sales promotions that took place in the supermarkets every
year. The annual cost of Kellogg’s trade promotions was $600 million. Using marketing metrics such as the sales uplift from
the trade promotions, Kellogg’s found that 59 per cent of its trade promotion events lost money for the company. Further, the
profit generated by the other 41 per cent was almost entirely eaten away by the events that lost money.40
While the use of the sales promotion metric (sales uplift from the trade promotion) was ideal for Kellogg’s purposes, it would
not be relevant for others. Let’s consider another example. A telecommunications company wanting to increase the
profitability of its business customers would require a different metric. Telecommunications business customers include
small- to medium-size businesses with up to 200 phone lines. A telecommunications company that wants to increase the
profitability of its business customers can conduct an experiment where some customers are offered specially designed
calling plans with unique pricing arrangements, while others are left the same. The success of this experiment can be tracked
using two marketing metrics — the customer’s ‘change in spend’ and the customer’s ‘churn rate’ (proportion of customers
choosing to change to another telecommunications company). Customers participating in the experiment can be compared to
a control group of customers who are continuing to use existing calling plans. The change in spend and customer churn can
help marketers to assess whether the specially designed calling plans increase the profitability of business customers.
Marketing metrics are vital for marketers. Marketers need to be able to articulate the return on investment for a host of
reasons. First, the ability to articulate a return on investment can provide a solid rationale for continued funding for
successful marketing programs — programs that might otherwise be cut if perceptions are that a program is too costly or is a
large budget item. For example, a marketing director could potentially address or avert tough budget questions from a board
of directors if they can demonstrate that their $3 million program contributed more than $6 million in sales. Second, return
on marketing investment metrics can help marketers allocate resources where they are most effective. Third, marketers can
build and share a database of returns on investment that should assist in evaluating the relative effectiveness of various
programs.
Once marketers have gained a thorough understanding of their past performance they need to look forward. Marketers need
to predict what they think is likely to occur in order to plan how they will compete in the market. A comprehensive
understanding of the marketing environment is used to identify the key factors that are likely to impact in the foreseeable
future.

The marketing plan

As illustrated earlier in figure 3.8, the situation analysis, together with the organisation’s objectives, should form the basis for
developing the marketing plan. Essentially, a marketing plan communicates how marketers plan to get from the current
situation to where top management thinks their company should be. Marketing plans are detailed documents. Although the
format and structure of marketing plans vary, the major components and types of information contained in a typical
marketing plan are outlined in figure 3.12 in the teal box below.
The marketing plan
Executive summary
The executive summary provides a brief overview of the marketing plan. The purpose is to outline the main features of
the marketing plan that will help the organisation to achieve its objectives. The executive summary is often the only part
of a report that decision makers read, so it needs to effectively communicate the key issues.

Introduction
Brief details on the internal environment of the organisation are provided in this section — its history, size, locations,
number of employees, revenue, profitability and so on.

Situation analysis
This is a more detailed section of the marketing plan. It includes a thorough analysis of the macro-and micro-
environmental factors. This situation analysis will typically be synthesised into a capstone SWOT analysis for the
organisation (an acronym for Strengths, Weaknesses, Opportunities and Threats). The SWOT analysis is explained in
more detail later in this chapter, including via a visual representation in figure 3.10.

Objectives
The organisation’s overall objectives and mission statement are included in this section, along with the marketing
objectives that are intended to help achieve the organisation’s overall objectives. All objectives should be:
Specific
Measurable
Actionable
Reasonable
Timetabled.

Target market
The marketing plan should contain a description of the organisation’s target market segments, their characteristics and
how the target market and market segments were selected. It is important that the description of the target market/segment
is as specific as possible. For example, if it has been determined by the situation analysis that the target market is urban
25–30-year-old single males, this needs to be what is stated, as opposed to a more general description such as ‘young
single men’.

Marketing mix strategy

Product
The product component of the strategy needs to be outlined, including an explanation of how the product offers value to
the target market. A discussion of branding should also be included. While you might not include a total product concept
analysis of the product in your marketing plan, it may be a useful exercise to inform the product strategy that is outlined
in the plan.
Price
Pricing objectives (e.g. cash flow, positioning and market share) and the pricing method(s) used to determine prices for
your product/s should be stated as part of the marketing mix strategy. Competitors’ pricing should also be discussed.

Promotion
The promotion mix (advertising, public relations, sales promotions and personal selling) that the organisation wishes to
pursue should be explained as part of its marketing strategy. Consideration should also be given to additional marketing
communication options, such as guerrilla marketing, sponsorship and viral marketing, if appropriate for the organisation.

Distribution (place)
Distribution is a further aspect of the marketing mix strategy that should be outlined in order to explain how the
organisation’s products will be available to customers where and when they want them. The distribution discussion
should address the use of marketing intermediaries, if applicable.

People
For services products, a people strategy should be discussed as part of the marketing mix strategy, including how the
organisation will address the specific service product characteristics of intangibility, inseparability, heterogeneity and
perishability. The people strategy should also outline how the organisation will ensure that its staff are technically
competent, able to deliver high standards of customer service and able to promote products through personal selling.

Process
The systems and procedures, particularly for services products, that will be used to create the organisation’s product
offering should be discussed in the marketing plan.

Physical evidence
For service products, the organisation should provide tangible cues as to the quality it offers. The organisation’s physical
evidence strategy may address issues such as shop fittings, background music and staff uniforms.

Budget
It is important that the budgetary requirements of the marketing plan be outlined in detail, to demonstrate how the plan
can be implemented with available resources.

Implementation
How the marketing plan will be put into practice should be explained, including specific steps and milestones, as well as
control mechanisms to ensure the implementation phase proceeds in accordance with the plan.

Evaluation
The plan needs to outline specific metrics (e.g. return on investment, market share) that will be used to evaluate its
success. These metrics can also be used by the organisation to inform both the refinement of the current plan if necessary
and the development of future marketing plans.

Conclusion/future recommendations
A brief summary/conclusion of the report should be provided, including recommendations for approval and/or action (e.g.
that the marketing plan be accepted by senior management for implementation, in order to exploit market opportunities
for growth).
FIGURE 3.12 The marketing plan
Spotlight: Walk to School
Physical activity and the consumption of a nutritious diet are two key components for health and wellbeing, and both are
important factors in the prevention of many chronic disease conditions. The combination of energy-dense but nutrient-
poor diets and more sedentary lifestyles is contributing to the growing obesity and poor health in Australia and
worldwide.
Children who actively walk to and from school have higher levels of physical activity and improved cardiovascular
fitness compared to children who do not. Studies indicate that the number of children walking to and from school — a
general indicator of levels of active travel — has declined dramatically over the years. Market research undertaken prior
to the launch of Walk to School Day uncovered some reasons why parents may not have been letting their children walk
to school, including perceptions of stranger danger, traffic concerns and neighbourhood crime. Market research also
highlighted that walking offered parents a way to connect with their kids and to de-stress.
Between the years 2006 and 2011, VicHealth funded an annual Walk to School Day to raise awareness of the need for
children to make walking part of their daily routine to improve fitness, friendships, the environment and their confidence.
In 2011 a reported 60 000 students from 380 Victorian primary schools took part in Walk to School Day.

In 2012, the program was changed. One key change was that Walk to School became a longer event starting on 8 October
aimed at encouraging kids to walk to school for the 18 school days in October 2012. Second, competition was thrown
into the campaign. A Walk to School iPhone app was introduced to help families and teachers keep track of how far, and
how often, kids have walked. The data collected allowed VicHealth to determine that students and families who took part
in Walk to School 2012 walked more than 241 000 kilometres — six times around the world!42

Questions

1. Use the information in this Spotlight, and any other necessary research, to develop a SWOT analysis for
Walk to School.
2. Walk to School is a not-for-profit cause to promote awareness and behaviour change. What marketing
metrics would you use to evaluate its effectiveness as a marketing campaign?
Concepts and applications check
Learning objective 6 understand the components of marketing planning
6.1 You are a marketer responsible for encouraging children to walk to school. You have enjoyed considerable success in this role,
but you need to pinpoint the specific marketing tactics that encouraged children to walk to school. What marketing metric will
you use to understand which tactics were effective in achieving that goal?
6.2 You have a new employee in your marketing department and you need them to undertake a situation analysis. In your own
words, explain to your new employee how they should approach a situation analysis.
6.3 Review the retail shop SWOT analysis in figure 3.10 and the surrounding discussion. Imagine you are the marketing manager for
the retail shop. How would you respond in order to effectively manage the identified strengths, weaknesses, opportunities and
threats?
6.4 You are the marketing manager for Snickers bars. Analyse two competitors. What are their strengths and weaknesses?

 3.5 Macro environment Summary 

SUMMARY
Learning objective 1: provide an overview of marketing, the marketing process, and the exchange of value
Marketing is a philosophy or a way of doing business that puts the market — the customer, client, partner and society,
and competitors — at the heart of all business decisions. The marketing process is cyclical in nature and involves
understanding the market to create, communicate and deliver an offering for exchange. Marketers start by
understanding the consumers, the market and how they are currently situated. Armed with this understanding,
marketers are next tasked with creating solutions, communicating the offering to the market, and delivering it at a time
and place that is convenient for the customer.
The essence of marketing is to develop mutually beneficial exchange. Exchange involves value creation for all parties
to the exchange. Marketers must understand how customers perceive value. Value perceptions vary from one
individual to another and they are ever changing. The customer is the focus of all marketing activities and successful
marketers are those who view their products in terms of meeting customer needs and wants.
Learning objective 2: describe the marketing environment and the purpose of environmental analysis
The marketing environment refers to all of the internal and external forces that affect a marketer’s ability to create,
communicate, deliver and exchange offerings of value. Marketers seek to understand, respond to, and influence their
environment. They use environmental analysis to break the marketing environment into smaller parts in order to better
understand it.
Learning objective 3: explain the factors at work in the organisation’s internal environment
The internal environment refers to its parts, people and processes. An organisation is able to directly control the factors
in its internal environment. A thorough understanding of the internal environment ensures that marketers understand
the organisation’s strengths and weaknesses, which positively and negatively affect the organisation’s ability to
compete in the marketplace. Different parts of organisations often have different goals. The most successful
organisations manage to align the goals of each part of the organisation to the overall market orientation of the
business. This is most likely to occur when each person and department understands their contribution and the
contribution of other departments.
Learning objective 4: understand the importance of the different micro-environmental factors
The micro environment consists of customers, clients, partners, competitors and other parties that make up the
organisation’s industry. The organisation cannot directly control its micro environment, but it can exert some influence
over it. Marketers must understand and respond to the current and future needs and wants of their target market. They
must understand how each of their partners’ processes work and how their partnerships benefit each party. They must
also understand the risks involved in working with partners and the relative power balance between the organisation
and each partner. Suppliers are a particularly crucial partner. Marketers must identify, assess, monitor and manage risks
to supplies and risks to the price of supplies. To succeed, marketers must ensure their offerings provide their target
market with greater value than their competitors’ offerings. Thus, marketers seek to understand their competitors’
marketing mix, sales volumes, sales trends, market share, staffing, sales per employee and employment trends.
Marketers should analyse total budget competition, generic competition, product competition and brand competition.
Learning objective 5: outline the different types of macro-environmental forces
The macro environment encompasses uncontrollable factors outside of the industry: political, economic, sociocultural,
technological, environmental and legal forces. Political forces describe the influence of politics on marketing
decisions. Economic forces affect how much money people and organisations can spend and how they choose to spend
it. Sociocultural forces affect people’s attitudes, beliefs, behaviours, preferences, customs and lifestyles. Technological
forces are those arising from the search for a better way to do things. Technology changes the expectations and
behaviours of customers and clients as well as how organisations work with their partners and within society. There are
wide range of environmental factors that companies need to be mindful of, including ecological and environmental
aspects such as weather, climate and climate change. Laws and regulations are closely tied to politics and establish the
rules under which organisations must conduct their activities. The most significant laws and regulations for marketers
are related to privacy, fair trading, consumer safety, prices, contract terms and intellectual property.
Learning objective 6: understand the components of marketing planning
 Situation analysis involves assessing an organisation’s current position and situation. Together with organisational
objectives, situation analysis is used as the platform for marketing planning. Essentially, a marketing plan
communicates how marketers plan to get from the current situation to where senior management thinks their
organisation should be. Marketing metrics are used to measure current performance and the outcomes of past activities.
A SWOT analysis is used to identify strengths (those attributes of the organisation that help it achieve its objectives),
weaknesses (those attributes of the organisation that hinder it in trying to achieve its objectives), opportunities (factors
that are potentially helpful to achieving the organisation’s objectives) and threats (factors that are potentially harmful
to the organisation’s efforts to achieve its objectives).

 3.6 Situation analysis, organisational

Endnotes 
objectives and the marketing plan
ENDNOTES
1. A-M. Laslett, P. Catalano, Y. Chikritzhs, C. Dale, C. Doran, J. Ferris, T. Jainullabudeen, M. Livingston, S. Matthews, J.
Mugavin, R. Room, M. Schlotterlein, and C. Wilkinson (2010), The range and magnitude of alcohol’s harm to others,
Foundation for Alcohol Education and Research, Canberra, www.fare.org.au.
2. National Health and Medical Research Council (NHMRC) (2009), Australian guidelines to reduce health risks from
drinking alcohol, Commonwealth of Australia, Canberra, www.nhmrc.gov.au; World Health Organization (2009), ‘Working
document for developing a draft global strategy to reduce harmful use of alcohol’, www.who.int.
3. Australian Institute of Health and Welfare (2011), ‘2010 National drug strategy household survey report,
www.aihw.gov.au.
4. S.R. Rundle-Thiele (2009), ‘Social gain: is corporate social responsibility enough?’, Australasian Marketing Journal
Special Issue on Sustainability, Social Entrepreneurship and Social Change, 17(4), pp. 204–10.
5. G. Hastings and K. Angus (2011), ‘When is social marketing not social marketing?’, Journal of Social Marketing, 1(1),
pp. 45–53.
6. This definition was adopted by the American Marketing Association in October 2007.
7. American Marketing Association, October 2007. The AMA reviews the definition every few years to ensure it reflects
current marketing practice. See L.M. Keefe (2008), ‘Marketing defined’, Marketing News, 15 January, pp. 28–9.
8. ‘Rainforest Alliance’, McDonalds Australia website, www.mcdonalds.com.au/mccafe/rainforest-alliance.
9. I. Maignan and O.C. Ferrell (2004), ‘Corporate social responsibility and marketing: an integrative framework’, Journal of
the Academy of Marketing Science, 32(1), pp. 3–19.
10. Keefe (2008), op. cit.
11. ADK (2012), ‘Co-creation project led by ADK and eYeka, France “Stand for Japan” receive Co-Creation Award’, News
release, 13 November, www.adk.jp/english.
12. Cancer Council Australia website, www.cancer.org.au.
13. Department of Health and Ageing, ‘Breast Screen Australia Program’, www.cancerscreening.gov.au.
14. Viva, ‘Viva TV & Computer Screen Wipes Kit’, www.viva-cleaning.com.au.
15. Australian Marketing Institute, ‘The winners: 2012 AMI Awards for Marketing Excellence’, www.ami.org.au; and Viva,
op. cit.
16. K. Midena (2013), ‘Sharapova’s Sugarpova lolly range “smacks of irresponsible marketing”’, The Australian, 11 January,
www.theaustralian.com.au; and C. Chase (2013); Maria Sharapova’s candy line, Sugarpova, is taking off’, USA Today
Sports, 10 January, www.usatoday.com; N. Harman (2013), ‘Maria Sharapova to become “Sugarpova” to promote sweets
brand’, The Australian, 20 August, www.theaustralian.com.au.
17. Market Data (2010), ‘Battle of the bottle: Aussies love of NZ wines continues’, Professional Marketing, pp. 38–9.
18. USM Events website, www.usmevents.com.au.
19. A. Hepworth (2012), ‘Power bills high but wholesale prices low’, The Australian, 23 March, www.theaustralian.com.au.
20. E.J. Schulz (2012), ‘Snickers surging to top of global candy race’, Advertising Age, 20 September, www.adage.com.
21. V.A. Zeithaml (1988), ‘Consumer perceptions of price, quality and value: a means end model and synthesis of evidence’,
Journal of Marketing, 52 (July), pp. 2–22.
22. K. Miller (2007), ‘Investigating the idiosyncratic nature of brand value’, Australasian Marketing Journal, 15(2), pp. 81–
96.
23. J.C. Sweeney and G. Soutar (2001), ‘Consumer perceived value: the development of a multi-item scale’, Journal of
Retailing, 77, pp. 203–20.
24. X. Luo and C.B. Bhattacharya (2006), ‘Corporate social responsibility, customer satisfaction and market value’, Journal
of Marketing, 70(4), pp. 1–18.
25. M. Creamer (2012), ‘If marketing had a five-year plan, here’s what it would be and what you can do to prepare’,
Advertising Age, 8 October, www.adage.com; N. Bell (2012), ‘The dilemma dogging Telstra shareholders’, Sydney Morning
Herald, 18 June, www.smh.com.au.
26. W. Jiabao (2013), ‘Report on the work of the government’, Xinhua News Agency, online.wsj.com.
27. Discovery News (2013), ‘Beijing bemoans smog and sandstorms’, 28 February, news.discovery.com.
28. Environmental Protection Agency (2012), ‘Particle, pollution and health’, www.epa.gov.
29. D. Roberts (2013), ‘Pollution, risk are downside of China’s “blind expansion”’, Bloomberg Business Week, 5 May,
www.businessweek.com; M. Fitzpatrick (2013), ‘The answer to Chinese pollution? It’s in Japan’, CNN Money, 4 March,
tech.fortune.cnn.com; D. Carrington (2012), ‘More than 1000 new coal plants planned worldwide, figures show’, The
Guardian, 20 November, www.guardian.co.uk.
30. M. Bingemann and M. Sainsbury (2009), ‘Telstra pulls $32m deal with Satyam’, Australian IT, 26 March,
www.australianit.news.com.au.
31. L. Cutcher (2008), ‘Service sells: exploring connections between customer service strategy and psychological contract’,
Journal of Management and Organization, 14(2), pp. 116–26.
32. N. Shoebridge (2009), ‘Marketing’s moment of truth’, BRW, 26 March–29 April, p. 76.

33. J. Stensholt (2009), ‘Sky’s the limit’, BRW, 8–14 October, pp. 26–7.

34. Stuart Alexander website, www.stuartalexander.com.au; R. Millar & M. Fyfe (2012), ‘Small grocers say Woolies, Coles
killing competition’, Sydney Morning Herald, 11 June, www.smh.com.au; Matthew Carney (2012), ‘Coles, Woolies
“deliberately killing competition”’, Lateline, 14 August, www.abc.net.au, Master Grocers Australia (2012), Let’s have fair
competition report, available by request from www.mga.asn.au.

35. C. Henshaw (2013), ‘Suncorp has received 4500 claims so far from Qld floods’, The Australian, 29 January,
www.theaustralian.com.au.

36. T. Nolan (2011), ‘Big retailers wage war on web’, The 7.30 Report, 5 January, www.abc.net.au.

37. SBS (2012), ‘Factbox: carbon taxes around the globe’, www.sbs.com.au.

38. Inside Retailing (2012), ‘Australia’s online boom’, 23 July, www.insideretailing.com.au; Australian Bureau of Statistics
(2013), ‘Retail trade, Australia, Feb 2013’, 4 April, cat. no. 8501.0, ABS, Canberra.
39. J. Summers and B. Smith (2010), Communication skills handbook, 3rd edition, John Wiley & Sons, Milton, Queensland,
p. 72.
40. Australian Marketing Institute (2004), ‘What value marketing: a position paper on marketing metrics in Australia’,
discussion paper, www.ami.org.au.
41. Tourism Alliance Victoria (2003), ‘Drought & regional tourism’, issues paper, www.vtoa.asn.au; Australian Marketing
Institute (2004), ‘What value marketing: a position paper on marketing metrics in Australia’, discussion paper,
www.ami.org.au; Victorian Employers Chamber of Commerce (2007), ‘VECCI survey shows drought impacts
disproportionately on regional tourism businesses’, www.vecci.org.au.
42. World Health Organization (2003), ‘Diet, nutrition and the prevention of chronic disease’, Report of Joint WHO/FAO
Expert Consultation, WHO Technical Report Series 916, Geneva; VicHealth (2012), ‘Victorian families encouraged to enter
Walk to School 2012’, 20 September, www.vichealth.vic.gov.au; VicHealth website, www.vichealth.vic.gov.au.

 Summary 4 Identifying customers 

 CHAPTER 4

Identifying customers

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

4.1 understand the target marketing concept
4.2 identify market segmentation categories and their variables for consumer and business markets, and develop market
segment profiles
4.3 select specific target markets based on evaluation of potential market segments
4.4 understand how to effectively position an offering to a target market in relation to competitors, and develop an
appropriate marketing mix.
Target marketing and marketing Target
Australian retailers have been doing it tough as they struggle to come to terms with the challenging global economic
environment, combined with the continued strong growth of online shopping. There are conspicuous exceptions, such as
the large supermarket chains — especially Coles and Woolworths, which seem to be relatively immune from these
‘macro-environmental’ threats. In addition, there are retailers, such as JB Hi-Fi, whose cost structures and business
models allow them to compete successfully on price against local and online retailers.

For many established retailers, however, the position is less rosy. In particular, traditional department stores such as David
Jones and Myer face a seemingly perpetual challenge to remain competitive with their high cost structures, combined
with diminished levels (and public perceptions) of customer service. In particular, the cost to provide ‘traditional’
department store customer service is clearly prohibitive in the face of discounted prices offered by ‘big box’ retailers like
Harvey Norman and Bing Lee, and the familiar discount department stores like KMart and Big W.
However, even among the discount department stores, the news is not all good. Kmart has pushed its prices down and
introduced a house brand for most products. Big W and Target have both sustained damage from this new approach. Like
all retailers, Big W was stung by discounting in the home entertainment segment, and Target is ‘viewed neither as a value
proposition nor an upmarket brand-centric department store’. Some have suggested that parent company Wesfarmers
would be wise to close some Target stores and rebrand them as KMart.
Clearly, Australian shoppers are benefiting from the intensity of the competition and the resulting price competition. Just
as is the case in the ‘traditional’ department sector, we may soon witness the creation of another ‘duopoly’, as either
Woolworths or Wesfarmers decides that enough is enough.1

Questions

1. Based on your own perceptions and shopping experience, where are you more likely to shop? In Target,
KMart or Big W?
2. Where do you think Target is going wrong, and what should it be doing to win you as a customer?
INTRODUCTION
The challenges faced by Target are difficult and will require brave and expensive strategies. Target’s problems may be
partially of its own making, but it must also be understood in the context of a highly crowded and competitive market in
which shoppers are ‘spoilt for choice’. For Target, the challenge is to carve out a viable market. As for all businesses,
identifying potential customers and understanding the needs of those potential buyers is fundamental to market success.
There are consumer markets (also known as business-to-consumer or B2C markets) and business markets (business-to-
business or B2B markets). Consumer markets consist of households and individuals that buy products for private
consumption. We are all members of consumer markets for an almost unlimited range of products that we use in our daily
lives. Business markets consist of individuals and organisations that purchase products to resell, to use in production or to
use in business operations. In this chapter, we will explore this broad categorisation further and examine how we can better
describe and segment the market. Because consumers and businesses have different needs, wants and demands, it is
impossible for most organisations to successfully appeal to the entire market. Instead, the organisation typically identifies
those parts of the total market to which it can offer the most value. Market segmentation enables the organisation to form a
strategy for a group, or segment, that has common features, rather than try to market to everyone. The organisation makes
use of its knowledge of these market segments to develop the most effective marketing mix for each. This approach is known
as the target marketing concept and it is fundamental to marketing — identifying smaller, more targetable market segments,
then tailoring the marketing mix to best appeal to those segments.
We discuss how businesses can best segment consumer and business markets for their particular purposes. Once the market
has been segmented based on relevant variables, the organisation assesses the potential of each segment in order to decide
which segments to target. We conclude the chapter with a discussion of how to position products relative to competitors in
each target market.

 Endnotes 4.1 Target marketing 

4.1 TARGET MARKETING
Learning objective 1
understand the target marketing concept

There are various ways to view the market and the particular perspective an organisation takes has a pervasive influence on
all of its marketing activities. Consider the following three different perspectives.

1. Buyers have common wants, needs and demands.

2. Buyers have unique wants, needs and demands.
3. The market contains subgroups — known as market segments — who share common or similar needs in regards to
certain characteristics.

These perspectives suggest fundamentally different approaches to marketing. If all potential buyers are similar, then it should
be possible to take an undifferentiated approach to the marketing mix; that is, the organisation makes the same offer to
everyone. If all buyers have unique needs, then the organisation will be more successful if it differentiates its products to
match the individual needs of potential customers.
If buyers differ, but have some shared needs and defining characteristics, then it should be possible to use an undifferentiated
marketing mix for any one group, while differentiating the offering between groups.
The marketer can make an undifferentiated offer to the market as a whole (mass marketing).
The marketer can make a differentiated offer to each individual buyer (one-to-one or customised marketing).
The marketer can make an undifferentiated offer to groups of buyers with common wants or needs, but differentiate the
offerings it makes to different groups.
Individuals and organisations in a market have different wants, needs and demands. The choice of marketing strategy
typically involves a degree of compromise between the necessity to respond to the particular desires of potential customers
and the objective of achieving the lowest possible production and marketing costs, principally through economies of scale.
Hence, most marketers practise target marketing in identifying and responding to the needs, wants and demands of
individual buyers or groups of buyers. Target marketing is based on three premises:

1. individual buyers or groups of buyers can be identified

2. sellers understand the needs of buyers
3. sellers will seek to shape their offer to meet the needs of target buyers.

Examination of these three premises shows that they reflect a market orientation. (In this case, however, the focus is on
groups of buyers.) They are important factors in understanding, creating, communicating and delivering offerings of value.
The decision to address them through target marketing reflects the difference between a market orientation and a production
orientation, as illustrated in figure 4.1.
FIGURE 4.1 Production-oriented and marketing-oriented views of the market

We will now discuss the key differences between mass marketing, one-to-one marketing and target marketing based on
market segments, before moving on to a detailed discussion of the target marketing process. The different approaches to the
market are illustrated in figure 4.2.

FIGURE 4.2 Three market strategies

Mass marketing
A mass marketer sees buyers as having common wants, needs and demands. Under such circumstances, it is possible to
create, communicate and deliver a single product offering to meet the needs of most people in the market. This represents an
undifferentiated approach to marketing. This undifferentiated offering, ideally, can be produced in large volumes and at a low
cost per unit (by taking advantage of ‘economies of scale’). The low unit cost makes it possible (although not essential) to
sell at a low price, further expanding the market and driving costs lower again. In this way, organisations that practise mass
marketing can capture very large markets at very low cost per unit, ensuring high levels of profitability. This strategy is
characteristic of commodity products such as salt and of global mass market products such as blank CDs, bandages and
pharmaceuticals. The market for government services also displays a high level of homogeneity, in that all citizens are
entitled to a common, minimum level of service and benefits such as public transport. As long as all consumers have
homogeneous needs, this model can be extremely successful and profitable. It is the model for many iconic, market leading
consumer products, such as Coca-Cola and Nescafé (who also charge premium prices). However, it is common for markets
to evolve as consumer preferences become increasingly diverse, with the result that only one version of the product no longer
satisfies consumers’ wants.
One-to-one marketing
The one-to-one marketer seeks to appeal to each customer by providing a unique, customised offering that will meet their
individual needs. In closely meeting their needs, the seller seeks to build a very close relationship with a customer in the
expectation that the customer will reward them with loyalty and repeat purchasing, as well as positive word-of-mouth to
friends and colleagues. Many small services businesses take a one-to-one marketing approach. For example, when a family
engages an architect to design their new home, the architect will discuss their needs and preferences, study their land, assess
their budget, and create and refine draft designs based on their feedback. A simpler example is a hairdresser who — usually
— styles each customer’s hair the way the customer (or client) wants. One-to-one marketing is also common in industrial
business markets, where the size of purchases often dictates customisation of the marketing mix for each potential customer.
A one-to-one approach usually results in higher unit costs and a more restricted market. These conditions typically form the
basis of a focus or niche strategy.

Target marketing based on segments

Markets made up of buyers with diverse needs are said to be heterogeneous. Not everyone wants to dress the same, drive the
same car, eat the same food or watch the same television shows. In this sense, most consumer markets can be said to be
heterogeneous. Even so, most buyers or consumers can be grouped into segments: the segment has distinctive needs, but the
members of the segment have similar needs.
The third marketing option — market segmentation — is the logical and common choice for many organisations that want to
meet the needs of large numbers of customers more closely, but that lack the resources to address each customer as an
individual. In choosing a market segmentation strategy, the focus of the organisation shifts from the individual buyer to the
target market segment. The opportunity for the organisation becomes that of identifying groups of buyers (market segments)
who have wants or needs in common that match well with the organisation’s capabilities. The key task of the organisation is
to develop marketing programs to reach those market segments that have been identified, typically following marketing
research. For many organisations, it is therefore common to view the target customers not as individuals, but as a market
segment — and to design the organisation’s offer to meet the needs of that market segment. In this way, market segmentation
forms the basis of the target marketing concept, implemented through the target marketing process.
When choosing target markets, the organisation will generally consider three factors.

1. Its own resources — does the organisation have the financial, marketing and other resources required to cover the
entire market?
2. Market demand — do all customers look for the same attributes and benefits in the product?
3. Competition — have competitors already segmented the market or are they selling to all buyers as a group?

With a differentiated targeting strategy, an organisation identifies a range of target market segments, covering the majority
of the total market, and for each market segment develops a tailored marketing mix. This approach is favoured by most
market leaders, which are able to serve almost all viable market segments with a product and offer designed specially to meet
their needs. For example, Westpac offers a complete range of financial services designed to meet the needs of all consumer
and business and government market segments. IBM offers computer hardware, software and consulting services for all
business users. A market leadership position is often accompanied by premium prices in each market segment and product
category, enabling high total revenues and profits. At the same time, it should be recognised that a differentiation strategy
also entails higher costs. Achieving high profits through this strategy generally requires a combination of higher retail prices,
high volume sales, strong market share and strong customer loyalty.

Product and market specialisation

Small organisations with limited financial resources frequently adopt one of the following specialised approaches to target
marketing.
Product specialisation, in which all efforts are concentrated on a single product range offered to a number of market
segments. Hasselblad, for example, competes by concentrating solely on cameras. Stihl focuses on chainsaws.
Market specialisation, in which all efforts are concentrated on meeting a wide range of needs within a single market
segment. For example, Elders provides a comprehensive range of goods and services to farmers. Similarly, credit
unions provide a wide range of financial services to members who live in particular local communities or who are
 employed in particular industries. Apia (a Suncorp brand) targets seniors (over 50) and the retired community. The
differences between product specialisation and market specialisation are summarised in figure 4.3.
Product–market specialisation, in which the product and market specialisation approaches are combined to offer a
single product to a single market segment. Micro businesses (e.g. local trades and professional services businesses)
commonly adopt this approach. For example, restaurants will choose to offer a narrow menu, often based on a national
cuisine, to a local market from a single location.

FIGURE 4.3 Product and market specialisation

Specialisation approaches usually only succeed if the following five conditions are met.

1. The market is characterised by a wide range of needs and product preferences.

2. Clear market segments, or product categories, are identifiable, each with its own distinctive preferences or
characteristics.
3. The market is clearly divisible into segments so that each can be evaluated and compared.
4. Individual market segments, or product categories, are sufficiently large to represent profitable sales volume.
5. The organisation is able to reach individual market segments with a particular marketing offer and mix.

Organisations that pursue a specialisation strategy seek to establish a dominant position in their chosen market niche. Such
organisations run the risk of putting all their eggs into one basket, but, if successful, they establish a strong, deep and long-
lasting position. Such an approach enables an organisation to concentrate all its limited financial and other resources while
achieving a strong market reputation and a secure position among its loyal customers. At the same time, such an approach
clearly limits a company’s growth potential in the longer term. This was the situation facing car maker Porsche when it
expanded beyond its sports cars focus into the large four-wheel-drive market.

The target marketing process

The target marketing process is a fundamental component of marketing strategy for any organisation. The process involves
three main stages, with each requiring detailed analysis and decision making. This process is illustrated in figure 4.4 and is
discussed in detail throughout the rest of the chapter.
FIGURE 4.4 The target marketing process
Spotlight: Ten off target?
The Ten television network has been struggling under pressure from a depressed share price and poor ratings. At the heart
of poor audience figures are questions around Ten’s focus on the youth market. More than any of its commercial network
competitors, Ten has directed its programming at capturing and owning the youth market. In adopting this targeted
strategy, it could be arguably seen to be mimicking the very successful approach of the Triple M radio station which, for
many years, has offered a consistent (and persistent) appeal to the youth market with very ‘mainstream’ music and
entertainment tastes (unlike its youth market competitor Triple J, which has a more ‘alternative’ focus). In contrast, the
Seven and Nine television networks have pursued a less focused, mass market approach, with the familiar combination of
broad-based programs of Australian news, current affairs and ‘soaps’; US sitcoms and dramas; ‘reality’ programs; and
sports including the major football codes, motor racing and ‘blockbuster’ events like the Olympics.
As a result of its ‘tanking’ share price, audience ratings and profits, Ten’s CEO Hamish McLennan announced that the
network has dropped its ‘extreme youth’ focus, flagging it won’t target the ‘young’ and ‘promiscuous’ audience that saw
it produce failures like Being Lara Bingle and The Shire. Of course, there are likely to be many and complex explanations
for Ten’s difficulties but, at its heart, the problem appears to be the result of targeting gone wrong in a number of possible
ways.
Firstly, there may be a mismatch between Ten’s positioning and its programming. This explanation would be consistent
with the failures of Being Lara Bingle and The Shire. A second explanation is that the chosen market segment is either
insufficiently large or, indeed, that it is ‘promiscuous’ and not as loyal as theory would suggest. A third explanation is
that competitors, deliberately or otherwise, may be stealing a large chunk of Ten’s target audience. A fourth explanation is
that the target audience is less interested in ‘free-to-air’ television, and that their interests are diverse and satisfied by a
wide array of alternatives including streaming, live entertainment, pay TV channels, social media, radio and podcasts. In
2011, Ten launched its digital channel, 11, with programming aimed at the under-30s market, albeit with only limited
success.

Regardless of the true explanation, Ten’s difficulties highlight the potential downside of a single-minded targeting
strategy in a mass market dominated by a small number of large players, and the risks of playing all your eggs in one
basket.

Question

How would you test each of the above explanations using audience or other market research data?
Concepts and applications check
Learning objective 1 understand the target marketing concept
1.1 Outline the difference between how mass marketers and one-to-one marketers would view a market.
1.2 In your own words, describe the concept of market segmentation.
1.3 Use an example to demonstrate your understanding of a differentiated targeting strategy.
1.4 Outline the three main stages of the target marketing process.

 4 Identifying customers 4.2 Segmentation 

4.2 SEGMENTATION
Learning objective 2
identify market segmentation categories and their variables for consumer and business markets, and develop market
segment profiles

The first stage of the target marketing process is market segmentation. As shown in figure 4.5, there are two steps in the
market segmentation phase: identifying variables that can be used to define meaningful market segments; and profiling the
market segments so they can be assessed in the second stage of the target marketing process.

FIGURE 4.5 The target marketing process stage 1: Segmentation

Identify segmentation variables

The target marketing process aims to identify groups of buyers (market segments) who have wants or needs in common that
are a good match with the organisation’s ability to deliver products of value. This begs the question: On what bases can the
total market be segmented? Segmentation variables are characteristics that buyers (i.e. individuals, groups or organisations)
have in common and that might be closely related to their purchasing behaviour. Age, gender, income and occupation, for
example, can all be linked to the purchase or consumption of particular products.
The key to effective segmentation is to choose segmentation variables that are:
easy to measure and readily available (e.g. demographic data made available from the national census)
linked closely to the purchase of the product in question (e.g. consumers’ ethnicity will be an accurate predictor of
their choices of food, restaurants and entertainment).
Market research plays a crucial role in the process of understanding the link between segmentation variables and consumers’
purchasing behaviour. To be effective, market segmentation must be based on an in-depth, accurate and up-to-date
understanding of the needs and buying behaviours of potential customers, and how those needs and behaviours might be
changing.
Having identified appropriate segmentation variables, it is then important to understand how many possible segments an
organisation might choose to pursue. An organisation cannot market to all potential customers, unless it is a market leader
with virtually limitless market coverage and marketing resources. Of course this is rare, and so market segmentation and
target marketing typically involve organisations making difficult choices about which target markets to select (and which
market segments to ignore).
For most organisations, therefore, the question is not whether or not to segment the market; it is — given that we must
segment the market — which variables represent the best variables for identifying relevant target markets? The choice of
segmentation variables is discussed in the remainder of this section.

Segmenting consumer markets

The range of possible variables for segmenting consumer markets is almost limitless. They fall into four broad categories:
geographic, demographic, psychographic and behavioural variables.

1: Geographic segmentation
Geographic segmentation is market segmentation based on geographic variables. Geographic variables are reliable
predictors of customer needs and purchasing behaviours for a wide range of products. Useful geographic variables include:
climate
local population
region
topography
urban, suburban and rural location.
Geographic segmentation is particularly relevant to a country that is both large and diverse, such as Australia. The provincial
regions of New Zealand also suit segmentation on this basis. Producers of building materials, for example, need to know how
customers’ needs and purchase behaviours differ by geographical region (e.g. lightweight timber construction is more
popular in tropical regions; whereas brick, stone and concrete construction is more popular in colder climates). Similarly,
purchase of certain product categories may depend upon the geographical terrain or topography of a given area. Toyota’s
LandCruiser is the preferred motor vehicle for those living in rugged inland and remote areas of Australia and Subaru built
its early reputation in Australia among visitors to, and residents of, the snow country.
The number of buyers or potential buyers in any given geographical area is an important measure of market potential.
Targeting geographic areas with lots of potential customers also creates efficiencies in advertising and distribution (using
local press, radio and TV stations, for example), compared to areas with a smaller number of potential buyers. In the latter
case, less intensive promotional media (e.g. direct mail) or less intensive distribution through agents may be more financially
effective.
An emerging trend in segmentation is geo-demographics, which combines demographic variables and geographic variables
to profile very small geographical areas (such as a suburb). Geo-demographic segments enable intense and specific targeting
of small groups. Organisations such as Pacific Micromarketing have developed analysis tools based on publicly available
data such as the census, which, when combined with proprietary analysis tools, enable them to produce precise profiles of the
residents and businesses located in closely identified geographical areas. Such analyses are particularly useful to retail
businesses that could choose to vary their product offerings based on the distinctive demographic characteristics of these
areas. For the large supermarket chains, there is an opportunity to vary their product range based on, for example, the ethnic
characteristics of the local customers. This may be necessary to compete with local retailers, such as delicatessens, that may
have established market share based on their particular appeal to these ethnic market segments.

2: Demographic segmentation
Demographic segmentation is market segmentation based on demographic variables, which are related to the quantifiable
social characteristics of populations. They are the most commonly used variables for market segmentation. Consumer
behaviour is often closely linked to demography, and ongoing studies by organisations such as the Australian Bureau of
Statistics and Statistics New Zealand ensure demographic information is readily available, up-to-date and comprehensive.
We will discuss a few of the demographic variables most frequently used by marketers to illustrate how they form the basis
for market segmentation.
Age is one of the most commonly used segmentation variables and can be linked to the emergence of market segments such
as Generation Y, Generation X and the grey nomads. It has become very popular to refer to different age bands in the
population as a ‘generation’. The most commonly used groupings are.
The Baby Boomer generation. Baby Boomers were born in the prosperous years after World War II (1946–64) and are
now beginning to retire from the workforce. Overall the Baby Boomers have been one of the most powerful
 generations: relatively wealthy; in positions of power in society, politics and the workplace — and willing and able to
stay active as prominent members of society in their older years.
Generation X. This term was coined by Douglas Copeland in his book, Generation X, to describe a group of self-
indulgent slackers. The term has been redefined (by marketers!) to mean the people born between 1965 and 1980.
Their formative years in Australia were during a period of high unemployment, high inflation and high interest rates.
The generation is characterised by a strong work ethic, loyalty and quite a lot of frustration with Baby Boomers.
Generation Y. This generation, born from 1980 to 2001 and sometimes also known as the ‘Nintendo Generation’, is
characterised by comfort with technology; strong, almost tribal, friendships and loyalties; and high expectations in all
spheres of their lives.
Generation Z. This generation, born after 2001, was born digital. The internet, video games, mobile phones, wireless
networks, social media and ‘friends’ they’ve never met are all second nature to Generation Z.
It is important that marketers remain aware that these classifications are broad, but they can be very useful. For example,
television networks use age as a segmentation variable for their range of programs (e.g. Law & Order and NCIS are aimed at
Generation X; Better Homes and Gardens and Getaway are aimed at Baby Boomers) and to identify opportunities for new
formats such as reality television (aimed mainly at Generation Y).
Ethnicity is a useful segmentation variable for marketers of some products (e.g. food and travel during the Chinese New Year
festival). Australia and New Zealand have ethnically diverse populations that present opportunities for marketers to identify
direct links between ethnicity and the purchase of particular products. For example, descendants of European immigrants
may still display strong loyalty and preferences for traditional wine and food from their native countries. Similarly, restaurant
proprietors may target local consumers who share the same ethnic origins as the proprietor. At the same time, restaurateurs
usually prefer to market to a larger, more diverse local population that includes customers who are attracted to the
‘multicultural’ experience.
Household composition is an umbrella variable that is influenced by a number of other demographic variables, including age,
income, marital status and the number of members in the household. Segmentation on such variables is complicated by the
changes occurring in household composition, including increasing divorce rates, increasing numbers of single-parent
households, increasing numbers of people choosing not to have children, and even trends such as friends sharing housing to
make renting or buying a home more affordable. Household composition has profound effects on consumer behaviour. To
varying extents, married couples live different lifestyles to single people; adults living with their parents spend their money
differently to adults living in shared rental accommodation; and parents have needs for various services that are not so
important for childless people. Household composition can be a particularly useful segmentation variable for marketers of
financial services products, such as personal loans and mortgages, credit cards, and superannuation and investment products,
all of which are closely linked to stages in people’s lives.
Income is, of course, a strong determinant of what people can buy. Not only does it determine what they can afford to buy in
absolute terms, but it is also significantly linked to the types of products they prefer. Many purchases are aspirational in
nature — reflecting the lifestyle a person would like to have as much as the one they can actually afford. It is important that
marketers do not make the mistake of simply targeting high-income earners — while they have more money to spend,
marketers should be more concerned with identifying those market segments to which they can offer the most value.
Sex is another segmentation variable that has obvious implications for marketers of clothing, beverages, pharmaceuticals and
magazines. For example, males constitute the heaviest consumers of beer. In contrast, females represent the heaviest users of
‘alcopops’ and, more recently, cider.
Of course, there are many other demographic variables that marketers can use for segmentation — occupation, level of
education attained and so on. The appropriate demographic variables to use will vary depending on the type of product.
While demographics are rarely advocated as the sole basis for market segmentation, there is a strong case for their use as an
integral part of the segmentation process: the data are freely available and, for many goods and services, demographics have
proven to be reliable predictors of purchase and use. The need for consumption of government services such as health,
education, police and social welfare is best predicted by demographics.

3: Psychographic segmentation
Like demographic and geographic variables, psychographic (psychology plus demographics) variables are based on
consumer characteristics. Psychographic segmentation is based on differences in:
psychological traits (personality attributes and motives)
key demographics
 lifestyles (the expression of the two former categories).
In contrast to using demographics (e.g. age, gender and education) alone to explain who consumers are, psychographics
seeks to understand consumers by identifying their mind-sets and how they are expressed in their lifestyles. Psychographics
combines insights of psychology with demographics to give a more precise description of consumer groups. People who
share common demographics may lead very different lifestyles. Consider, for instance, 20-year-old women who have just
completed their first year of university. It is easy to imagine that within this demographic group there are women who love
university for the subjects they are studying, the realm of ideas they are being exposed to, and the satisfaction that self-
discipline brings as they study instead of party. It is also easy to imagine there are other women in the same group who love
university more for the parties and the heightened sense of stimulation than for the love of knowledge. Psychographics brings
out differences like these that demographics miss. It is details like these, as well, that can make or break a marketing
campaign.

4: Behavioural segmentation
Geographic and demographic segmentation are both based on ‘consumer characteristics’. These consumer characteristics are
relatively unchanging over time or between product categories. As such, they are reliable, but they may not provide the most
useful insights or provide timely evidence of emerging trends in purchase behaviours or the consumption of particular
products.
In contrast, behavioural segmentation is not based on consumer characteristics; rather, it is based on actual purchase and/or
consumption behaviours, typically towards particular products. It is therefore likely to be a better indicator of market
segments and their purchasing behaviour than segmentation based on generalised consumer characteristics. Behavioural
variables include:
benefit expectations
brand loyalty
occasion
price sensitivity
volume usage.
Segmentation based on expected benefits represents perhaps the most convincing basis for market segmentation, in that it is
based upon the marketer’s concern with a deep understanding of purchase and consumption motivations. It is a means to
better understand why consumers purchase particular products and brands, and to base market segmentation around this
understanding. Such an approach to segmentation is likely to prove rigorous, but time-consuming and expensive, as the
consumer benefits sought for any particular purchase are likely to be specific to that particular product or product category.
For example, consumers’ choice of toothpaste may be variously motivated by concern with fresh breath, whiteness, pleasant
taste, or by the need to minimise plaque or the discomfort associated with brushing. Similarly, consumers of breakfast cereal
might be motivated by the preferred taste or perceived benefits of elevated levels of vitamins, minerals, fruit, roughage, or
even lower levels of sugar, salt, carbohydrates and fats. Effective benefit segmentation therefore generally requires thorough
research among users of a product category, in order to understand underlying purchase and consumption motivations.
Notwithstanding the additional time and expense required to develop benefit segmentation, there are good grounds for the
belief that the effort is worthwhile, especially for marketers undertaking such segmentation for the first time. With additional
experience, it may prove that less complex means of segmentation, such as using demographics, provide equivalent insights
and guidance for less effort and at less cost.
Occasion is also an important segmentation variable in products such as entertainment, wine, travel and high-fashion. The
assumption behind occasion-based segmentation is that it is the occasion that dictates the decision to purchase and the final
choice of product. Wine purchasers may choose different wines based on the occasion for which it is purchased (e.g. as
a.pngt, for the evening meal, for a celebration, or for ‘cellaring’). For Chinese people around the world, the occasion of
Chinese New Year represents a time of optimism, extravagance,.pngt giving, enjoyment and travel.
Segmentation based on volume usage seeks to identify heavy, medium and light users of a product category, helping an
organisation identify and target, for example, the 20 per cent of buyers who typically account for up to 80 per cent of profits,
purchase volume or value. In this context, middle-aged males represent the biggest purchasers of high-end analogue watches.
Notice, however, that this segment is also described in standard demographic terms, demonstrating that volume usage, by
itself, is insufficient as a market segment descriptor.
The behavioural variables of brand loyalty and price sensitivity are complex topics and are discussed in detail in the chapters
on product and price respectively.
Segmenting business markets
Business markets are often characterised by a small number of buyers, each of which might display a very close relationship
with the seller. Under such circumstances, traditional market segmentation variables may be less relevant, and ‘customised’
or ‘one-to-one’ marketing may be the most logical approach. For example, chartered accountants, architects and business
consultants deal with their business clients personally and individually. Fujitsu and IBM work closely with their major
banking clients to develop ‘tailored solutions’. At the same time, many business markets do have a large number of buyers
and market segmentation is a necessary approach to dealing with buyer diversity.
When a large organisation, such as Telstra, addresses itself to business markets, it is potentially dealing with all businesses in
the country. It therefore needs to segment these businesses in a meaningful way to enable it to concentrate its marketing
resources and maximise its marketing effectiveness. Under such circumstances, businesses of the size of Telstra and IBM
will investigate how best to categorise their buyers in such a way that they have common hardware, software and service
needs and are likely to respond in a common way to marketing programs. For example, Telstra could meaningfully segment
its business market customers based on whether they are a small business, a medium-sized business, a large business or a
multinational corporation. The organisation’s size — in terms of employees or revenues — naturally affects its purchase
volumes, purchasing procedures and the closeness of its relationship to the seller. Very large business customers will
typically purchase directly from the seller and will expect advantageous volume, delivery and credit arrangements. They
might have contracts with Telstra for thousands of landlines and mobiles, very large internet bandwidth and international
roaming arrangements for some of their mobile services. Conversely, small business buyers may purchase through
intermediaries and may be virtually indistinguishable from private buyers, with just a phone line, a couple of mobiles and a
broadband internet connection. Officeworks, for example, does not distinguish between small business and retail consumer
buyers in its retail stores.
Segmenting based on factors such as the size of the business customer is roughly equivalent to the demographic
segmentation approaches that were described for consumer markets. Another ‘demographic’ type of approach in business
markets relates to industry (sometimes known as vertical markets or segments). IBM, for example, would identify different
markets in education, health, manufacturing and distribution industry ‘verticals’. Australian and New Zealand businesses
seeking to segment their markets in this way can access the Australian and New Zealand Standard Industrial Classification
System (ANZSIC), which is produced by the Australian Bureau of Statistics and Statistics New Zealand. This system divides
all business enterprises into 19 standard industry groups (e.g. manufacturing construction, transport and storage). These, in
turn, are broken down further into 53 subdivisions. The subdivisions, again, are broken down into more specific categories.
ANZSIC provides a comprehensive overview of the industry structure and participants. The information from ANZSIC can
help an organisation to identify its potential customers and its competitors in terms of size, growth, profitability, sales and
potential purchase activity. For example, polystyrene is used in a vast range of industrial applications in the manufacture of
motor vehicles, toys, electronics, furniture, bedding and insulation. Each of these product applications typically represents
major and distinct customer groups, each with their own purchase requirements and with varying needs for specialist
technical support from their chemical suppliers. Segmentation based on the use of the product, or ‘product application’, is
therefore a useful approach in business markets. For example, a polystyrene manufacturer will treat car and car parts
manufacturers, refrigerator, bedding and insulation manufacturers as separate segments.
A commonly used method of segmentation in business markets is based on geography. Marketers of pesticides and
herbicides, for example, need to consider the unique requirements of farmers — including the location and climate of their
properties — in order to maximise the appeal of their products

One final commonly used method of segmentation in business markets is based on geography. In large countries such as
Australia and geographically diverse countries such as Australia and New Zealand, geography can be highly relevant in
business markets. For example, marketers of agricultural chemicals, fertilisers and pesticides would often segment the
market according to the location of the buyer. Farmers — the largest buyers of pesticides and herbicides — differ in their
purchases according to location and climate, be they coastal, inland, dry, cold or tropical, and to the crops or livestock suited
to these areas. Similarly, geographic location may be an important indicator of buyers in particular industries. For example,
Caterpillar will focus much of its marketing of heavy mining equipment in Western Australia, Queensland and the Hunter
region of New South Wales, as these are the country’s primary mining areas.
While the segmentation approaches we have described are commonly used, much of business-to-business marketing depends
on individual relationships, and so it is necessary to develop a system for identifying individual potential customers. To
enable an organisation to ‘drill down’ to the level of individual customers requires more detailed information. Commercial
industrial directories provided by commercial organisations such as Compass, BIS Shrapnel and Dunn and Bradstreet contain
information on individual companies, such as the name, industrial classification, address, phone number, types of products
and annual sales, the names of chief executives and other details. This enables business marketers to isolate business
customers and to develop targeted marketing campaigns to each individual potential business customer.

Effective segmentation criteria

An almost limitless number of segments can be created using segmentation variables. It is crucial, of course, that the
segments are of use in formulating a marketing approach. To ensure that segmentation is effective, the segments should be
evaluated against the following criteria.

1. Measurability. The variables used to define the market segment must lend themselves to accurate and comprehensive
measurement. Segmentation variables based on demographic variables are highly measurable and extensive data are
available through commercial databases and organisations such as the Australian Bureau of Statistics and Statistics New
Zealand. More abstract variables, such as personality, can be notoriously difficult to measure.
2. Accessibility. Segments must be able to be clearly identified, reached and served through distribution and communication
channels. In this sense, opinion leaders are attractive to marketers but very difficult to identify and communicate with.
3. Substantiality. Market segments must be of sufficient size and purchasing power to make them a profitable target market.
Ideally segments should be as large as possible, but still be homogeneous in their purchase preferences and behaviour. In
this sense, market segments in New Zealand may not be viable in sales revenue terms, where they may be in a country
like the United Kingdom. While manufacturing technology is advancing and mass customisation is increasingly possible,
it is still true that aggregate sales volumes represent a vital constraint on industry profitability.
4. Practicability. Segments are only of use if marketing programs can be formulated to identify, communicate with and
service those chosen market segments. Segmentation based on personality or psychological variables, while theoretically
sound, might be incapable of easy or successful implementation, particularly if no relevant and recent data are available.
 In particular, the chosen target markets should be large enough, clearly identifiable and able to be communicated with,
and distributed to, in order to be viable.

Profile market segments

Having identified the range of ways in which market segments can be described, the next task is to develop a market
segment profile. Such a profile describes the typical potential customer in the market segment; that is, it describes the
common features shared by members of market segments and how they differ between market segments. Segment profiles
will typically be described in terms of a number of segmentation variables. Individual segments will be uniquely described
by a combination of segmentation variables, such as gender, age, occupation and lifestyle. With all the range of possible
segmentation variables that can be used, it is usual for segments to be constructed in a multivariate and hierarchical fashion.
For example, consider how the total market for athletic shoes in Australia could be segmented. A multivariate market
segment profile within the overall athletic shoe market could be built as follows:
segment initially on demographic grounds (e.g. gender and people aged 7 to 12 years, 13 to 18 years, 19 to 30 years,
31 to 50 years, and over 50)
then segment on usage variables (e.g. casual walkers, joggers, cross-trainers, serious amateur athletes, full-time elite
athletes)
as well as benefits (e.g. active, comfortable, supportive, durable, fashionable, performance enhancing).
As with this example, it is important to understand that the number of possible segments grows by multiples when an
additional segmentation variable is added. Thus, adding gender doubles the number of market segments. This may also
explain why there are literally hundreds of different types of sports shoes available, most targeting narrow, specialised
segments. With such diversity of market segments, an important requirement of effective segmentation is to understand the
target market segments completely: the insightful and creative marketer will know such target market segments implicitly —
as if they were close friends. To develop such an intimate understanding of market segments will usually require
comprehensive qualitative and quantitative market research.
It is also important that market segments are sufficiently different from each other, so that a distinctive offer and message can
be created for each target market segment without the risk of overlapping segments and/or sending confusing images and
messages.
Having developed rich and vivid profiles of the range of possible market segments, it is important to determine how closely
the organisation’s current or potential product offerings might match the needs of these market segments. We will examine
this next stage in the target marketing process in the next section.
Spotlight: Geodemographic segmentation
We are all aware of conspicuous differences between the geographic locations in which we live. We all know where the
best restaurants are located, where younger age groups prefer to live, where older people move to retire and where people
would prefer to live if they won Lotto. Geodemographic segmentation is a technique for identifying such geographical
areas, usually based on suburbs, postcodes, electorates or local government areas. The aim of geodemographic
segmentation is to discover distinctively different behaviours (usually purchasing or lifestyle behaviours) between groups
based on geographic locations (usually where people live).
Why is geographic location so important? In simple terms, assuming that the differences between the populations in
geographic locations are significantly different, marketers will direct their distribution and promotional resources where
target customers are most concentrated. Such groups are identified and quantified, and promotion and distribution can be
directed to these geographical locations for the most effect.

Geodemographic segmentation is based on two simple principles:

people who live in the same area are more likely to have similar characteristics than are two people chosen at
random
geographical areas can be categorised in terms of the characteristics of the population which they contain. Any two
areas can be placed in the same category (i.e. they contain similar types of people, even though they may be widely
separated).
Two geodemographic segmentation systems used in Australia include Mosaic and geoSmart. The Mosaic system is
Experian’s people classification system, and covers 29 countries including most of Western Europe, the United States,
Australia and the Far East. In Australia, Mosaic is marketed by Pacific Micromarketing. Mosaic Global is Experian’s
global consumer classification tool, covering 400 million households worldwide. It is based on the simple proposition
that the world’s cities share common patterns of residential segregation. It has identified ten types of residential
neighbourhood that can be found in each of the countries.
The geoSmart system is based on the principle that people with similar demographic profiles and lifestyles tend to live
near each other. It is developed by an Australian supplier of geodemographic solutions, RDA Research. geoSmart
geodemographic segments are produced from Australian Bureau of Statistics Census data, and the system is updated for
recent household growth. The geoSmart system has 54 segments and 7 groups organised on the two dimensions of
‘socioeconomic status’ and ‘family orientation’. geoSmart geodemographic segments provide valuable insights into the
needs, resources and lifestyles of customers for a diverse range of products and services.2

Questions

1. List some product categories for which consumption will differ significantly based on suburban locations.
2. Conversely, can you suggest product categories that might not lend themselves to geodemographic
segmentation?

Concepts and applications check

Learning objective 2 identify market segmentation categories and their variables for consumer and business markets,
and develop market segment profiles
2.1 Briefly outline the major categories of segmentation variables in (a) consumer markets, and (b) business markets.
2.2 Why are behavioural variables a better indicator of purchasing behaviour than other consumer market segmentation variables?
2.3 Explain the four main criteria that can be used to assess whether an identified market segmentation scheme can be effectively
implemented.
2.4 What is a market segment profile?
2.5 Choose a product (a good or service) and think of ten people that you know. Using your knowledge of those people, build a
meaningful market segment profile based on appropriate segmentation variables relevant to the product you have chosen.

 4.1 Target marketing 4.3 Targeting 

4.3 TARGETING
Learning objective 3
select specific target markets based on evaluation of potential market segments

Having identified and described the range of possible market segments to which an organisation might direct its offer, the
second stage in the process is that of market targeting (see figure 4.6). This stage involves a systematic examination of the
range of possible market segments, their potential sales volume and revenues, and the relative ability of the organisation to
satisfy the expectations of members of these market segments. This step also requires a close understanding of competitors,
and how their offerings are seen by potential target market segments. In this context, it is important to realise that no
company or brand can be all things to all people, especially when considering the vast array of potential customers and their
diverse needs, wants and demands.

FIGURE 4.6 The target marketing process stage 2: Targeting

Each of the strategies of undifferentiated marketing, differentiated marketing and specialised marketing offers advantages
and disadvantages, which make the choice of target marketing strategy crucial for long-term survival and profitability. The
choice of appropriate targeting strategy ultimately depends on:
an understanding of the size and attractiveness of the market segments that have been identified
an assessment of the organisation’s ability to service and compete for the chosen market segments.
We will discuss these issues over the following few pages.

Evaluate potential segments

The evaluation of potential market segments involves detailed and rigorous analysis of sales potential, the competitive
situation and cost structures. We will discuss each of these in turn.

1. Sales potential
Market potential is the total volume of sales of a product category that all organisations in an industry are expected to sell in
a specified period of time, assuming a specific level of marketing activity. For example, the market potential for new car
sales in Australia is around one million cars a year. An organisation’s sales revenue is equal to its total volume of sales
multiplied by the average selling price. The total volume of sales is determined by the organisation’s market share. For
example, Toyota’s market share is around 20 per cent. Therefore Toyota’s total volume of sales will be about 200 000 units
(20 per cent of one million) and its total sales revenue will be 200 000 multiplied by the average price of its cars.
While the overall sales and level of marketing activity for new cars (a well-established and well-defined product) can be
predicted with some certainty, allowing for varying economic conditions, it can be difficult to determine the likely marketing
activity and sales relating to new products or product categories, such as apps for use with smartphones and tablet computer
devices. Market size can be measured at several levels, including product category or geographical area. It is important, of
course, that the organisation analyses the size of the market it can actually reach.
Company sales potential is an estimate of the maximum sales revenue and market share that an organisation can expect to
achieve for a specific product. Several factors influence the organisation’s ability to achieve its sales potential in a given
market segment:
the market potential (i.e. the maximum possible sales in the total market for a product category)
the organisation’s ‘served market’ (i.e. those segments of the market for which the organisation chooses to compete)
the level of industry marketing activity, which directly influences the market potential
the effectiveness of an organisation’s promotional spending, which depends on the organisation’s ‘share of voice’ (i.e.
the organisation’s promotional spending relative to total industry promotional spending) and the use of effective
‘tactical’ promotional spending designed to maximise impact.
As we saw earlier in this section, one approach to estimating sales potential is to look at total market size, current market
share, planned marketing activities and environmental factors. For example, project home builders typically use Australian
Bureau of Statistics data on the aggregate level of ‘housing commencements’ and Reserve Bank data on aggregate bank
housing lending to estimate the size of the total market. Next they would calculate their likely market share of that market,
and then calculate the company sales potential in volume (units) and revenue ($) terms. The use of historical data (and
sometimes even current figures) in isolation can, however, be misleading. For example, the project home builder looking at
housing construction data over the past several years may have seen dramatic fluctuations brought about by changes in
interest rates, the unemployment rate and government first-home buyer grants and subsidies. In addition, buyer ‘confidence’
is also crucial in this market. Forecasting is a complex process subject to numerous uncertainties. Another approach to
estimating sales potential is to examine individual parts of the market (e.g. sales territories), take into account the size or
population of each territory and the organisation’s relative share of total marketing activity, and then sum each territory’s
estimates to produce a sales figure for the total market.

2. Competitive situation
Any estimate of sales potential must be conducted in the context of a thorough assessment of the organisation’s competitive
situation — the activities of competitors already in the marketplace and their relative market shares. This is usually done as
part of a situation analysis.
Without a competitive assessment, sales estimates can be misleadingly optimistic, especially where an organisation is
entering an established competitive market. Under such circumstances, it is important to evaluate the level of competitive
activity and the strengths and weaknesses of individual competitors before estimating the organisation’s likely market share.
To increase market share, it may be necessary to allocate a larger than normal promotional budget. It is safe to assume that
competitors will take steps to defend their market shares when an organisation enters a new market. This can lead to
promotional warfare, which can depress profits through higher costs and lower margins, even though sales volumes may be
at the expected level. This has been the experience of the Masters hardware venture of Woolworths, which has achieved
disappointing results in its attempt to disrupt Bunnings’ dominant position.

3. Cost structure
The organisation needs to consider the costs involved in creating, communicating and delivering an offering to meet the
needs of each potential market segment. Costs directly affect the price the organisation will need to charge for its products,
its price competitiveness and its profitability given any particular sales volume. The organisation’s cost structure includes
production costs, administrative overheads and all associated promotion and distribution costs. Knowledge of sales potential,
the competitive situation and the organisation’s cost structure combine to give a good indication of expected profit. Of
course, in many cases the organisation may decide that the financial returns do not outweigh the expected costs. When
considering an organisation’s cost structure, it is important to distinguish between fixed and variable costs. Fixed costs are
constant, regardless of production and sales volumes. If they are high they serve as an ‘entry barrier’, and an organisation
may choose not to enter a market even though revenue and volume expectations may be attractive.

Select target markets

With a detailed evaluation of potential market segments based on sales potential, the competitive situation and the
organisation’s cost structures, the organisation can proceed to decide which market segments it will target and which it will
disregard. Also, from an understanding of its chosen target market strategy (i.e. undifferentiated, differentiated or
specialised), the organisation will now better understand how it needs to tailor its offer to best meet the needs of each
segment. With an understanding of the opportunities and costs of serving each potential target market segment, the next stage
is for the organisation to choose particular target market segments, recognising that this will require ignoring some market
segments, which may not offer sufficient sales potential or for which the organisation may lack the resources or may not be
well placed to compete.
Having identified a range of potential target market segments, the organisation needs to undertake a rigorous analysis to
choose between the range of possible segments. If segmentation has been done effectively, then it is likely that there will be
little overlap in the demands of key target markets. On the other hand, if the range of demands is relatively homogeneous,
then the organisation may be able to cover several market segments with a single product offer and marketing mix. The
organisation could use an undifferentiated approach, and in so doing capture larger sales volumes at lower incremental cost.
However, such a position may leave the organisation vulnerable to attack by competitors that target each segment
individually.
Assuming that several segments offer sufficient revenue opportunities, the organisation must decide which and how many of
these segments to target. This decision will be based on the revenue opportunities identified in the previous step, together
with an understanding of the organisation’s costs, resources and capabilities and the likely response of competitors. The size
of the available market will be a prime consideration in deciding how many segments to target. Consider, for example, the
rapidly growing energy drink category in Australia. Tackling mainstream brands such as Red Bull, V and Mother is an
enormous challenge for new entrants in the market, but the identification of particular segments that are less well-served can
provide a profitable niche for new competitors. This has been proven by entrants into the health-conscious beer drinking
segments, including BlueTongue Brewery’s Bondi Blonde. In New Zealand, boutique brewers have targeted particular
segments to try to find a niche. For example, the Epic Brewing Company targets its pale ale at drinkers with a preference for
a strongly flavoured beer and a rebellious image. Of course, once they do establish a successful niche, they should expect
large competitors to introduce their own products targeting those segments.
Estimating market potential in each target market segment is important in determining whether the chosen target market
strategy will lead to healthy sales volumes and sustainable profitability. This step requires estimation of market potential for
individual market segments and, in this process, it is important that the organisation develops sales forecasts based on
systematic, objective and reliable methods, and that the forecasts are sufficiently accurate. A range of methods are available,
including market research (particularly surveys), analysis of historical trends, statistical analysis to identify underlying
purchasing patterns, test marketing results and indeed just the intuition of decision makers. In such circumstances, it is
important that the decision to launch should be supported by the market estimates under the most conservative of
assumptions, thus avoiding the common error of basing launch decisions on ‘wishful thinking’.
Selecting particular market segments (and deciding to ignore others) is therefore at the heart of the marketing concept. The
organisation is no longer referring to an individual buyer or the entire mass market — it is now a target market segment or
segments (although the organisation may describe such target market segments as if they were individuals).
Spotlight: The death of the mass market
While the logic and advantages of mass marketing have been long recognised, some marketing commentators believe that
the days of the mass market may be numbered. While they acknowledge the cost advantages which accrue from
economies of scale in mass marketing, they point to the fragmentation of mass markets into micro markets. This
fragmentation is seemingly inevitable and results from the combined effect of the increasing diversity in consumer tastes
and the advent of mass customisation, which enables manufacturers to tailor their products to the preferences of
individual buyers.

BMW, for example, can produce thousands of different versions of its most popular ‘3 series’ cars. Production
technology, together with developments in information technology and database marketing, makes it technologically
feasible to talk of ‘marketing to a segment of one’. This is especially attractive to organisations such as banks that are
seeking to build long-term relationships with every individual customer and in particular to build stronger and more
profitable relationships with high-value customers. Combined with the interactive capabilities of the internet, the
marketer has the opportunity to develop a closer and more mutually satisfying relationship with the customer.
An important consideration, however, is whether the customer truly wants a unique offer. And, if so, are they willing to
pay a premium price for it?
Of course, the mass market will still enjoy a profitable future, especially where the mass marketing approach delivers
customers real benefits through lower prices or through some psychological need, such as their identification with the
collective (such as is provided by global brands such as Levis, Nike and Harley-Davidson).

Questions

1. Choose a product (a good or a service) and discuss how market fragmentation into micro markets affects
the marketers of that product.
2. Discuss the pros and cons of ‘marketing to a segment of one’ from (a) the perspective of the marketer, and
(b) the perspective of the customer.
Concepts and applications check
Learning objective 3 select specific target markets based on evaluation of potential market segments
3.1 Recall the most recent item of clothing that you purchased. Describe the market segment(s) at which you think it is targeted.
3.2 What factors should form the basis of an organisation’s evaluation of potential market segments?
3.3 Choose a magazine that you read at least occasionally. List all of the possible market segments the magazine could target, and
outline the competitive situation that the publication potentially faces in each. Which segment do you believe would be the
most attractive for the magazine to target? Justify your answer.

 4.2 Segmentation 4.4 Positioning 

4.4 POSITIONING
Learning objective 4
understand how to effectively position an offering to a target market in relation to competitors, and develop an appropriate
marketing mix

The market targeting stage will provide organisations with a clear understanding of their best prospective market segments,
and of their ultimately chosen target market segments. The issue then arises as to the offer to be made to each segment, and
how the organisation wants to be perceived by its target markets. The organisation must determine how its offer is
‘positioned’ in the minds of each of its target market segments and develop its marketing mix accordingly. Positioning
describes how target markets perceive the organisation’s offer relative to competing offers. It is how customers distinguish
the organisation, its products and its brands from competitors when they are selecting from among the available alternatives.
Notice that positioning is based on customer perceptions which may or may not closely correspond with the product’s
objective characteristics. For example, Penfold’s Grange Hermitage wine is strongly positioned as Australia’s premier wine
in the minds of customers, even though some of its close competitors may be judged above it from year to year. The
important issue is how potential buyers perceive the brand, and this requires that the marketing organisation undertakes
regular qualitative and quantitative market research to obtain an accurate understanding of the position it occupies in the
minds of its target customers.
The organisation can pursue positioning to manage:
how it, as a whole, is perceived relative to competitors in the minds of its stakeholder groups. Virgin, for example,
seeks to position itself as the most friendly, casual and perhaps even ‘irreverent’ competitor across its range of
businesses
how its brands are seen, typically focusing on distinguishing product attributes. For example, Apple focuses on
simplicity, breakthrough design and the wide range of applications (apps) for its iPad and iPhone
how the market distinguishes its offering from those of closely competitive brands. For example, Audi competes
closely with BMW and Mercedes for the same target markets with closely comparable prices and product features.
Position is fundamentally important for organisations, because it describes how the organisation is perceived by the market,
relative to its competitors on the attributes that customers regard as important in their decision making. In this way,
positioning describes how customers make sense of the complex, crowded marketplace and make their brand choice
decisions in an efficient way. Positioning enables buyers to take a ‘shortcut’ and arrive at decisions without an excessively
complex or confusing process. When it is done successfully, positioning is generally based on simple propositions, with
which customers agree and which can be easily retained in memory. In this sense, Qantas’ positioning around the theme ‘I
still call Australia home’ is believable, memorable and unique.
While communicating a product’s attributes through advertising and other promotional campaigns is crucial in establishing
an initial market position in the minds of target customers, it is important to understand that such promotion and
communication can only attract ‘first-time’ buyers to the brand. Once customers have sampled the brand, the brand’s
positioning will subsequently depend very largely on the customer’s experience of the brand. In this sense, the crucial
question for positioning is ‘Does the customer’s experience match the promise?’ It is easy for an organisation such as an
airline or a bank to promise ‘friendly and efficient service’ in seeking to attract new customers. The crucial and more difficult
question for the long term is whether or not the organisation’s performance corresponds with its promise and its market
positioning.
Positioning involves two steps: firstly, determining the position that the company wishes to occupy in the minds of buyers;
and secondly, developing a marketing mix to reflect the expectations of the target market segment and which reflects that
positioning. This is shown in figure 4.7.
FIGURE 4.7 The target marketing process stage 3: Positioning

Step 1: Determine positioning for each segment

To determine the appropriate positioning for its products, an organisation needs to undertake detailed market research to
understand its current position in the minds of its target market segments. A common technique for determining positioning
is called perceptual mapping, which typically produces two-dimensional maps showing how each of the competing brands
relate to each other in terms of a range of product attributes. This, of course, assumes that consumers in the target segment
are already familiar with the brand and its competitors and are able to subjectively or objectively compare them on attributes
that they believe to be important. In a familiar product category like toothpaste, consumers will generally have little difficulty
in describing how they distinguish between competing brands such as Colgate and Maclean’s in terms of a range of attributes
such as fresh breath, cavity protection, pleasant taste and suitability for sensitive gums. Under such conditions, familiar
brands such as Colgate Total occupy clear and strong positions, which is paradoxically both a strength and a limitation. It
represents a strength in that existing consumers are in no doubt about the benefits and features of the product. At the same
time, such a strong position is difficult to change in the short term. Conversely, new brands in the market are better able to
establish new positions based on new benefits as consumers develop awareness of newly discovered issues (for example,
gingivitis).

Analysing current positioning

The process of establishing an organisation’s current positioning is clearly of strategic importance and, as such, should be
undertaken based on rigorous analysis and market research. Furthermore, positioning is a long-term strategy and, as such,
should not be changed frequently unless it is demonstrably necessary. The first step in determining the current positioning of
a brand is to identify those product attributes that consumers use to distinguish between competing products or brands
(‘salient’ product attributes). For example, consumers differentiate between home and contents insurance products based on
price and extent of coverage. Qualitative research methods such as focus group studies are commonly used to ascertain the
relevant, salient attributes.
Once the product attributes responsible for creating consumers’ different perceptions have been identified, the organisation
needs to assess how its own product or brand, and competitors’ products or brands are positioned in relation to those
attributes. This is typically done through quantitative survey research, using rating scales to establish how each competing
brand scores on each of the product attributes within each of the target market segments. Based on the results of these rating
scales, a perceptual map can be constructed. Figure 4.8 shows a perceptual map for the Australian surfwear industry. The
perceptual map shows how the different brands are currently positioned relative to each other on those attributes that
consumers use to distinguish between their offerings.
FIGURE 4.8 A perceptual map of the Australian surfwear industry

The next step is to devise some concept of the ideal position of the organisation’s product or brand. This may need to be
adjusted on the grounds of practicability — the desired position may not be technically feasible or attainable given the
resources available. (For example, electric cars are currently hampered by modest cruising range due to limitations in battery
technology.)
Finally, the organisation needs to develop a plan to move to the desired position.

Competitive positioning and repositioning

Refer back to figure 4.8. Having established its current position, Rusty, for example, might feel that its position as an
individual and independent choice is holding it back from securing more market share. It might want to move towards a
position related to peer status. For Rusty, the question would be ‘How might we reposition?’ One option would be to pay
celebrities to wear the brand. Secondly, Rusty could change its advertising appeals to try to persuade the public that it is more
‘mainstream’ and not so representative of independence. A further attribute which is not represented in this perceptual map,
but which is present in almost all consumers’ mental maps, is price. Generally price is relatively independent of other
product attributes, and all competing brands will be evaluated on price.
It should now be clear that positioning is fundamentally important in the marketing of individual brands and in the
organisation’s long-term competitive success. It should also be apparent that, once established, a competitive position should
be protected and nurtured for the long term. This involves communicating a consistent message and delivering a consistent
product and service offering over the long term. In this sense, positions should not be chopped and changed, but rather
should be created, nurtured and consistently reinforced.

Step 2: Determine the marketing mix for each segment

With knowledge of the optimal, practicable positioning of our brand, the final step in the target marketing process is to
determine an appropriate marketing mix for each target market segment. The marketing mix describes the overall offer the
organisation makes to its target customers. The marketing mix for each segment should:
be consistent with the desired positioning
be internally consistent — each element of the marketing mix should be coordinated and supportive of the other
elements
be sustainable in the long term.
Developing the appropriate marketing mix for target market segments will be central to all of your work in marketing.
Spotlight: Opel Leben Autos
When Opel launched in the Australian market in 2013, it could hardly have been called ‘young’ — Opel has been
building cars since 1899. Nor were Opel products entirely unfamiliar to the Australian market, as cars such as the Corsa,
Kadett, Vectra and Zafira have been marketed as Holden Geminis, Barinas, Vectras and Zafiras since the 1970s. Even the
quintessentially Australian Holden Commodore was originally derived from the Opel Commodore. Today, beyond the
Commodore, General Motors Holden sources its small cars from General Motors’ Korean operations as part of its global
branding and production programs.
The decision of General Motors to belatedly introduce the Opel brand to Australia could be seen as a response to the
strong Australian dollar, which has made European brands — especially Volkswagen and the European Fords (Mondeo,
Focus and Fiesta) — much more price competitive. The long-term success, or otherwise, of Opel would depend on its
continued competitive costs (determined largely by the Euro/AUD exchange rate), and therefore its pricing; but it would
also fundamentally depend on the success of its positioning in a very crowded and competitive marketplace. Opel’s
launch positioning strongly emphasised its German origins, and Volkswagen was its obvious immediate competitor,
together with the European Fords, Renault, Peugeot and Volkswagen’s other European brand Škoda. The Opel brand and
range of Corsa, Astra and Insignia (which were to be joined by Zafira and Mokka) was positioned as strongly German,
while offering a value package of enhanced product features at a comparable price to Volkswagen (or a lower price when
comparing ‘like for like’).

However, as several European brands (for example, Alfa Romeo, Fiat, Lancia, Seat and Škoda) have already discovered,
a proud heritage and strong European market presence do not guarantee success in Australia. Opel’s entry strategy and
positioning was a ‘work in progress’. To everybody’s surprise (including staff and dealers), on 2 August 2013 Opel
Australia announced it was withdrawing from the market immediately, citing the current $19 990 price point of
comparable products to its Astra as being prohibitively low. Clearly, the recent slide in the Australian dollar was a
contributing factor. One of Opel’s dealers claimed that the company had been ‘perhaps a little naive’ in its Australian
market strategy. For example, Škoda (a minor European brand also owned by Volkswagen) had been operating in
Australia for over five years, and had only recently been making headway.3

Questions

1. Construct a perceptual map showing the positioning of Opel together with its immediate competitors (e.g.
European Fords, VW, Renault, Peugeot) in the Australian market.
2. Based on the map, what positions do you think Opel could and should have feasibly adopted?
Concepts and applications check
Learning objective 4 understand how to effectively position an offering to a target market in relation to competitors, and
develop an appropriate marketing mix
4.1 Explain the concept of market positioning.
4.2 Choose five different products (goods or services) and list those attributes of each that would be used by consumers to
distinguish between competing brands.
4.3 Why is it important for a marketer to take a long-term view of positioning and the marketing mix?
Case study
Generation Z defined: global, visual, digital
With the oldest Generation Zs having reached adulthood, and the youngest having started school, here’s an analysis of
what defines this global, 21st-century generation.
The world is changing at a rapid pace, and has been transformed in the lifetime of our Gen Zs. Just ten years ago if you
said ‘Do you have the latest app?’, ‘Did you read that tweet?’, ‘Like my post!’ or ‘Oh, you have an android’, people
would wonder what planet you are from. Such is the speed of technological change that while it took almost ninety years
for there to be one car in Australia for every person, it’s taken just ten years for smartphones to have the same reach!

Generation Z: growing up in shifting times

Generation Z are the children and teenagers growing up in these fast-moving, complex times. Born between the mid
1990s and around 2010, the youngest of this cohort are just entering primary school, while the oldest have put down their
pens and exam papers after finishing their final school exams. There are currently 4.6 million Gen Zs in Australia, and
with this generation the learners of today and the employees of tomorrow, understanding what has shaped them, as well
as what motivates them, is critical. In light of that, here are seven top trends shaping Generation Z.

7 trends defining Generation Z

1. Demographically changed. Australia is experiencing both an ageing population and a baby boom, with over 300 000
babies born each year. Since 1966, Australia’s population has doubled and is now growing by a new Canberra every
year. Not only is the population growing, but our households are changing. The nuclear family (parents and children)
is still the most common household form (33 per cent of all households). However, within a few years, the couple-
only household will be the most common, and with our ageing population, the lone person household has been the
fastest growing.
2. Generationally defined. Generations are comprised of people who share a similar age and life stage, have been
shaped during their formative years by similar conditions and technologies and have lived through the same events
and experiences which have impacted them. For Generation Z, coming of age in the 21st century has created a unique
generation — from the global financial crisis to growing cultural diversity, from global brands to social media and a
digital world. Generation Z are the most materially endowed, technological saturated, formally educated generation
our world has ever seen.
3. Digital integrators. While all age groups have embraced the digital technologies of the 21st century, the age at which
they first utilise the technology determines how embedded it becomes in their lifestyle. We refer to adults as the
digital transactors who use technology in a practical, functional, structural way, using the new technology to achieve
tasks that they previously used old technology to achieve. However, Generation Z are digital integrators in that they
 have integrated technology seamlessly into their lives and, having used it from the youngest age, it is almost like the
air that they breathe, permeating almost all areas of their lifestyle and relationships. A recent study showed that more
than half of Australian young people don’t wear a wristwatch because the smartphone has become the primary device
used to tell the time (in addition to being the primary device for getting directions, checking the weather and taking a
photo).
4. Globally focused. Generation Z is the first generation to be truly a global one. Not only are the music, movies and
celebrities global for them as they have been for previous generations, but through technology, globalisation and our
culturally diverse times, the fashions, foods, online entertainment, social trends, communications and even the ‘must-
watch YouTube videos and memes’ are global as never before.
5. Visually engaged. At 4.7 billion searches per day, Google is the number one search engine, but with 4 billion
YouTube searches a day, YouTube is a close number two. We have an emerging generation, many of whom are opting
to watch for a video summarising an issue rather than read an article discussing it. In an era of information overload,
messages have increasingly become image based and signs, logos and brands communicate across the language
barriers with colour and picture rather than words and phrases. Analysis of learning styles has shown the dominance
in the visual and hands-on learning styles above that which traditionally dominated the classroom — the auditory
delivery format.
6. Educationally transformed. While the Australian federal government had a target of 90 per cent of students
completing year 12 by 2015, many schools had already surpassed this years earlier. And while the average young
person is spending more years in formal education than ever before, with tertiary education rates similarly increasing,
for today’s students, education is no longer life stage dependent (i.e. before the career commences), but a lifelong
reality. Not only have students changed, but also their schools, with a shift from teacher centred to learner adaptive,
from content driven to engagement focused, and from formal delivery to more interactive environments.
7. Socially defined. More than any other generation, today’s youth are extensively connected to and shaped by their
peers. In a recent study by McCrindle Research, it was found that while nearly all the generations had the same
amount of close friends (an average of 13), Generations Y and Z had almost twice as many Facebook friends than the
older generations. And so, the network that influences them is greater numerically and geographically and, being
technology based, is connected 24/7. This technology, while helping to facilitate their relational world, can also
negatively impact it, with research showing that a third of students have been bullied via social networking websites,
instant messaging, texts or email.

Australia’s Generation Z, coming of age in the 21st century, are alive at an amazing time in human history, living in one
of the most amazing places in the world and — being at the start of their lives — have amazing opportunities,
unimaginable just a generation ago. Understandably, very few Generation Zs would swap their lives with any other
generation at any other time and in any other place. The challenge for the older generations is to offer the wisdom,
guidance and support so that this emerging generation can make a positive difference in their era and for the generations
of the future.
Source: ‘Generation Z defined: global, visual, digital’ (2012), The McCrindle Blog, 20 December,
www.blog.mccrindle.com.au.

Questions

1. What are the key distinguishing characteristics of Gen Z that set them apart from previous generations?
2. In what markets do Gen Z represent an important opportunity for marketers?
3. How will marketing to Gen Z be different to marketing to previous generations?
4. What will be the key challenges in marketing to Gen Z?
Advanced activity
The opening case at the start of the chapter highlighted the pricing competition between discount department stores. Apart
from discount department stores, make a list of five other sectors of the consumer market that might be expected to
experience a similar level of competition intensity. Choose one of these sectors, and outline what cost structures and
business models you would implement to allow a business to compete successfully on price against local and online
retailers.

Marketing plan activity

Develop the ‘target market’ section of a marketing plan based on an organisation of your choice. Be as specific as
possible, outlining the following for each target market segment that you identify:
demographic characteristics
geographic characteristics
behavioural characteristics.
Finally, analyse the needs of each target market segment, explaining the following:
the current (and potential future) needs of each target market segment
how your chosen organisation’s current product offerings meet these needs (or will be able to be positioned to meet
these needs)
how competing product offerings currently meet these needs (or will likely be positioned in future to meet these
needs).
This needs-analysis may require additional market research to be conducted.

 4.3 Targeting Summary 

SUMMARY
Learning objective 1: understand the target marketing concept
Market segments are subgroups within the total market that are relatively similar in regards to certain characteristics.
Marketers can choose to make an undifferentiated offer to the market, to customise the offering for each individual
customer, or to make offers that are tailored to the needs of market segments, but not further differentiated within each
segment. Target marketing is an approach to marketing based on identifying, understanding and developing an offering
for those segments of the total market that an organisation can best serve. Small organisations with limited resources
often choose to specialise their offering to a particular market segment, focus on one product, or combine both
approaches. The target marketing process involves market segmentation, market targeting and market positioning.
Learning objective 2: identify market segmentation categories and their variables for consumer and business
markets, and develop market segment profiles
Market segmentation involves identifying variables that can be used to define meaningful market segments and then
creating profiles of the market segments. The ideal market segmentation variables are those that are likely to be closely
linked to purchasing behaviour. In consumer markets, geography, demographics and behavioural variables are useful
for segmentation. In business markets, organisation size, product use and geography are typically used. Whatever the
segmentation variables, the defined segments should be measurable, accessible, substantial and practicable. Based on
market segments, the marketer can develop a market segment profile, which is a description of the typical customer in
the market segment in relation to their shared characteristics and the characteristics that distinguish them from other
segments.
Learning objective 3: select specific target markets based on evaluation of potential market segments
Market targeting is the selection of target markets resulting from the evaluation of the market segments that have been
identified. The choice of target markets will be made upon thorough assessment of the market segment’s sales
potential, the competitive situation in the market, and the organisation’s cost structures. Once these factors are known
for each segment, the most appealing segment or segments will emerge as the clear targets for the organisation’s
marketing strategy.
Learning objective 4: understand how to effectively position an offering to a target market in relation to
competitors, and develop an appropriate marketing mix
Market positioning refers to how target markets perceive an organisation’s offering in relation to its competitors’
offerings. Market positioning is fundamental to how customers choose between competing products. Organisations
may choose to undertake positioning at the company or brand level, or to focus on differences with close competitors.
To implement a positioning strategy, the organisation must determine how it wishes to be perceived by the market and
then develop a marketing mix that will produce that perception. The first step in analysing positioning is to determine
which product attributes consumers use to distinguish between competing offerings. The organisation then assesses
how it and its competitors are positioned against those attributes. Once the current market position is known, the
organisation can develop a concept of where it would like to be positioned. Finally, it must develop a plan to move to
the desired position. The marketing mix developed for each target market segment must be fully consistent with the
desired position.

 4.4 Positioning Endnotes 

ENDNOTES
1. E. Knight (2013), ‘Store wars: set for new campaign’, Sydney Morning Herald, 12 April, www.smh.com.au.
2. Mosaic Australia website, www.mosaicaustralia.com.au; GeoSmart, RDA Research website,
www.rdaresearch.com.au/geosmart.
3. ‘History and heritage’, Opel Australia website, www.opel-australia.com.au; T. Beissmann (2013), ‘Opel Australia closure:
how it happened and where to from here’, Car Advice, 8 August, www.caradvice.com.au; J. Dowling (2013), ‘Opel abandons
Australian arm after less than a year after poor sales’, www.news.com.au, 2 August.

 Summary 5 Elements of the marketing mix 

 CHAPTER 5

Elements of the marketing mix

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

5.1 explain the elements of the marketing mix
5.2 define ‘product’, and understand product classification, product differentiation and branding
5.3 understand the concept of price and customer value perceptions
5.4 understand the integrated marketing communications (IMC) approach to marketing promotion and the major elements
of the promotion mix
5.5 understand the concept of place and how distribution channels connect producers and consumers
5.6 describe how to develop and manage an effective marketing mix based on the unique characteristics of services.
Naturally! Sunny Queen Eggs
Sunny Queen Australia is an Australian farmer–owned company specialising in quality farm-fresh egg products from
across the country. Sunny Queen has farms located throughout Queensland, New South Wales and Victoria, and is
committed to providing eggs that are fresh, safe, wholesome and quality guaranteed.
Sunny Queen Australia partnered with BCM, a leading Queensland integrated marketing communications agency, to
build its egg business. The aim was to launch Sunny Queen Eggs in Victoria and to gain national distribution in Coles and
Woolworths, who together represent over 80 per cent of the national grocery retail market in Australia. BCM commenced
with market research, identifying a significant market opportunity — a strong and growing interest in natural foods for
young women with kids.

The solution that BCM found was already available in the Sunny Queen Australia egg portfolio — the ‘vegetarian egg’.
Hens laying Sunny Queen Natural Grain Eggs are fed a diet of wholesome, Australian-grown grains, resulting in
delicious eggs with rich golden yolks. At only around 5 cents more per egg, Natural Grain Cage Free eggs offer value for
money for people seeking natural foods for their children. The product was renamed, packaging was updated, and an
integrated marketing communication was developed to coincide with the Victorian launch of Sunny Queen Eggs.
According to Julie Proctor, National Marketing and Innovation Manager, before the BCM campaign sales of Sunny
Queen Eggs were 59 000 dozen per month, and after the campaign sales were 300 000 dozen per month.
Source: Sunny Queen Australia website, www.sunnyqueenaustralia.com.au; ‘Natural Grain Cage Free Eggs’, Sunny
Queen Australia website; BCM, ‘Sunny Queen Facebook case study’, www.bcm.com.au.

Questions

1. Analyse Sunny Queen Natural Grain eggs in terms of as many of the elements of one of the marketing mix
frameworks as possible.
2. Describe Sunny Queen’s broad product offering in terms of a bundle of attributes that benefit customers.
Refer to the difference between needs and wants in your answer.
INTRODUCTION
In the preceding Marketing chapters, we explored the marketing environment and the various factors involved in identifying
customers. Combined with the ability to divide the market into target segments, this information helps us begin to answer the
following question: ‘How do we formulate the marketing mix to best serve our potential customers?’ In this chapter, we will
examine the key components of the marketing mix — product, price, promotion and place (as well as people, processes and
physical evidence). Unlike factors in the micro environment and macro environment, the marketing mix can be directly
controlled by the organisation. Finally, we will explore ethics and corporate social responsibility.

 Endnotes 5.1 The marketing mix 

5.1 THE MARKETING MIX
Learning objective 1
explain the elements of the marketing mix

The marketing mix is the term given to a set of variables that a marketer can exercise control over in creating an offering for
exchange. Various frameworks for the marketing mix have evolved over time, including:
the 4 Ps framework — product, price, promotion and place (place is more easily understood as distribution). The 4 Ps
framework was the first approach to the marketing mix.
the 5 Ps framework which evolved from the 4 Ps model by adding a fifth P, ‘people’, to the 4 Ps framework.
the 6 Ps framework which added ‘process’ to the 5 Ps framework
the 7 Ps framework which added ‘physical evidence’ to the 6 Ps framework.
To frame their thinking, marketers often choose to target certain types of customers. Markets are heterogeneous — they are
made up of many different people with many different needs and wants. A target market is a group of customers with
similar needs and wants. Not all customers in a target group will have exactly the same needs and wants but they are more
similar than different. By narrowing their thinking to a target group, marketers can think about how they can best
communicate, deliver and exchange their offerings with customers. A business can also aim for multiple target markets. For
example, Subaru targets different groups with various cars: its Outback range of station wagons is aimed at families and
couples who value comfort, safety and life in the great outdoors, while its Impreza WRX STi hatch is aimed at performance
car enthusiasts (with a lot of money).
Marketers cannot act with complete freedom in determining their marketing mix. They are governed by the costs of
implementing the various marketing mix options, as well as the forces at play in the marketing environment. They are also
governed by the people in their organisation. There is little point creating something that is simply not possible to implement.
We will now examine each of the elements of these various marketing mix frameworks. It is important to remember that
marketing — whatever marketing mix framework you apply or consider — is ultimately about a total focus on servicing the
needs and wants of the customer.

 5 Elements of the marketing mix 5.2 Product 

5.2 PRODUCT
Learning objective 2
define ‘product’, and understand product classification, product differentiation and branding

The marketing process comprises creating, communicating, delivering and exchanging offerings that have value for
customers. A product is defined as a good, service or idea offered to the market for exchange. Clearly, product plays a vital
role in the marketing process. Without a product, a marketer has nothing to offer. On the other side of the exchange, potential
customers require products to satisfy functional, social and psychological needs, wants and demands. The core concept is
that both parties must gain value from the exchange.
Goods are physical, tangible offerings that are capable of being delivered to a customer. Because it is tangible, you can see,
touch, taste and smell a good (depending on what it is). The purchase of a good usually involves the transfer of ownership
from marketer to customer; when the customer buys a good, they usually become the owner of the good. Examples of goods
include toothpaste, shoes and cars. Services are intangible offerings to the market. As they are intangible, a service cannot be
touched or tasted and does not involve ownership; instead, you experience a service. Haircuts, legal representation and
massages are all examples of services. An idea can also be offered to the market in the form of a concept, issue or
philosophy. Ideas are often the products of community organisations, charities and political parties. Examples of ideas
include Quit for Life; Slip, Slop, Slap; and Clean Up Australia or Keep New Zealand Beautiful.

The total product concept

Products have many different features that can provide value for customers, clients, partners and society at large. At the most
basic level, marketers must ensure that the product attributes satisfy the needs and wants of potential buyers. It is this ability
to satisfy a need or want that makes the product of value to potential customers. To make a product of more value than
competing offerings, the marketer must take a more comprehensive view of the product. To understand how the product’s
value is perceived by potential customers, it is useful to describe the product in terms of its four levels: core product,
expected product, augmented product and potential product. This view of the product is known as the total product concept
and is illustrated in figure 5.1.1

FIGURE 5.1 The total product concept

It is crucial for marketers to understand that when customers choose a product, they do not purchase some ‘thing’; rather,
they buy a solution to a problem. For example, a company that operates vending machines that serve hot drinks should view
its business as one that quenches people’s thirst, warms them when out on chilly winter nights and gives them a caffeine
boost when they are feeling tired; not as a business that places machines on train station platforms and mixes lukewarm
water with powdered flavouring in a cardboard cup. The total product concept is a way of viewing a product as the totality of
value and benefits it provides to the customer. Products are offered to the market to be an answer to the customer’s problem
of an unsatisfied need or want.
The core product
The core product comprises the fundamental benefit that responds to the customer’s problem of an unsatisfied need or want.
So what is it that will satisfy a customer’s need? What is the key benefit they want from a product? For a marketer,
understanding these questions will greatly assist in providing the right product to the market, and make sure customers
purchase from you and not a competitor. For a mobile phone, the core benefit is reliable, accessible communications; for a
credit card, it is the ongoing provision of credit; for a coffee, it is satisfaction of thirst. Regardless of other changes made to a
product, the core product generally remains the same.

The expected product

The expected product describes those attributes that actually deliver the benefit that forms the core product. They are the
attributes that fulfil the customer’s most basic expectations of the product. Marketers generally try to differentiate their
offering using fundamental characteristics such as branding, packaging and quality standards at the expected product level.
For a mobile phone, an expected product could be a conveniently sized phone with easy-to-read screen and keypad; for a
credit card, it could include a plastic card with the card number and a signature panel that can easily fit into a wallet or purse.

The augmented product

At the augmented product level, the product delivers a bundle of benefits that the buyer may not require as part of the basic
fulfilment of their needs. The augmented product level enables marketers to significantly differentiate their offerings from
those of competitors. It is often the augmented product features that form the main reason for choosing a particular brand.
This can include support services, such as guarantees. For mobile phone companies, augmented product features include
access to a variety of downloadable apps. For a mobile phone, product augmentation may extend to superior sound quality or
the ability to use the device for ‘virtual’ tickets (e.g. Apple’s Passbook application enables the ability to store event and
travel tickets). For a television, it could be the expansion of smart TV capabilities, with an increased convergence of
television and the web. Over time, features that form part of the augmented product level can become so widely incorporated
into the product that they become part of the expected product layer.

The potential product

The potential product comprises all possibilities that could become part of the expected or augmented product. This includes
features that are being developed, planned or prototyped, as well as features that have not yet been conceived. Over time,
many potential product features become part of the augmented product or even the expected product. For example, in the
early days of mobile phones, SMS was an idea for a potential product feature. Within a few years, SMS capability became an
augmented product feature and, ultimately, an expected product feature. Today, potential product features of a mobile phone
could include digital television or contactless payment capability (i.e. the ability to ‘swipe’ the phone in much the same way
as a contactless credit card). Potential product features are attractive to marketers as they offer new ways to differentiate their
product and increase the value for customers. Figure 5.2 shows how a product (a mobile phone) can be analysed using the
total product concept.
FIGURE 5.2 Analysing a mobile phone using the total product concept

Product relationships
Many organisations produce multiple products or several different styles of a product. The relationships between the
organisation’s products can be described as follows.
Product item — a particular version of a product that can be differentiated from the organisation’s other product items
by characteristics such as brand, ingredients, style or price. For Bonds, a product item in their men’s underwear range
is Bonds Boxers.
Product line — a set of closely related product items. The close relationship is usually in terms of end use, target
market, technology or raw materials. Using the Bonds example, the product line for Bonds men’s underwear includes
trunks, Y-fronts, boxers and hipsters.
Product mix — the set of all products that an organisation makes available to customers. For Bonds, it is underwear,
singlets, shorts, track suits, hoodie jackets, socks, and T-shirts, as part of their men’s, women’s and children’s wear.2
The product mix can be described by its width and depth. Product width refers to the number of product lines offered
by a company. Product depth is the number of different products available in each product line.

Product classification
Products can be classified into consumer products and business products according to the circumstances in which they are
bought and their intended use. Consumer products are those products purchased by households and individuals for their
own private consumption. Business-to-business products are those products purchased by individuals and organisations for
use in the production of other products or for use in their daily business operations. Some products are both a consumer and a
business product. Reflex photocopy paper, for example, can be purchased as a consumer product at a discount store to be
used for a home inkjet printer, or as a business product from a wholesaler by the pallet to be used by an organisation’s office
printers and photocopiers.
The classification of products into consumer products and business-to-business products is a helpful first stage in
understanding the different circumstances in which products are bought and the different uses customers have for them. It is
useful, however, to develop the classification further.

Consumer products
It is useful to further subclassify consumer products into one or more of the following main categories:
shopping products
convenience products
specialty products
unsought products.
Shopping products are irregularly purchased items that involve moderate to high engagement with the decision-making
process: consumers will often visit a number of stores, looking at the range and comparing items based on features, quality
and price. Shopping products exhibit the following characteristics:
they are expected to last a long time
they are purchased relatively infrequently
they are stocked by a small number of retail outlets
they sell in low volumes
they have reasonably large profit margins.
Examples of shopping products include electrical appliances, furniture, cameras and clothing.
Convenience products, also known as fast-moving consumer goods, are inexpensive, frequently purchased consumer
products that are bought with little engagement in the decision-making process. Convenience products are usually available
from a wide range of retailers, including supermarkets, corner stores and petrol stations. Being cheap, they usually depend on
a high volume of sales to generate a reasonable profit. They are often self-service products and so packaging plays a major
role in grabbing consumers’ attention. Convenience products can be further broken down into three main categories.

1. Staple products — products that are bought and used by consumers regularly, such as milk, bread, rice and soap.
Usually, there is not much promotion for branded staple products.
2. Impulse products — products that are bought with little planning, often purchased only after seeing the item at the
retail store. Impulse products include magazines, chocolate and chewing gum. They are often positioned immediately
next to the cash register in a store.
3. Emergency products — products that are bought when the product is needed in an ‘emergency’; for example, an
umbrella when you are caught in the rain or the services of an electrician if the power goes off.

Specialty products have unique characteristics that are highly desired by their buyers. The purchaser of a specialty product
usually knows exactly what they want — they are not interested in comparing brands or considering alternatives. As such,
consumers are willing to expend considerable effort to obtain specialty products. If someone is interested in purchasing a
BMW car they will go to a BMW dealer and they will be prepared to travel some distance to get there if necessary. The main
characteristics of specialty products are:
they are pre-selected by the consumer
there are no close substitutes or alternatives
they are available in a limited number of outlets
they are purchased infrequently
they sell in low volumes
they have high profit margins.
Unsought products are those goods or services that a consumer either:

a. knows about but doesn’t normally consider purchasing

b. doesn’t even know about.

A fundamental challenge for marketers with any product is to make consumers aware of the product’s features and benefits,
and the needs it satisfies. This is especially the case for unsought products, and marketing communication efforts are crucial.
For unsought products in category (a), a sudden, unexpected need may arise for consumers. For example, although most
consumers will know that various home security products exist, it may take a spate of burglaries in their neighbourhood to
prompt the consideration of purchasing such products. An actual break-in, of course, would prompt the engagement of police
services. In such situations where unexpected needs arise, prior marketing communication efforts are likely to be crucial in
order for a particular product or brand to be ‘top of mind’ for the consumer. For example, the consumer may be aware that
‘Crimsafe’ is a popular brand of home security products, due to concerted marketing communications efforts by the company
over a number of years.
For unsought products in category (b), marketing communication is again crucial in terms of making consumers aware that
the product is available, and that its features and benefits satisfy needs. Only then will demand for the product potentially be
generated, in order for it to move out of the less desirable ‘unsought’ category and into one of the other consumer product
classification categories (shopping, convenience or specialty).
In closing our discussion of consumer product classification categories, it is important to note that a product can be
purchased as a different product class, depending on the customer’s usual purchase behaviour or the reason for purchasing
the item. For example, an umbrella may be especially purchased as a shopping product as a.pngt for someone, while an
umbrella may also be bought as a convenience product if you are stuck outside in the rain.
Spotlight: Harley-Davidson — exclusive product and dealer
For motorbike riders, there is something very special about Harley-Davidson. It is one of the most recognised brand
names in the world and evokes images of history, quality, confidence, power and passion. Those who love the Harley-
Davidson brand certainly have a passion for it.
So if you wanted to purchase a new Harley-Davidson motorbike, where would you go? You wouldn’t go to a department
store, or even the local used car dealer to buy it. As it is a specialty product, you would make the effort to find the
exclusive authorised dealer. One such authorised dealer is Trivett Harley-Davidson.
John Trivett founded the Trivett Group in 1984 and developed the business into a specialist luxury car dealer, now
representing 17 major international automotive brands, employing more than 600 people and selling over 9000 vehicles a
year. Trivett Classic owns dealerships in brands including Rolls Royce, Aston Martin, BMW, Bentley and Porsche. In
addition to its operations in Australia and New Zealand, Trivett also has showrooms in China and India. In 2006, Trivett
Harley-Davidson officially began trading, and now has a state-of-the-art showroom in Sydney. The showroom has a range
of Harley-Davidson motorcycles, parts, accessories, collectibles, clothes, and offers service work, modifications and
advice. It is a heaven for Harley-Davidson enthusiasts.

The showroom displays a range of Harley-Davidson models, enabling potential customers to compare the attributes (and
price tags) of the different bikes. One of the most popular styles is the Softail Fat Boy, which has a similar style to the
famous Harleys of the 1960s and 1970s, and sells for around $30 000. Although, if you want something different, a Super
Low Sportster is worth around $14 000 while a CVO Ultra Classic Electra Glide is available for almost $50 000. If you
have the money and a passion to ride a Harley down the highway, the best place to start is at an exclusive dealership to
analyse the model options and their individual attributes.3
 Questions

1. Harley-Davidson makes a range of motorbikes and collectibles. If the brand is so loved by its customers,
why doesn’t it make its products available at a lower cost and sell in a larger number of dealerships? What
might the rationale be for promoting the motorbikes as ‘specialty products’?
2. Find out as much as you can about Harley-Davidson motorbikes, and then classify their features under the
four levels of the total product concept.

Product differentiation
As we discussed earlier, a product is a complex concept with a number of characteristics and attributes that can provide value
to the customer and assist them in making their final purchase decision. The marketer, therefore, must decide on which
product characteristics to include in the product offering that would best benefit and satisfy their customers’ needs and wants
and contribute to the organisation’s objectives. Deciding on the right characteristics is not always an easy decision and it is
recommended that marketers regularly undertake some type of market research to determine potential customers’:
desires in relation to the product category
attitudes towards the product offering
attitudes towards the product’s features.
When making decisions about a product, it is important to decide on the characteristics that will make the product different to
competitors’ offerings. Product differentiation is the creation of products and product attributes that distinguish one product
from another. If customers perceive there to be a difference between competing products, they will examine the specific
product characteristics (as well as the other elements of the marketing mix) to assist them in making the final purchase
choice. In terms of the product, most of the differentiating features are part of the augmented product layer of the total
product concept. Some of the characteristics that customers may perceive to be differentiators include design, brand, image,
style, quality and features. Any of these can potentially give the company a competitive advantage in the marketplace. These
characteristics can also be used in the product’s promotional activities to emphasise the value of the product and differentiate
it from competitors. To better understand the creation of competitive advantage through product differentiation, let’s look at
some examples.
The Swedish furniture company IKEA focuses on simplicity and minimalism in its furniture designs. Most of its furniture is
plastic or light-weight, laminated wood, held together by screws and other fasteners. It offers coordinated pieces that enable
an entire room or house to be furnished. It also sells most of its furniture flat-packed. This lets IKEA keep more stock on
hand and achieve cheaper prices, but requires customers to transport and assemble the furniture themselves. Contrast IKEA’s
product offering with another furniture company, Jimmy Possum.4 Jimmy Possum sells solid, handcrafted, fine furniture,
made from handsome timbers using traditional techniques. Its products require careful upkeep, such as polishing and oiling
to preserve the wood. While both companies sell dining tables that are the same at the core and expected product levels the
product attributes at the augmented product level are substantially differentiated in terms of appearance, quality, branding
and positioning. In addition to product differences, they also vary significantly in terms of pricing, promotion and
distribution.
Product attributes that serve to differentiate competing offerings are not always as dramatic as the difference between IKEA
and Jimmy Possum. Consider Kiwibank, a bank operated by New Zealand Post.5 Kiwibank was established to compete with
ANZ, ASB, BNZ, National Bank and Westpac, which have long dominated the New Zealand banking sector. It offers the
standard range of services, such as savings accounts and loans, but Kiwibank has successfully differentiated its offerings
through product attributes including New Zealand ownership, longer opening hours (including weekends at many branches),
lower fees and interest rates, and innovative online banking services. In less than a decade, it has secured more than 15 per
cent of the New Zealand population as customers.
Warranties, installation, in-home training and free phone help lines are all examples of add-on services that some
organisations use to differentiate their products from competitors. For some customers, certain extra services may be an
essential product requirement. For example, those who are not computer literate may only choose to buy computer products
that are backed with a reliable customer service help desk in a store or a toll free telephone support service. Apple has built a
reputation on good after sales service and customer relations. Support does not necessarily mean a response to a problem; it
can mean satisfactorily dealing with requests, complaints, suggestions and maintenance. Such services can encourage repeat
purchases, positive ‘word-of-mouth’ promotion and customer loyalty.
Products can also be differentiated within an organisation’s product mix; for example, when purchasing a new car, a luxury
or sports model may include specific features (such as air-conditioning, air-bags and leather seats) that are not included in the
base model. Of course, the luxury model will also feature a higher price. Similarly, the base model of a Dell computer is
worth a certain amount of money; however, if you purchase it with a scanner/laser printer, high-quality speakers and a wide-
screen monitor, then the price will be higher. Further into a product’s life, such features are often added while the price
remains unchanged. In this way, the marketer can maintain sales volumes, but will sacrifice some profit.
From these few examples, it should be clear that, in seeking a competitive advantage, organisations commonly differentiate
their products based on design, quality, functionality and add-on services, as well as on the other elements of the marketing
mix. These differences serve to create a unique value offering to the market and influence how the product is positioned (i.e.
how customers perceive it relative to competing offerings). Product differentiation based on product attributes is intimately
linked with product positioning. Consider power tools as an example. The German power tool manufacturer Bosch divides
its product line and promotional efforts into a ‘DIY enthusiast’ sector and a ‘professional’ sector. The DIY line focuses on
affordability and features that make the tools easier to use. The professional line focuses on durability (including the
warranty offered) and power. Customers in each sector have significantly different definitions of the features, price and
quality that constitute value. Bosch takes this a step further by offering several variations within each sector. For example,
within the DIY line, it offers several models of jigsaw that vary on power, accessories (such as laser guides), aesthetics, size
and packaging. Even a government-owned organisation like Australia Post, which is usually identified as a nationwide postal
service, has been differentiating its services. With the growth of courier companies, and the rise in popularity of paying bills
online, there has been a decline in its traditional businesses. In a recent year Australia Post expanded into the insurance
market, offering car insurance. The organisation also has plans to expand into other areas, like travel, home and contents
insurance.
Product differentiation must not be viewed as a static concept. Marketers usually modify, upgrade and reposition products
during their life cycle to try to ensure their competitive advantage is maintained or improved.
Spotlight: Adopt a Pet
Getting a new pet is a major decision for a household. While the decision to buy could be full of good intentions, there
have been many impulse purchases of animals resulting in large numbers of animals being dumped — especially after
Christmas. It is estimated that 150 000 dogs and cats are euthanised each year in Australia, many being unwanted pets
from pet shops.
There has been a growing criticism of pet shops for animal cruelty and for encouraging ‘puppy farms’ (where hundreds of
dogs are bred in poor conditions). Unwanted animals often end up at the RSPCA (Royal Society for the Prevention of
Cruelty to Animals), where the organisation aims to find them new homes. The RSPCA runs an ‘Adopt a Pet’ program to
differentiate RSPCA animals from those available in pet stores. Rather than just buying a dog, cat, guinea pig or bird, the
RSPCA focuses on the adoption of what will be a ‘new family member’ to love. Sometimes even farm animals like goats
and cows are available for adoption!
The RSPCA Adopt a Pet website (www.adoptapet.com.au) offers a ‘pet matchmaker’ feature, where potential pet owners
can select from certain criteria (such as animal type, age and temperament) and are matched with suitable animals
available for adoption. It is a national website, allowing visitors to view some of the (abandoned or stray) animals waiting
adoption at RSPCA shelters and adoption centres right across Australia. Therefore, rather than an impulse buy of a cute
dog at the pet store or an emotion-charged visit to a shelter to look at a large number of sad-faced animals, Adopt a Pet
allows you to search for your perfect pet from home.

Importantly, all animals have undergone health and temperament checks to ensure their suitability to the potential adopter,
and have been ‘desexed, microchipped, treated for internal and external parasites (such as worms and fleas), and had their
initial vaccination. Dogs are also heartworm tested and treated’. The RSPCA also offers experienced staff and vets to
provide information and advice to potential adopters.
As a product, a pet is unlike toothpaste or soap — it should not be returned or thrown away if it does not meet initial
expectations. A pet will become an important member of the family, so great care is needed to decide on the right animal.
By using Adopt a Pet, customers can bypass the negative aspects of local pet stores and puppy farms, and ‘adopt’ a new
family member — thereby giving it a life-changing second chance.6
 Questions

1. What are the differences between ‘puppy farm’ pets and those from an RSPCA shelter? Describe the
advantages and disadvantages of each.
2. Why do you believe the RSPCA has differentiated its ‘product’ the way it has? Do you think it is a good
strategy for the RSPCA?

Branding
The brand name can be one of the most important aspects in a customer’s purchase decision. Brand refers to a collection of
symbols, such as the name, logo, slogan and design, intended to create an image in the customer’s mind that differentiates a
product from competitors’ products. A brand can identify one item, a family of items, or all the items of a seller. Brands play
a particularly important role in high-involvement purchase decisions. Most consumers will prefer a well-known, reputed
brand over a cheaper, unknown brand when making high-involvement purchases. For consumers, the brand helps speed up
consumer purchases by identifying specific preferred products. The brand can provide a form of self-expression and status,
as well as denote product quality. It can also arouse a collection of images in the customer’s mind. Brand image is the set of
beliefs that a consumer has regarding a particular brand. People can have a positive or negative brand image for a given
brand, depending on things like past experience or word-of-mouth, which can substantially influence whether they would be
willing to buy the product or not. When marketers make decisions about products, the decisions must relate to the product’s
brand and brand image.

Brand name
Organisations with a well-known brand name are very protective of it and will be willing to spend large amounts of money
ensuring it is not used or abused by other individuals or organisations. A brand name is part of a brand that can be spoken
and can include words, letters and numbers. Coca-Cola, IBM and 2Xist are all examples of brand names. The Nielsen
Company’s ‘Australian Online Landscape Review’ report has found Google to be the number one online brand in Australia,
followed by Facebook, NineMSN and YouTube.7 A brand mark is the part of a brand not made up of words — it often
consists of symbols or designs. McDonald’s ‘Golden Arches’, Qantas’ ‘Flying Kangaroo’ and the International Olympic
Committee’s ‘Olympic Rings’ are among the most recognisable brand marks.
Selecting a brand name is not easy, but it can make a crucial difference to the success of an organisation. A name that might
sound good at first could give rise to unintended problems, particularly if you are going to sell your product in another
country. For example, XXXX (pronounced 4X) is a beer from Queensland with a strong brand name in Australia, but in the
UK the name XXXX is a brand of condoms. The ideal brand is distinctive, easily recognisable and relevant to the products it
represents. Accordingly, brand recognition (both prompted and unprompted) is a key marketing metric.
Once the brand has been chosen, an organisation should guard its brand from misuse; for example, from competitors that
might want to use it or a similar name. To protect the brand, an organisation can register it as a trade mark with the relevant
body (e.g. IP Australia, or the Intellectual Property Office of New Zealand).8 Once registered, organisations have legally
enforceable rights to the exclusive use of the name. Applications to register trade marks are carefully assessed against
numerous rules and guidelines. A brand should be chosen so that it can be protected easily; for example, it should be
distinctive and consist of more than a description of the products.

Brand equity
A well-known brand can be very valuable to an organisation in both financial and non-financial terms. Table 5.1 lists the ten
most valuable global brands.9 The list was compiled by Brand Finance Australia, and measures the strength, risk and future
potential of a brand relative to its competitors.
TABLE 5.1 The most valuable brands in Australia

RANK BRAND SECTOR BRAND VALUE (A$ MILLIONS)

1 Woolworths Retail 7086

2 Telstra Telecommunications 5129

3 Coles Retail 4731

4 Commonwealth Bank Banking/Financial Services 4120

5 NAB Banking/Financial Services 4039

6 Westpac Banking/Financial Services 3466

7 ANZ Banking/Financial Services 3333

8 Optus Telecommunications 2455

9 Macquarie Bank Banking/Financial Services 1852

10   St. George Banking/Financial Services 1481

For marketers, the brand:

identifies the organisation’s products
differentiates the organisation’s products from competing products
attracts customers
helps introduce new products
facilitates the promotion of same-brand products.
The value of a brand is found in the influence it has over purchase decisions. The added value that a brand gives a product is
known as brand equity. All of the value in products arises from the choices that consumers make among those brands
offered to them for purchase; brand equity is therefore a consumer-based concept.

Brand loyalty
The underlying factor in brand equity is brand loyalty. Brand loyalty exists when the customer:
shows a highly favourable attitude toward a specific brand
would prefer to buy a specific brand over any other brand in the market.
Brand-loyal customers are highly valued by organisations and represent a core segment for product sales. Some firms
encourage brand loyalty by having a loyalty program, whereby customers are given an incentive to continue to make repeat
purchases of a particular brand or product. For example, Gloria Jeans has a ‘Frequent Sipper Club’ card that entitles regular
customers to a free drink after every ten purchased drinks. Brand loyalty exists on a continuum. At one end are fiercely loyal
customers who will go to great lengths to obtain their preferred brand. They may be completely unwilling to accept a
substitute. This degree of loyalty tends to be found for football codes and for specific clubs (i.e. brands) within each code. At
the other end of the scale are consumers who have no brand preference for a particular product type. In such cases,
purchasing decisions are likely to be based on other factors, such as price and convenience. In the middle are customers who
prefer a particular brand, but will choose an alternative if their favourite is unavailable.

Brand metrics
To measure the value of brands is extremely useful to organisations. Brand equity metrics include:
brand assets (e.g. trade marks and patents)
stock price analysis
replacement cost
brand attributes
brand loyalty
 willingness-to-pay analysis.
High brand equity can be a valuable asset for a company and provide a strong competitive advantage.
Spotlight: McDonald’s rebrands as Macca’s
Australians love to abbreviate and shorten words and names. For example, mosquitoes are ‘mozzies’, swimming
costumes are ‘cossies’, someone called Barry is ‘Baz’ (like Baz Luhrmann). And, even though they may be sometimes
called ‘the Golden Arches’, McDonald’s is ‘Macca’s’. The name is unofficial, of course — at least it was until
McDonalds decided to rebrand some of its stores as part of an Australia Day campaign.
Since McDonald’s, a US-based global organisation, first began operating in Australia in the Sydney suburb of Yagoona in
1971, it has been a massive success. It currently has 780 outlets and employs 85 000 people, and is a popular choice for
quick, convenient food. For many, it is known as Macca’s. In fact, McDonald’s has submitted the word ‘Macca’s’ to be
considered for inclusion in the next edition of the Macquarie Dictionary.

According to McDonald’s Chief Marketing Officer Mark Lollback:

We’ve been a part of Australia for over 40 years now and we’re incredibly proud to embrace our ‘Australian-only’ nickname. What better way to
show Aussies how proud we are to be a part of the Australian community than change our store signs to the name the community has given us?

From 8 January to 4 February 2013, 13 McDonald’s stores across Australia had new signage and were rebranded as
‘Macca’s’. However, it wasn’t just a matter of changing a few signs. All stores also offered an Aussie range of products,
including the McOz, Aussie BBQ Lamb Burger, Aussie BBQ Brekkie Roll and Pavlova McFlurry. The campaign was
also supported by digital, print, outdoor and social media advertising.
With such a strong existing brand name and brand image, McDonald’s was able to have fun rebranding itself for a
particular campaign, resulting in more positive attitudes from customers.10

Questions

1. McDonald’s nickname is Macca’s. What other well-known brands have nicknames? Why do you think that
it would be special for a company to have a nickname for its brand?
2. Do you believe that this was a good idea for McDonald’s? What are the risks of rebranding, even for a short
campaign?
Concepts and applications check
Learning objective 2 define ‘product’, and understand product classification, product differentiation and branding
2.1 A product can be tangible, intangible or a combination of both. Give examples of tangible and intangible products.
2.2 Consumers give little thought to unsought products until the need for them suddenly arises. How would you market an unsought
product? Illustrate your answer with an example.
2.3 How would you define the four levels of a product in the purchase of a mobile phone?
2.4 Using an example of your own, differentiate between an organisation’s product line and its product mix.
2.5 For one type of product, explain the concept of product differentiation using examples other than those discussed in the chapter.
2.6 Prepare arguments for and against this statement: ‘In today’s highly competitive marketplace, developing a sustainable
competitive advantage through product differentiation is impossible.’

 5.1 The marketing mix 5.3 Price 

5.3 PRICE
Learning objective 3
understand the concept of price and customer value perceptions

The key to successful marketing lies in the creation of a mutually beneficial exchange of value between one party and
another:
For the buyer, the benefit is the satisfaction derived from the consumption or ownership of the product. In normal
circumstances, a buyer will only engage in an exchange if that benefit is in excess of what they must give for the
product.
For the seller, the benefit is primarily the revenue derived from purchases. In normal circumstances, a seller will only
engage in an exchange if that benefit is in excess of the cost of creating and delivering the product.
Price serves as a visible expression of the value of the product to be exchanged and enables buyers and sellers to negotiate
and agree on that value.
In financial terms, this concept is straightforward. Someone buying a bag of apples pays a price of a few dollars. While an
exchange of money and a product between the buyer and seller is the usual method, it is important to recognise that not all
exchanges of value involve a financial transaction (and therefore not all involve a monetary price). Exchange may take place
through bartering (the direct exchange of goods and services in payment for other goods and services). In this case, the
goods and services given actually constitute the price. While it may seem old-fashioned, bartering remains common in many
parts of the world and it is still an important method of exchange in business markets. In fact, the Bartercard business was
established to help businesses trade goods and services. Its system works on ‘points’ earned and spent by members through
the exchange of goods and services with other members. Its key advantage is that it removes the need to directly exchange
one product for another. It also helps businesses administer their bartering activities, which can otherwise be complicated by
tax and legal issues.
When the product is an ‘idea’ rather than a good or service, the ‘seller’ is typically seeking to influence the opinions (e.g.
through political campaign advertising) or the behaviours (e.g. through anti-smoking ‘Quit’ campaigns) of ‘buyers’. The
exchange of value may therefore occur in the ideas or behaviours exchanged by both parties. The astute social marketer will
be mindful that, for the ‘buyer’, the required behaviour is the price of the transaction.
The attitudes and likely behaviours of customers are clearly at the heart of all marketing decisions. For marketers, a crucial
question is ‘How do our current and target customers perceive our price?’ Customer perceptions are of course subjective and
particular to each individual, but it is important that marketers try to match pricing as closely as possible to customers’
expectations. Prices above customers’ expectations will result in the loss of potential sales — and all other marketing
activities will have been wasted. Prices below customers’ expectations sacrifice revenue and profits, as well as potentially
destroying the product’s image and the organisation’s brand equity.

The psychology of pricing

Consumer purchasing behaviour is usually based on a rational evaluation of value. The relative importance of price varies
between individual consumers, however. For example, consumers who are particularly price conscious may concern
themselves primarily with price when making purchasing decisions. Other consumers, however, may be more concerned
with prestige; for them, price is only relevant in so far as it contributes to that sense of prestige. An important indicator of the
importance of price in consumers’ purchasing decisions is the perceived uniqueness or differentiation of the product. For
example, Apple has enjoyed considerable success with its iMac, MacBook, iPod, iPhone and iPad products by creating the
perception that its products are technologically advanced, very user-friendly and uniquely styled. This perception enables
Apple to charge premium prices, while maintaining very high levels of customer satisfaction and loyalty.
Different market segments will have varying levels of sensitivity to price. For example, David Jones and Kmart customers
will respond differently to price changes. In general, however, it can be assumed that a proportion of consumers in many
markets can be characterised as ‘price shoppers’ and businesses need to decide if these customers will be included in their
target markets. While all customers will ultimately be concerned with value, what customers regard as value is personal and,
at times, idiosyncratic. Some customers will regard value in terms of low price, while others will see value as high quality at
reasonable prices. At the same time, these perceptions will vary across product categories, and over time, especially over
economic cycles between booms and recession.

Customer value perceptions

Customers’ attitudes to price can be extremely variable and predicting customers’ responses to particular prices can prove
difficult. All customers will have a notional price range or specific price in mind when contemplating a purchase. When the
retail price falls outside that price range, buyers might experience ‘price tag shock’. Some approaches to pricing attempt to
influence how buyers perceive prices. The seller may, for instance, implement pricing based on ‘trigger points’; that is, prices
at which buyers’ resistance is appreciably lower. For example, a product priced at just under $100 (even $99.95) may
psychologically be significantly more attractive than a price of just over $100 (e.g. $104.95) to certain market segments.
Specific forms of psychological pricing that attempt to manage customers’ perceptions of value are summarised in table 5.2.

TABLE 5.2 Managing customers’ perceptions of value and price

APPROACH DESCRIPTION EXAMPLE ADVANTAGES DISADVANTAGES

Odd–even Pricing based on the theory that Prices are often set to $19.95 or $99.95 Manages customers’ Research on the
pricing odd prices are perceived as rather than $20 or $100 respectively
perceptions of price and effectiveness of this
significantly cheaper than even Prices such as $17.58 are unusual value technique is
prices
inconclusive
The use of idiosyncratic prices to
attract attention and create the
perception that the price is
discounted to the lowest amount
possible

Reference Pricing a product at a moderate ‘Upsize’ deals at fast food restaurants

The customer may use Upsize deals have
pricing level and positioning it next to a Real estate agents frequently show buyers the higher price as a drawn criticism from
more expensive model properties outside their price range before relevant comparison; that health groups for
showing the most suitable property is, as an external contributing to
reference price
obesity
The customer may
choose to ‘trade up’ to
the more expensive
product

Multiple-unit Multiple units of a product are Ice creams are sold in six packs in Customers save by Margin per product
pricing sold for a single price, usually supermarkets
buying at a low unit price
may be lower
significantly lower per unit than Batteries are offered in a range of pack Customers benefit from
the individual price sizes, from single batteries to several convenient bulk
dozen
packaging
Wine and beer are available per case or
Retailers gain from
per carton respectively
higher aggregate sales
Consumption of products
may increase, due to the
ready availability of the
product at home

Bundle Selling a combination of Fast food ‘meal deals’

Offers extra value to the May undermine
pricing complementary products for a ‘Run out’ deals on cars, in which the customer
pricing of unbundled
single price, which is less than manufacturers bundle popular Can increase the overall products
the sum of the individual product combinations of extras at a lower sale
prices incremental price than if the extras were
purchased separately

Customers assess value by comparing expected product benefits with the price. Of course, this is often difficult to do prior to
purchase. Customers thus often use reference prices to help them form an impression of value and price. For familiar
products such as beer, soft drinks and petrol, consumers have clear expectations about an acceptable price range based on
past experience. In other words, they have an internal reference price for the product. For less familiar products, however,
consumers are more likely to rely on an external reference price, such as a comparison price provided by retailers,
advertisers or salespersons. For example, during a stocktake sale, a retailer may claim that the usual price for an LCD
television is $3995, but is on sale now for $2495. It is important that manufacturers and retailers ensure that this external
reference price is realistic; otherwise potential buyers will reject the message. Consumers’ reference prices are also
influenced by their most recent purchases and their expectations of prices in the future. For example, buyers of imported
products such as most cars and premium electronic equipment may base their reference prices and purchases on the likely
future exchange rate. Consumers will also consider their purchasing costs including time, travel, inconvenience and
uncertainty.
As discussed earlier, a marketing exchange is unlikely to take place unless both parties gain value from it. In some cases,
however, one party may feel it has no choice; for example, a person who loses their job and cannot meet their mortgage
repayments may have to sell their house and accept whatever price they can get for it. Even in less drastic circumstances, a
person seeking to sell their home may be forced to accept less than they had hoped for if they want to complete the
transaction. In such circumstances, where sellers feel they have little choice but to sell at the offered price, they will
experience dissatisfaction in the sale and will try to avoid engaging in a similar transaction in future. Similar dissatisfaction
can arise whenever a purchaser or seller feels they have not benefited from the marketing exchange. In this sense, both
buyers and sellers will look beyond the current transaction to consider it in the context of the longer term relationship.
Against this background, such dissatisfaction with the current transaction is highly unlikely to result in lasting relationships
between buyers and sellers.
For many organisations, it can be advantageous to set prices for groups of products rather than to set a price for each
individual product. This approach is known as product-line pricing. It ensures consistency in pricing over a product line,
while enabling the prices of individual products to be adjusted to meet the needs of particular market segments. For example,
when Sony prices its Bravia LCD televisions, there are clear price steps between different sizes of screens and different
levels of features. Sony is therefore able to cover the entire spectrum from entry-level to high-end products, and to provide a
progressive transition to enable customers to consider taking the next step up in price. An example of product-line pricing is
setting a limited number of prices for selected groups or lines of merchandise. This approach is known as price lining. For
example, a computer retailer may sell notebook computers in three price ranges: $1000, $1500 and $2000. Such an approach
reduces the importance of price differences in consumers’ decisions once the price range is chosen. Within the price range,
the greater emphasis is on factors other than price.
Spotlight: The cost of prescription pharmaceuticals
As Australia confronts the seemingly insoluble macro-environmental challenges of an ageing population, as well as
weathering the world’s turbulent economic conditions, the cost of prescription pharmaceuticals to patients and taxpayers
looms as a chronic problem. Ironically, the ageing population ‘problem’ is largely attributable to the benefits of improved
drugs used in the treatment of chronic medical conditions such as hypertension, diabetes, ulcers, arthritis, asthma,
bronchitis, emphysema, Alzheimer’s and Parkinson’s. We are living longer, so it is inevitable that we will be afflicted
with chronic diseases, and the costs to patients and the taxpayers who subsidise these costs through the Pharmaceutical
Benefits Scheme (PBS) are considerable.
New drugs and more demand for existing medicines are the main drivers for increased spending on the PBS. A
government report co-authored with Medicines Australia, Trends in and drivers of Pharmaceutical Benefits Scheme
expenditure, shows PBS spending rose by $500 million a year to reach $8.9 billion in the 2010–11 financial year. The
report showed the ageing population and increasing numbers of people with chronic disease were placing pressures on
spending for subsidised prescription drugs to Australian residents.

At the same time, the government has been criticised for not negotiating hard enough with the pharmaceutical companies,
with the result that Australian taxpayers are paying significantly more than comparable countries with government-
subsidised pharmaceutical schemes. Health economists and consumer groups recently argued that the government is
wasting $260 million every year because it is ignoring advice that it is paying too much for the most commonly
prescribed drug in Australia, the cholesterol-busting drug atorvastatin (commonly sold under the name Lipitor). To date,
the drug has remained far above the upper limit set by the Pharmaceutical Benefits Advisory Committee. Professor Philip
Clarke at the Centre for Health Policy, Programs and Economics at the University of Melbourne said the committee made
the decision that the government should not pay more than 12.5 per cent more for atorvastatin than it does for a
competitor drug.
“It is hard to understand why an evidence-based recommendation of the committee has been ignored. Why should Australian taxpayers pay $38
per month, when governments in England or New Zealand pay less than $3 for the same drug?”

All the present indications are that, while we can all expect to live longer, the pricing of prescription pharmaceuticals will
remain a constantly challenging issue for all stakeholders — consumers, the government, taxpayers and the
pharmaceutical industry.
 Question
Australian consumers of prescription pharmaceuticals have generally proven to be less willing to purchase
‘generic’ versions of formerly patent-protected branded drugs, despite often substantial price differences. How
might you explain this reluctance to purchase generics?

Concepts and applications check

Learning objective 3 understand the concept of price and customer value perceptions
3.1 Outline some ways in which a marketer can influence a customer’s perception of price.
3.2 Explain the concept of value from both a customer’s and an organisation’s perspective.

 5.2 Product 5.4 Promotion 

5.4 PROMOTION
Learning objective 4
understand the integrated marketing communications (IMC) approach to marketing promotion and the major elements of
the promotion mix

Promotion is the creation and maintenance of communication with target markets. In marketing, promotion is usually
thought of as comprising a strategic mix of advertising, public relations, sales promotions and personal selling. As promotion
is basically about communicating a message to the marketplace, a term for promotion that is growing in popularity is
‘marketing communication’. Further, when carefully combined and coordinated to achieve a consistent and effective
message, the promotional approach is known as integrated marketing communications (IMC). The idea behind IMC is that
the planning of each part of the promotion mix — advertising, public relations, sales promotions and personal selling —
should not be done in isolation; rather, strategies should be planned so that they work together to achieve greater clarity and
consistency, and a better overall result. When everything is working effectively, other elements, such as word-of-mouth
communication, can have a strong influence on consumers in some product markets (especially in relation to services such as
movies, restaurants, doctors and accountants, but also in relation to some products, such as books). These other elements also
need to be managed by the marketing organisation.

Integrated marketing communications (IMC)

Just as the different elements of the marketing mix need to be carefully coordinated to achieve the best possible effect,
promotional efforts also need to be constructed to maximise the return on what is often a large investment. Integrated
marketing communications (IMC) is the term given to the coordination of promotional efforts to maximise the
communication effect.
The goal of IMC is to consistently send the most effective possible message to the target market. The four main components
of IMC are advertising, public relations, sales promotion and personal selling. As you will discover in this chapter, these
categories overlap and some promotional activities do not fall neatly into any of the main components. Nevertheless, they
provide us with a useful framework for analysing and designing IMC.
As advertising, public relations, sales promotion and personal selling approaches have become more sophisticated,
personalised, targeted and specialised, they have also become more expensive. In response, management in marketing
organisations has placed greater emphasis on evaluating marketing efforts and demonstrating the return achieved on the
investment in promotion. The best return on promotional efforts is achieved when there is a high degree of consistency, and
hence synergy, across the four areas of promotion. This possible high return on promotional efforts has led to the growing
popularity of IMC approaches.

The promotion mix

Various combinations of promotional methods are used to promote a specific product (good, service or idea). We will now
provide an overview of the relative strengths and weaknesses of each of the four main elements of a promotion mix —
advertising, public relations, sales promotion and personal selling — to provide a basis for understanding how to establish,
monitor and adjust the appropriate promotion mix.

Advertising
Advertising is the transmission of paid messages about an organisation, brand or product to a mass audience. Advertising is a
big business, worth over $13 billion a year in Australia, with many large organisations spending millions each year on
traditional media advertising. Table 5.3 lists the top advertisers in Australia, while table 5.4 shows the corresponding
percentage of media expenditure.

TABLE 5.3 Top 10 advertisers — Australia

 RANK ADVERTISER ANNUAL EXPENDITURE A$ KEY BRANDS
GROUP/ADVERTISER (MILLIONS)

  1 Wesfarmers 215–220 Coles supermarkets, Kmart, Target, Officeworks, Liquorland

  2 Woolworths Limited 155–160 Woolworths supermarkets, Big W, Dick Smith

  3 Commonwealth Government 150–155 Defence, Health & Ageing, Medibank Private, Environment
& Water Resources

  4 Harvey Holdings 145–150 Harvey Norman, Domayne

  5 Telstra 90–95 Telstra Corp Ltd, Trading Post Group, Universal Publishers

  6 Reckitt Benckiser 80–85 Nurofen, Finish, Airwick, Mortein, Dettol, Strepsils, Harpic

  7 Toyota Motor Corporation 75–80 Toyota, Lexus

  8 Victorian Government 75–80 Transport Accident Commission, Transport, Sustainability &
Environment

  9 Westpac Banking Corporation 70–75 Westpac, St George, BT Financial, RA MS, BankSA

10 McDonald’s Family Restaurants 70–75 McDonald’s Family Restaurants, McCafé

Source: Nielsen Top Media Groups/Advertisers 2011.

TABLE 5.4 Advertising by media sector — Australia

SECTOR PERCENTAGE

Internet 28.6

Free-to-air TV 26.9

Metropolitan/national daily newspapers (including inserted magazines) 21.9

Radio   7.9

Magazines   7.1

Outdoor   3.8

Pay TV   3.2

Cinema   0.6

Source: Phil Ruthven (2013), ‘Internet ads surge ahead’, BRW, 21 March, www.brw.com.au.

The main benefit of advertising is the ability it offers to reach a lot of people at a relatively low cost per person. While
advertising is expensive, its ability to reach a lot of people makes it cost effective based on price per exposure. It is also
possible to aim advertising at particular target markets by choosing appropriate media. For example, high-end watch
companies tend to advertise in GQ and BRW, whereas makers of baby formula tend to advertise in New Idea. The choice of
the right media can add to the brand image of the product, so if a perfume advertises in Vogue or Harper’s Bazaar it is
perceived as a high-quality product.
The main limitations of advertising are the difficulties in measuring its effectiveness (one of the most famous quotes in
advertising, attributed to US retail pioneer John Wanamaker, is that ‘Half the money I spend on advertising is wasted; the
trouble is I don’t know which half’). Because of its mass market approach, there is very limited presentation and
personalisation of the marketing message carried by advertising. TV commercials are often only 30 seconds in length, which
can limit the content presented. Even the most sophisticated personalisation approaches in direct mail usually do little more
than include the reader’s name along with a standard message.

Public relations
Public relations refers to communications aimed at creating and maintaining relationships between the marketing
organisation and its stakeholders. Stakeholders include customers, suppliers, owners, employees, media, financial institutions
and those in the immediate and wider environment. Effective public relations are created when the public relations messages
are timely, engaging, accurate and in the public interest.

The main benefits of public relations promotions are credibility (as public relations efforts do not appear to be advertising),
the significant word-of-mouth communications that can result, their low or no cost nature, and their effectiveness in
combating negative perceptions or events. For example, McDonald’s runs the annual McHappy Day, one of Australia’s
longest running charity days, which raises over $3 million for Ronald McDonald House Charities (RMHC). More than 800
celebrities and local VIPs donned aprons and took drive-thru orders at close to 800 McDonald’s restaurants across Australia,
including Delta Goodrem (singer and judge on The Voice on Channel Nine) and actress Melissa George.11
Public relations strategies have some limitations, however, including that many efforts are seen by the news media as
attempts to obtain free advertising and are thus rejected. This can result in poor exposure of the organisation’s public
relations message. Another limitation is that a marketing-savvy public is increasingly cynical about the motivations of
businesses when they involve themselves in activities other than the direct marketing of their products. Many consumers,
rightly or wrongly, now view sponsorship of a concert as an effort to sell something, rather than as a philanthropic effort to
bring the arts to the public. Nevertheless, the consumers are still exposed to the marketer’s message and branding.

Sales promotion
Sales promotions offer extra value to resellers, salespeople and consumers in a bid to increase sales. They are often used on
an irregular basis to smooth demand. For example, businesses that install home air-conditioning offer sales promotions (such
as price discounts, a bonus remote control or free ceiling insulation) in winter in hot areas and in summer in cold areas.
The main benefits of sales promotions are to smooth out sales in periods of low demand and to facilitate retailer support.
While sales promotions targeted at consumers are familiar and obvious, many sales promotions are aimed at the resellers and
salespeople, rewarding them for selling the company’s products or particular volumes of products. Motor dealers almost
universally get bonus payments from car manufacturers based on exceeding certain threshold levels in sales each month or
quarter. This is why car buyers can often negotiate a better price on a car towards the end of a month or quarter than right at
the start of a new trading period. If you go into a mower store, you might find the staff wearing shirts with Stihl branding or
Honda branding, even though the store sells both brands (and others besides). This is both a promotion aimed at the
salespeople and at customers who go into the store.
The main limitations of sales promotions are that they can lose effectiveness if overused (in particular, customers can come
to expect some bonus or price discount and simply wait en masse for a promotion to begin before they buy a product), they
are easily copied (particularly price discounts and bonus offers), and the public is becoming increasingly cynical about
whether they offer any real value or whether they just highlight that the usual price and conditions under which a product is
purchased has a great deal of extra margin built in.
Personal selling
Personal selling refers to personal communication efforts that seek to persuade consumers to buy products. Certain industries
or types of products tend to favour personal selling as a promotional activity, such as expensive, high-involvement or
industrial products.
Personal selling benefits include that the message can be very specifically and personally tailored to the individual consumer
— thus having greater influence than less personal advertising, sales promotions and public relations strategies. Personal
selling also enables the marketing message to be adjusted based on feedback given by the target of the selling effort.
Personal selling also has limitations, including that it is expensive and has a limited reach. During personal selling, the
potential customer consumes all of the salesperson’s time and effort. Personal selling is labour intensive and time consuming.
Additionally, as consumers become more and more educated and informed — often having done considerable research
online before entering a store — efforts at personal selling are viewed with increasing cynicism. At its worst, the customer
can know much more about the product they are interested in than does the salesperson.

Integrating promotion mix elements

Armed with a basic understanding of each component of the promotion mix and some of their relative strengths and
weaknesses, we will now consider how they are chosen and combined to form an effective IMC strategy. The most effective
choice and mix of promotion elements will vary with the specific goals of the marketing effort, individual product
characteristics, individual target market characteristics, the nature of the marketing organisation itself, and the resources and
budget available to the marketer.
All marketing organisations have different promotional needs and finite financial and other resources, and so must choose
from competing options in the promotion mix. Marketing organisations with very large promotion budgets will usually use
multiple promotional strategies, while those with smaller budgets will rely on fewer and simpler strategies, often executed on
a smaller scale (e.g. advertising in the free local newspaper or sponsoring the local under-10s cricket team as opposed to
advertising on television and sponsoring the Olympic swim team).
Consider the promotions mix of the Myer department store:
advertising through expensive large, glossy catalogues delivered by mail and inserted in newspapers (and available
online); television commercials, multiple-page newspaper and magazine advertisements; website
sales promotions, including offering ‘sales’ (discounts on normal pricing), interest-free credit terms (pay nothing for
three months), and bonus products (e.g. two shirts for the price of one)
personal selling in-store by staff working on commission in departments run as independent businesses
public relations by hosting book signings, fashion shows and product launches in selected stores; for example, with
Jennifer Hawkins, Jamie Oliver, Harry Kewell and the Bondi Rescue team.
Contrast this with a smaller operator such as a Rivers store:
advertising through television and radio commercials, small advertisements in newspapers; and a website
sales promotions, including offering ‘sales’
personal selling in-store by expert staff.
Now consider a very small operator such as local dress shop:
advertising through the Yellow Pages and a website
personal selling in-store by expert staff.
The appropriate promotion mix is likely to change over time as each of those characteristics changes and as the effectiveness
or otherwise of the current promotional mix is evaluated. Formulating an appropriate promotion mix can be a complex
undertaking. In the case of franchises, franchisors usually hand most of the promotion mix to the franchisees. This
concentrates the strategic work and ensures a consistent promotional message. It does, however, limit franchisees from
responding to local conditions.

Pull policies and push policies

In addition to choosing a mix of promotional tools, marketing organisations must choose whether to primarily aim their
promotions at consumers or at marketing partners such as retailers, or both. A pull policy is an approach in which the
producer promotes its product to consumers, usually through advertising and sales promotion, which then generates demand
upward through the marketing distribution channel. For example, the consumer becomes interested in a product through the
producer’s television advertisement and then enquires at a retailer. The retailer asks its suppliers about the product and the
suppliers seek out the producer. This approach often reflects the business-to-consumer (B2C) relationship, as the main
promotional effort goes directly from the producer to the potential consumer. By contrast, a push policy is an approach in
which the product is promoted to the next organisation down the marketing distribution channel. For example, a producer
promotes its product to a wholesaler, which in turn promotes the product to a retailer, who finally promotes the product to
consumers. Of course, many products are promoted via both techniques. Additionally, producers and retailers may undertake
a cooperative advertising campaign where both the producer and the retailer are promoting the product to its target market.
This approach emphasises a business-to-business (B2B) relationship as the promotional effort moves down the channel of
distribution.
Often the guide to which strategy to use is based on discovering where the consumer decides on obtaining more information
or buying the product. For example, if the consumer is more likely only to think about purchasing the product at the retail
outlet, a push strategy would be favoured; whereas, if consumers are more likely to think about the product independently
(i.e. away from the store environment), a pull strategy may be more appropriate. Elements of a pull strategy are often evident
in producers’ websites.
Spotlight: Deals Direct: online needs integrated campaign
The ease of setting up an online business has resulted in a massive number of digital companies trying to get the attention
of potential customers. But how does a little-known virtual company get people to come to its website? An easy answer is
to use online media; however, this can be difficult if the target market is not always online, and many companies may
need to drive people to the website. Therefore, an integrated campaign that includes traditional media is a strategy being
followed by companies like Deals Direct.

Beginning in 2004, Deals Direct was an Australian pioneer in e-business, and has grown to offer a range of brands across
21 departments and with 15 000 products online. Over the years, it has delivered four million parcels to over one million
customers. However, until recently, there was still some uncertainty about Deals Direct’s image. Deals Direct’s chief
marketing officer David Fernandez said:
Our research showed that there was a lot of confusion about exactly what Deals Direct stood for, particularly with the proliferation of ‘daily
deals’ sites. Once we reframed Deals Direct as an Online Department Store to customers, it resonated strongly.

To better position itself, Deals Direct, with retail specialist agency IdeaWorks, launched a multichannel, integrated
marketing campaign repositioning it as ‘Australia’s #1 online department store’. The campaign included ‘every
touchpoint from television and digital executions to the wrapping paper on products shipped from the warehouse’. Its
television commercials were 30-second spots that could also be seen on YouTube.
Chief executive of IdeaWorks Jon Bird said of the campaign:
Online retailing is an increasingly crowded territory, and the department store metaphor generates an image instantly in customers’ minds. By
bringing the proposition to life via a simple, clean animated style, the brand’s personality will cut through.
By using an integrated marketing approach, Deals Direct aimed to clarify its brand image and present a consistent
message that it is the #1 online department store in the marketplace across several media, both online and offline.
Therefore, in a changing world, traditional media can still have a place for online retailers.12

Questions

1. Describe how Deals Direct’s integrated marketing communications campaign could help sell the company’s
brand image to customers.
2. Do you think that some online companies would be hesitant to use traditional media in an integrated
marketing communications campaign? Why/why not?
Concepts and applications check
Learning objective 4 understand the integrated marketing communications approach to marketing promotion and the
major elements of the promotion mix
4.1 What is meant by ‘promotion’? How do marketing communication activities assist the other elements of the marketing mix in an
organisation’s marketing strategy?
4.2 Explain what is meant by the term ‘integrated marketing communications’ and the advantages of an IMC campaign for a
company. How can a company combine promotional mix elements to achieve more communication impact?
4.3 Analyse the major elements of the promotion mix, explaining the advantages and limitations of each.
4.4 Outline how each major element of the promotion mix could be used in an integrated marketing communication campaign for a
product of your own choosing.
4.5 How can knowing about ‘pull’ and ‘push’ marketing channel strategies assist in planning promotional campaigns? Describe
some ‘push’ examples at a retail outlet of your own choosing.

 5.3 Price 5.5 Place 

5.5 PLACE
Learning objective 5
understand the concept of place and how distribution channels connect producers and consumers

Many manufacturers and service businesses deal directly with the consumers of their products. For example, if you have
bought a loaf of bread from Baker’s Delight, flown in a Qantas jet, had an injured limb x-rayed in a hospital or bought
software from Adobe’s website, you have been a consumer dealing directly with the producer of those goods and services.
This approach to marketing is known as direct distribution and it is particularly common for services products, as services
are directly tied to the service provider. Conversely, many producers, especially makers of physical products, rely on other
organisations and individuals to help them get their product to end users. This approach is known as indirect distribution and
the main organisations and individuals who act in the distribution chain between the producer and end user are known as
marketing intermediaries. The key marketing intermediaries are industrial buyers, wholesalers, agents and brokers, and
retailers. The path from the manufacturer or service provider to the end user is known as the distribution channel or
marketing channel.
Marketing intermediaries are useful and necessary when they can more efficiently connect producers with their customers
than can the producers themselves. Perhaps you have bought fruit or vegetables from a roadside stall next to a farmer’s
driveway. If so, you as the consumer have connected directly with the producer and no intermediaries have been involved.
However, most of the farmer’s produce only gets to the consumer via a string of intermediaries, such as agents, wholesalers
and retailers, before ending with the final consumer. It is obvious that a farmer is not going to be able to sell a million-dollar
apple harvest from a stall at the end of their driveway or even to individual buyers via a website. It is also obvious that you
do not want to drive to a farm every time you want to buy an apple. The same applies to most producers and most
consumers. Even if a producer can manage to get their product directly to end users, they are often better off to concentrate
on their core abilities (production) and rely on specialist intermediaries who can more efficiently move the product closer to
customers. Because they have expertise, equipment, experience, contacts, skills and scales of economy, intermediaries help
producers achieve better results than producers can achieve when acting alone.
When they are well managed, effective intermediaries operating in distribution channels achieve the following benefits.
They:
make products available to the consumer at the time that the consumer wants to purchase them
make products available in the locations that the consumer wants to purchase them
customise products to the consumer’s particular needs
make transactions as efficient, simple and cheap as possible for consumers, producers and other intermediaries by
establishing and managing efficient exchange processes.
Conversely, when poorly managed, or inappropriately chosen, marketing intermediaries can add to costs, reduce efficiency,
create delays and cause frustration. Consumers are often wary of intermediaries, believing they are ‘middlemen’ who add no
value but increase the price they must pay for products. Some producers blame intermediaries for every problem they face
and, like consumers, can feel they add little value to the marketing process.
Figure 5.3 shows an example of the simple exchanges required for breakfast. For breakfast, a person may want to consume
Sanitarium Weet-Bix cereal, Dairy Farmers milk, Tip Top bread and Berri orange juice, but if there was no marketing
intermediary, the consumer would have to go to each producer and each producer would have to go to each consumer, as
shown in figure 5.3(a). The benefit of a well-managed distribution channel compared to marketing without the involvement
of marketing intermediaries is shown in figure 5.3(b).
FIGURE 5.3 The benefits of using distribution channel intermediaries

The existence of distribution channel intermediaries reduces the number of interactions from 32 to 8 in figure 5.3, as the
consumer can go to the one intermediary (e.g. a supermarket) to purchase the products for breakfast. This shows that the
existence of an intermediary can make the whole process more efficient for both the producer and the consumer, which can
lead to cost savings.
It is clear then that intermediaries can add considerable value to a producer’s offering. In choosing a distribution channel, the
producer needs to first consider the way in which its product can best be marketed, so that the supply chain from producer to
consumer effectively becomes a value chain. The market coverage decision takes into account the nature of the product and
its target market. Generally, marketers will choose from:
intensive distribution, which distributes products via every suitable intermediary
exclusive distribution, which distributes products through a single intermediary for any given geographic region
selective distribution, which distributes products through intermediaries chosen for some specific reason.
Intensive distribution is an obvious strategy for everyday purchases such as milk. The consumer invests little time in
deciding where, when or how much to buy or how much to pay. They make their decision based on convenience, often just
purchasing at the closest store, whether that be a corner store, a supermarket, a petrol station or a takeaway food store. In
contrast, exclusive distribution is generally used for products that are only purchased after a great deal of deliberation by the
consumer or where exclusivity adds to the appeal of the product. Prestige cars and designer furniture are typical examples.
Producers and wholesalers can also increase the commitment of retailers in the marketing channel by promising them
exclusivity. Selective distribution falls somewhere between intensive and exclusive distribution. It is most appropriate for
goods that require some degree of deliberation by the consumer and where the consumer might visit multiple stores to
compare prices and products. Selective distribution is often chosen when the intermediary can provide some specific value-
adding function to the producer’s offering. While it may be good for the consumer, it is not generally beneficial to the parties
in the distribution channel to have consumers play suppliers against each other.
In the next section we will examine how different intermediaries operate in the consumer products market.

Consumer product distribution channels

For consumer products, the main marketing intermediaries are agents, wholesalers and retailers. A distribution channel can
consist of all, some or none of these between the producer and the consumer. Some of the possibilities are now discussed.
In distribution channel 1, the producer deals directly with the consumer. This model has increased in use in recent years and
is expected to continue to grow as more consumers use the web to research and ultimately purchase products. Examples of
this approach include: Dell and Apple, which sell their computers and other goods directly to consumers via their websites;
Domino’s Pizza, which makes and sells pizzas at its retail outlets; and Just Cuts hairdressing salons, which, like most
services businesses, produces and delivers the service at the same time. Because services are consumed as they are produced,
there is often little need for intermediaries. Note that it is not always the case though, as we will discuss in a moment. In
choosing distribution channel 1, producers must decide that, in addition to making the product, they are able to effectively
manage distribution and deal with customers one-on-one. They must also be wary of the reaction of retailers to producers
selling directly to customers. For example, when Dell began selling directly to customers, Harvey Norman threatened not to
stock Dell computers. In choosing to deal directly with producers, customers need to feel confident that they can get the level
of service, including after-sales support, they require. Dealing directly with producers can be attractive to consumers because
it can offer greater customisation (generally complete customisation in the case of services) of the product. For example, a
consumer dealing directly with Apple can choose to have more memory put in their new computer, software pre-installed on
an iPad, or a personal message engraved on an iPod. Consumers also often feel they can get a cheaper price by bypassing
retailers. This is often not the case, though, as producers are reluctant to undercut the prices of their retail distributors.
Dealing directly with producers will more often than not require the consumer to pay in full for the goods before receiving
them, if mail order or online purchasing is involved.

In distribution channel 2, producers provide their products directly to retailers for sale to consumers. Both Dell and Apple
use this strategy as well as the strategy in distribution channel 1. Many small boutique producers use this strategy, such as the
Byron Bay Cookie Company which sells its product at numerous outlets, including McCafe, Michel’s Patisserie, Harris
Farm, Coles, Woolworth’s, IGA, as well as Virgin Australia, Qantas and Tiger Airlines.13 Airlines and hotels can also use
this strategy, often in combination with distribution channel 1. For example, you can book a motel room directly with the
Best Western motel of your choice or use a travel agent or online service such as wotif.com or hotelclub.com. Similarly, you
can book a Qantas flight on the airline’s website, or use Flight Centre or some other intermediary. Large retailers often
choose strategy 2, preferring to deal directly with producers rather than wholesalers. From the consumer’s perspective, many
feel that they receive more personal service from a retailer than a producer, including the ability to examine the goods before
purchasing them and often to take possession of the goods when paying for them.

In distribution channel 3, producers sell to wholesalers who then sell on to the retailers. This is a common choice for goods
that are sold in high volumes through numerous retailers. Examples include grocery items and mass-marketed clothing. The
advantage for the producer is in dealing with larger volumes to fewer buyers rather than small volumes to numerous buyers.
The advantage for the retailer is the ability to buy a range of different lines from one source (the wholesaler) rather than
having to deal with large numbers of producers. In this distribution channel, consumers still deal with a retailer, so their
experience is essentially the same as in distribution channel 2. A possible difference is that a retailer that uses wholesalers
may carry a wider range of products.
Distribution channel 4 is a common choice for exports, where the complexities of dealing with different legal, regulatory and
cultural factors suggest an experienced and skilled agent will be able to more effectively deal with intermediaries in the
foreign market. It is also used for mass marketed products where the producer believes an agent can more effectively sell the
products to wholesalers.

Distribution channel 5 is commonly used in the financial services industry. For example, mortgage brokers deal directly with
consumers and the banks and other financial institutions that offer loans. For the consumer, they are able to offer a higher
level of service than the financial institutions (e.g. home visits after normal office hours) and for the producer (the banks),
mortgage brokers can bring new business from otherwise unidentified potential customers. However, the brokers are then
paid a trailing commission, which represents a cost to the bank (and therefore the consumer) and, during the housing boom in
the early 2000s, mortgage brokers approved loans for people who may not have met banks’ own lending criteria.
It should be clear from our discussion that marketing organisations do not always simply choose one strategy. Rather, they
might use a combination of strategies for different markets or even the same market. Similarly, consumers might choose
different channels. You might buy an iPad or iMac directly from Apple via its website or an Apple store, but you’d be less
likely to buy a spare USB cable via the website because the delivery charge would more than offset the convenience of not
having to visit a shop. You might also prefer to go to a shop to try out a new mouse or piece of software rather than rely on
the description of the product online.

Concepts and applications check

Learning objective 5 understand the concept of place and how distribution channels connect producers and
consumers/organisational buyers
5.1 Consumer product distribution channels can vary in the number of intermediaries involved. Choose five organisations and
describe their distribution channels.
5.2 Explain how supply channel management works. What can happen if this system does not run smoothly?
5.3 From a marketing perspective, what is meant by ‘place’? How do marketing intermediaries assist in bringing the product to the
customer?

 5.4 Promotion 5.6 The services marketing mix —

people, process and physical evidence 

5.6 THE SERVICES MARKETING MIX — PEOPLE, PROCESS
AND PHYSICAL EVIDENCE
Learning objective 6
describe how to develop and manage an effective marketing mix based on the unique characteristics of services

From your study of this E-Text so far, you may have begun to appreciate some of the underlying characteristics of services
that differentiate them from goods. The characteristics that formally distinguish services from goods are:
intangibility
inseparability
heterogeneity
perishability.
Each of these characteristics has important consequences for the development of the marketing strategy for service products.
They suggest that the marketing of services may be fundamentally different from, and perhaps more complex than, the
marketing of tangible goods. Although the marketing mix for services necessarily includes the familiar ‘4 Ps’ — product,
pricing, distribution (place) and promotion — the unique characteristics of services suggest an additional range of variables,
which need to be considered when formulating the marketing mix. These new variables have been conveniently labelled an
additional ‘3 Ps’ — people, process and physical evidence — to make up the ‘7 Ps’ marketing framework. We will now
discuss the extended services marketing mix.

The extended services marketing mix

The intangibility, inseparability, heterogeneity and perishability of services create the following issues for marketers:
inability for customers to inspect and evaluate a product prior to consumption
inevitable variability in service quality
inability to store product.
As we read earlier, marketers can pursue various strategies to deal with these issues:
create tangible cues
invest heavily in staff training
develop and implement standardised service delivery systems
use customer testimonials
manage customer expectations
manage supply and demand.
These strategies clearly involve managing the product, pricing, promotion and distribution of services. It should also be clear
from our discussion of the intangibility, inseparability, heterogeneity and perishability of services that there are additional
elements that need to be carefully managed when marketing services. These elements are people, process and physical
evidence, and they are focused upon ‘the delivery of the promise’; that is, the service delivery and customer’s experience.
Combined with the traditional ‘4 Ps’ of the marketing mix, they make up the ‘7 Ps’ marketing framework, also known as the
extended services marketing mix. The addition of these elements arguably means that the marketing of services is more
complex and difficult than the marketing of tangible goods, especially if it is to be effective and successful. We will discuss
each of these additional elements in turn.

People
Most successful services marketing organisations will readily claim that their ‘people’ are their most valuable asset and the
key to their success. Our discussion of the inseparability characteristic of services noted that the production and consumption
of most services occur at the same time and in the same place. This means, of course, that the customer or client will usually
have close contact with the person or people creating and delivering the service. In this sense, it could be argued that you
cannot separate the service from the person who provides it. Although customers and clients are usually focused on the
service outcome, rather than the person (or process) providing the service, it is crucial the marketing organisation
understands and manages the role of people in defining the quality of each customer’s or client’s service experience. The
‘people’ in the extended services marketing mix are those coming into contact with customers who can affect value for
customers: the organisation’s staff (particularly the actual service provider and/or its ‘front-line’ customer service staff); the
customer or client being served; and other customers or clients either directly or indirectly involved in the service experience.
The most controllable factor in service delivery is the organisation’s staff. It is essential that the organisation chooses staff
who are:
technically competent
able to deliver high standards of customer service
able to promote products through personal selling.
The heterogeneity of many organisations’ service offerings places particular demands on their people to deliver complex
service products to meet the individual needs of a wide range of customers. These service expectations therefore impose
additional demands on service organisations and their employees, particularly customer service staff. To ensure high
standards of service delivery, service organisations need to carefully consider the selection, training, outfitting, motivating
and rewarding of their staff so that they deliver services effectively, efficiently and to the standard expected by customers and
the organisation. In service organisations, a key issue for the delivery of high standards of customer service is the concept of
‘empowerment’, which enables staff to respond to the particular needs of individual customers. Companies which are
renowned for their customer service excellence will typically provide high levels of empowerment and discretion to front-
line customer service staff. A further requirement for customer service excellence is the development of a ‘customer service
culture’ (of which ‘empowerment’ is a common feature), but which also stresses the importance of customer service in the
functional management and organisation of the business. Experience across a wide range of industries suggests that the use
of ‘self-directed work teams’ with a dual focus on operational performance and customer service is an increasingly common
practice.
Beyond the organisation’s staff, the customer or client is, of course, an important factor in service delivery. Not only does the
customer or client often play a role as co-producer of the service, but the service provider also needs to manage the
customer’s expectations and their interaction with the organisation during the service transaction and in their future
relationship with the organisation. While the customer or client is not controllable in the manner that staff members are, the
service provider must train staff to ensure they can deal with customers effectively through the skills of technical
competence, customer service and personal selling. In doing so, customer service staff need to be able to display empathy,
flexibility and integrity in meeting customers’ particular needs.

Nightclubs employ bouncers to control the behaviour of patrons and to ensure that patrons meet minimum entry
requirements, such as having suitable identification. The presence of bouncers, and the role that they perform, helps to ensure
that other customers can enjoy the experience that is on offer at clubs

Beyond the staff and the customer, other customers within physical proximity of the service delivery can influence the
outcome of the service and customer satisfaction. Service organisations need to manage the behaviour of surrounding
customers to ensure that they do not intrude on the customer’s personal space or on the service process. In this context,
crowding and the behaviour of unruly or dissatisfied customers can significantly impact on customer satisfaction. For
example, at major sporting events, when spectators are sometimes forced to sit in crowded and cramped conditions for
extended periods of time, it is essential that security staff ensure that the behaviour of tired, unruly or intoxicated fans does
not impinge on the amenity and experience of others watching the match. Similarly, nightclubs usually employ bouncers to
control the number and behaviour of patrons.

Process
In the services context, process refers to all of the systems and procedures used to create, communicate, deliver and
exchange an offering. An organisation’s processes define the manner in which the service is coordinated and delivered. At
the same time, the inseparable nature of the service from its provider means that the success of the process will, to a very
large extent, depend upon the performance of the service staff member and their interaction with the customer. The key
concern is that the process delivers the service in a way that at least matches the customer’s expectations. Ideally, the
performance should exceed the customer’s expectation, although this becomes increasingly difficult over the long term of the
relationship. It is therefore essential that an organisation understands customers’ expectations and, from that understanding,
designs and delivers operational systems and procedures that enable staff to match those expectations consistently.
As a generalisation, customers usually have two kinds of expectations:
functional expectations — expectations of the technical delivery of the service transaction
customer service expectations — expectations that relate to the service experience and the social interaction between
the customer and service provider.
In this sense, it is generally advisable to be ‘efficient first and friendly second’. Service providers should therefore rightly
focus their attention primarily on the delivery of effective and efficient service. When this level of technical performance is
assured, they should focus additional energies on the customer service experience. At the same time, however, while most
services demand a combination of technical (‘hard’) and personal (‘soft’) skills, the heterogeneity of many services means
that it is difficult to ‘mass produce’ or ‘manufacture’ service. Thus, service staff will often face additional demands in
dealing with individual customers and their expectations or the demands of unique circumstances. Factors that help deliver a
consistently high level of service include service delivery systems, the management of customer expectations, and staff
training. It is important that organisations constantly assess customer service performance and a range of metrics are
available to do so. For example, Australia Post constantly measures delivery time and accuracy as key performance
measures.

Physical evidence
The intangibility of services makes it difficult for customers to evaluate the quality and suitability of services, especially
when using the service for the first time. As discussed earlier, one strategy marketers can use to manage the uncertainty that
intangibility creates is to offer tangible cues as to the quality of the service. Customers look to these cues and other physical
evidence as a way of evaluating the service prior to purchase.
Service marketers should therefore pay close attention to the physical environment in which the service is delivered and to all
the other accompanying physical cues. The physical environment should be designed to inspire confidence in the technical
delivery and effectiveness of the service and in the likely service experience. The physical environment includes architectural
design, floor layout, furniture, décor, shop or office fittings, colours, background music and even smell. All potentially affect
the customer’s or client’s experience, and need to be carefully ‘choreographed’. Similarly, staff uniforms, brochures, service
or delivery vehicles and stationery are all potentially influential in the customer’s experience. An important implication of
the heterogeneity of service is the necessity (and difficulty) in maintaining consistently high standards in the presentation of
all the physical evidence that customers will use to judge the quality of the service. In the case of McDonald’s, the consistent
cleanliness of the physical surroundings (particularly the restrooms) anywhere in the world is an important component of the
‘McDonald’s experience’, and maintaining that consistency is an important priority in the franchise system. Similarly, the
cleanliness of an aircraft when boarding may be an important indicator of a consistently high standard of service (or to the
contrary).
Concepts and applications check
Learning objective 6 describe how to develop and manage an effective marketing mix based on the unique
characteristics of services
6.1 Explain the major differences between goods and services in your own words.
6.2 Using service examples of your own choosing, outline several ways that marketers can offset potential consumer uncertainty and
risk.
6.3 What are some techniques that services marketers can attempt to balance supply and demand?
6.4 What measures can marketers take to ensure service quality?
6.5 In your own words, explain the ‘people’, ‘process’ and ‘physical evidence’ aspects of services marketing.

 5.5 Place Summary 

SUMMARY
Learning objective 1: explain the elements of the marketing mix
Marketing is a philosophy or a way of doing business that puts the market — the customer, client, partner and society,
and competitors — at the heart of all business decisions. The marketing process is cyclical in nature and involves
understanding the market to create, communicate and deliver an offering for exchange. Marketers start by
understanding the consumers, the market and how they are currently situated. Armed with this understanding,
marketers are next tasked with creating solutions, communicating the offering to the market, and delivering it at a time
and place that is convenient for the customer.
Learning objective 2: define ‘product’, and understand product classification, product differentiation and
branding
A product is a good, service or idea offered to the market for exchange. It can be tangible, intangible or a combination
of both. Marketers can better understand and analyse products using the total product concept, which describes four
levels of a product: core product, expected product, augmented product, and potential product. Products can be
classified as consumer products (products purchased by individuals to satisfy personal and household needs) and
business products (products bought by an organisation to be used in its operations or in the production of its own
products).
Learning objective 3: understand the concept of price and customer value perceptions
Customer perceptions are subjective and particular to each individual, but it is important that marketers match pricing
as closely as possible to customers’ expectations. These expectations are based partly on the customer’s internal and
external reference prices. Tactics such as odd–even pricing, reference pricing, multiple-unit pricing and bundle pricing
can be used to manage customer perceptions of value. In launching a new product, an organisation may choose a
penetration pricing or price skimming strategy to maximise volume or margin respectively. For established products,
an organisation may seek to implement differential pricing or promotional pricing. Pricing should always be consistent
with the other elements of the marketing mix.
Learning objective 4: understand the integrated marketing communications (IMC) approach to marketing
promotion and the major elements of the promotion mix
Integrated marketing communications (IMC) describes the coordination of promotional efforts to maximise their
effectiveness. The goal of IMC is to consistently send the most effective possible message to the target market. The
four main components of IMC are advertising, public relations, sales promotion and personal selling. With a basic
understanding of each component of the promotion mix and some of their relative strengths and weaknesses, a
manager can consider how they are chosen and combined. The most effective choice and mix of promotion elements
will vary with the specific goals of the marketing effort, individual product characteristics, individual target market
characteristics, the nature of the marketing organisation itself, and the resources and budget available to the marketer.
Learning objective 5: understand the concept of place and how distribution channels connect producers and
consumers
The concept of ‘place’, or distribution, involves the way products can be eventually ‘placed’ in the hands of the final
consumer through a supply chain between producers and consumers. The chain of distribution is known as a
distribution channel. The key organisations in the marketing channel, or intermediaries, include wholesalers, industrial
buyers, agents or brokers, and retailers. Marketing intermediaries are useful and necessary when they can more
efficiently connect producers with their customers than can the producers themselves. Even if a producer can manage
to get their product directly to end users, they are often better off to concentrate on their core abilities (production) and
rely on specialist intermediaries who can more efficiently move the product closer to customers. Because they have
expertise, equipment, experience, contacts, skills and scales of economy, intermediaries help producers achieve better
results than producers can achieve when acting alone.
Learning objective 6: describe how to develop and manage an effective marketing mix based on the unique
characteristics of services
Four characteristics fundamentally distinguish services from goods: intangibility, inseparability, heterogeneity and
perishability. These distinguishing characteristics have important consequences for how services are marketed. In
addition to product, pricing, promotion and distribution, the services marketing mix is usually extended to include the
factors of people, process and physical evidence, highlighting the need for the services marketer to focus on the role of
 people — staff, the customer and other customers — who affect service delivery, the procedures and systems they use
to ensure services are reasonably consistent in quality, and the tangible cues that services marketers use to reduce the
risk or uncertainty that people often feel when considering purchasing a service.

 5.6 The services marketing mix —

Endnotes 
people, process and physical evidence
ENDNOTES
1. Developed from T. Levitt (1983), The marketing imagination, The Free Press, New York.
2. See Bonds website, www.bonds.com.au.
3. Trivett Group website, www.trivett.com.au; Trivett Harley-Davidson Sydney website, trivettharley-davidson.com.au.
4. Jimmy Possum website, www.jimmypossum.com.au.
5. Kiwibank website, www.kiwibank.co.nz.
6. Adopt a Pet website, www.adoptapet.com.au; RSPCA Australia website, www.rspca.org.au; K. Picker (n.d.), ‘10 reasons
why you shouldn’t buy from pet shops or backyard breeders’, Roka Pet Photography website, www.roka.com.au.

7. A.C. Nielsen (2012), ‘Australian online landscape review’, The Nielsen Company, www.au.nielsen.com.

8. IP Australia, www.ipaustralia.gov.au; Intellectual Property Office of New Zealand, www.iponz.govt.nz.

9. ‘Big Aussie brands shedding millions in value’ (2012), News.com.au, 11 June, www.news.com.au; Brand Finance (2012),
Brand Finance: Australian top 30, May, Brand Finance Australia, Sydney.

10. McDonald’s website, www.mcdonalds.com.au; ‘McDonald’s re-names stores Macca’s in Australia Day PR stunt’ (2013),
Mumbrella, 8 January, www.mumbrella.com.au; AFP (2013), ‘McDonalds to become “Macca’s” in Australia’, NineMSN
Finance, 8 January, www.finance.ninemsn.com.au; Carleen Frost (2013), ‘Macca’s — an Australian-made nickname up in
lights for our national day’, Daily Telegraph, 8 January, www.dailytelegraph.com.au.

11. McHappy Day website, www.mchappyday.com.au; Ronald McDonald House website, www.rmhc.org.au/mchappy-day.

12. Deals Direct website, www.dealsdirect.com.au; ‘Online department store Deals Direct launches integrated marketing
campaign via IdeaWorks’ (2012), Campaign Brief, 9 October, www.campaignbrief.com; Campbell Phillips (2012), ‘Deals
Direct enters marketing partnership with IdeaWorks’, PowerRetail, 11 October, www.powerretail.com.au.

13. Byron Bay Cookies website, www.cookie.com.au.

 Summary Part 3 Microeconomics 

 PART 3
Microeconomics
6 Economics, demand and supply
7 Profit, cost and revenue
8 Market structures

 Endnotes 6 Economics, demand and supply 

 CHAPTER 6

Economics, demand and supply

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

6.1 explain key concepts that define core ideas in economics
6.2 understand the science behind economics
6.3 understand what a demand curve is, explain why it slopes downwards, and describe sources of shifts in demand curves
6.4 understand what a supply curve is, explain why it slopes upwards, and describe sources of shifts in supply curves
6.5 explain how demand and supply curves can be used to determine the market equilibrium price and quantity of a good
6.6 describe what is meant by the concept of price elasticity of demand.

INTRODUCTION
The past decade has seen tremendous changes in the world economy. Many of these changes are linked to new technological
advances that have transformed what the global economy produces; the ways in which many goods and services are
produced; where they are produced; and how goods and services are transferred from the firms that produce them to the
households, governments and other firms that buy them. New technologies are transforming everything, from how airlines
sell tickets to how cars are produced, from how we buy books to how we communicate with one another.
Like the industrial revolution of the eighteenth and nineteenth centuries that transformed first Britain and then other countries
from agricultural- to manufacturing-based economies, the information revolution of the late twentieth and early twenty-first
centuries continues to transform almost all aspects of our daily lives. New, high-tech firms Microsoft, Intel and Apple — the
producer of the Windows computer operating system; the major producer of the microprocessors at the heart of personal
computers; and the developer of the iPod, iPhone, iPad respectively — emerged as larger firms in market value terms,
surpassing old economy firms like Ford, Heinz and Toyota.
The old economy and the new economy coexist side by side. But it is not just the emergence of new software and internet
companies that represents the effects of new technologies. The way all firms do business is being changed, and their
customers are being affected too. Assembly lines now rely on robots aided and controlled by computers. Car repair shops
with grease-stained floors have been replaced by clean, quiet garages where computers diagnose a car’s problems. The way
we buy things is also changing. Whether an individual uses the internet to purchase a car, book or music; book a hotel or
plane reservation; or even apply for university admission, the relationship between people and firms is evolving. Even how
we form romantic relationships has changed from one of primarily personal introductions to the widespread use of the
internet and dating sites to find the ‘perfect’ mate or life partner.
With such far-reaching changes, what insights and understanding does the study of economics have to offer? After all, the
field usually looks to Adam Smith, an eighteenth-century Scottish professor of moral philosophy, as its founder. Smith
published his most famous book, The wealth of nations, in 1776, a time when today’s industrial economies were still
overwhelmingly agriculture-based. It might seem unlikely that a theory developed to understand the factors that determine
the price of wheat would have much to say about today’s modern economy. But, in fact, study of economics continues to
provide a critical understanding of today’s global economy. The way we produce things, what we produce and how goods are
exchanged have altered tremendously since Smith wrote. Yet, the same fundamental laws of economics that explained
agricultural prices in the eighteenth century can help us understand how economies function in the twenty-first century. The
foundation laid by Adam Smith and built upon by generations of economists has yielded insights that will continue to offer
guidance to anyone wishing to make sense of the modern economy.
Over the past two hundred years, economists have refined and expanded our understanding of economic behaviour. By
incorporating the role of information and technological change, they are now able to explain much more than was possible
just twenty years ago, offering new insights into topics that range from why car dealers build fancy showrooms to how the
factors important for encouraging the production of new ideas differ from those that encourage the production of new cars.
But what are these insights? What do economists study? And what can we learn from looking at things from the perspective
of economics? How can economics help us understand why we need to worry about the extinction of salmon but not of
sheep, why car manufacturers advertise but wheat farmers don’t, why countries that rely on uncoordinated markets have
done better than countries that rely on government planners, and why letting a single firm dominate an industry is bad?
Economists have a distinctive way of thinking about issues, and the best way to learn economics is to understand how to
think like an economist. Thinking like an economist involves focusing on trade-offs, incentives, exchange, information,
distribution and more. Economists focus on the choices individuals and businesses make when they are faced with scarcity.
These choices can involve a decision to eat at home rather than to go to a restaurant, to go to university rather than take a job
right out of high school, to locate a manufacturing plant overseas in Asia rather than in Australia, or any of a thousand other
alternatives. The choices made by individuals and business involve trade-offs and are affected by the incentives they face, the
opportunities for exchange that are available, the information at hand and the initial distribution of wealth. To understand
choices, economists start with a simple model of how individuals and firms interact with one another in markets to carry out
exchanges.

 Part 3 Microeconomics 6.1 What is economics? 

6.1 WHAT IS ECONOMICS?
Learning objective 1
explain key concepts that define core ideas in economics

Economics studies how individuals, firms, government and other organisations in our society make choices, and how these
choices determine society’s use of its resources. Why did consumers choose to buy small, energy-efficient cars in the 1970s
and large 4WD vehicles in the 1990s? What determines how many individuals work in health-care industries and how many
work in the computer industry? Why did the income gap between rich and poor rise in the 1990s? To understand how choices
are made and how these choices affect the use of society’s resources, we must examine seven concepts that play an important
role: scarcity, trade-offs, opportunity cost, incentives, exchange, information and distribution.

1. Resources are scarce. Incomes are limited but wants are unlimited.
2. Choice involves trade-offs — deciding to spend more on one thing leaves less to spend on something else; devoting
more time to studying economics leaves less time to study physics.
3. Opportunity cost represents the opportunity forgone of deciding on one course of action over another option. If an
individual decides to study full-time at university, they will forgo the income of a job.
4. In making choices, individuals respond to incentives. If the price of an Android smartphone falls relative to the price of
an iPhone, there is a greater incentive to buy an Android smartphone. If the salaries for engineers rise relative to the
salaries of people with an MBA, there is an increased incentive to choose to study for an engineering degree rather
than a business degree.
5. When we exchange with others, our range of choices becomes larger.
6. Making intelligent choices requires that we have, and utilise, information.
7. Finally, the choices we make — about how much education to get, what occupation to enter and what goods and
services to buy — determine the distribution of wealth and income in our society.

These seven concepts define the core ideas that are critical to understanding economics. They also guide the way economists
think about issues and problems. Learning to ‘think like an economist’ means learning how to discover the trade-offs and
incentives faced, the implications of exchange, the role of information, and the consequences for distribution.

1: Scarcity
Scarcity figures prominently in economics; choices matter because resources are scarce. For most of us, our limited income
forces us to make choices. We cannot afford everything we might want. Spending more on rent leaves less available for
clothes and entertainment. Getting a sunroof on a new car may mean forgoing leather seats to stay within a fixed budget.
Limited income is not the only reason we are forced to make trade-offs. Time is also a scarce resource, and even the
wealthiest individual must decide what expensive toy to play with each day. When we take time into account, we realise
scarcity is a fact of life for everyone.
One of the most important points on which economists agree concerns the critical role of scarcity. We can summarise this
point as follows: There is no free lunch. Having more of one thing requires giving up something else. Scarcity means that
trade-offs are a basic fact of life.

2: Trade-offs
Each of us is constantly making choices — students decide to study at the library rather than at home, to have pizza rather
than sushi, to go to university rather than work full-time. Societies, too, make choices — to preserve open spaces rather than
provide more housing, to produce computers and import televisions rather than produce televisions and import computers, to
cut taxes rather than increase government expenditures. In some cases, individuals or governments explicitly make these
choices. The government decides each year whether to cut taxes or to increase spending. In other cases, however, the choices
were the result of the uncoordinated actions of millions of individuals. Neither the government nor any one individual
decided that Australia would import cars from Japan and export wheat to India. But, in each case, choice involves trade-offs
— to get more of one thing involves having less of something else. We are forced to make trade-offs because of scarcity.

3: Opportunity costs
If someone were to ask you right now what it costs to go to a movie, you would probably answer ‘15 dollars’, or whatever
you last paid for a ticket. But the concept of trade-offs suggests that a full answer is not that simple. To begin with, the cost is
not the $15, but what that $15 could otherwise buy. Furthermore, your time is a scarce resource that must be figured into the
calculation. Both the money and the time represent opportunities forgone in favour of going to the movie, or what
economists refer to as the opportunity cost of the movie. To apply a resource to one use means that it cannot be put to any
other use. Thus, we should consider the next-best, alternative use of any resource when we think about putting it to any
particular use. This next-best use is the formal measurement of opportunity cost.
Some examples will help clarify the idea of opportunity cost. Consider a university student, Sarah, who works during the
summer. She has a chance to go surfing in Bali with friends, but to do so she has to quit her summer job two weeks early.
The friends have found a cheap airfare and place to stay, and they tell Sarah the trip will cost only $1000. To the economist,
$1000 is not the total cost of the trip for Sarah. Since she would have continued working in her summer job for an extra two
weeks if she did not go to Bali, the income she would have earned is part of the opportunity cost of her time. This forgone
income must be added to the airfare and hotel costs in calculating the total economic cost of the surfing trip.
Now consider a business firm that has bought a building for its headquarters that is bigger than necessary. If the firm could
receive $30 per month in rent for each square metre of space that is not needed, then that is the opportunity cost of leaving
the space idle.

4: Incentives
It is one thing to say we all face trade-offs in the choices we make. It is quite another to understand how individuals and
firms make choices and how those choices might change as economic circumstances change. If new technologies are
developed, will firms decide to increase or decrease the amount of labour they employ? If the price of petrol rises, will
individuals decide to buy different types of cars?
When faced with a choice, people evaluate the pros and cons of the different options. In deciding what to eat for dinner
tonight, you might weigh the advantages and disadvantages of having a frozen pizza again over going out for sushi.
Similarly, a firm evaluates the pros and cons of its alternatives in terms of the effects different choices will have on its
profits. For example, a retail chain deciding on the location for a new store must weigh the relative advantages of different
locations. One location might have more foot traffic but also higher rent. Another location might be less desirable but have
lower rent. Or they might decide, like an increasing number of firms, to have only an online presence and forgo any
shopfronts.
When decision-makers systematically weigh the pros and cons of the alternatives they face, we can predict how they will
respond to changing economic conditions. Higher petrol prices raise the cost of driving, but the cost of driving a fuel-
efficient car rises less than the cost of driving a 4WD. Therefore, households weighing a car purchase have a greater
incentive to choose the fuel-efficient car. If a firm starts selling more of its goods online, it will rely less on foot traffic into
its retail store. This shift reduces its incentive to pay a high rent for a good location.
Economists analyse choices by focusing on incentives. In an economic context, incentives are benefits (including reduced
costs) that motivate a decision-maker in favour of a particular choice. Many things can affect incentives, but among the most
important are prices. If the price of petrol rises, people have a greater incentive to drive less. If the price of MP3 players falls,
people have a greater incentive to buy one. When the price of a good rises, firms are induced to produce more of that good,
in order to increase their profits. If a resource used in production, such as labour or equipment, becomes more expensive,
firms have an incentive to find new methods of production that economise on that resource. Incentives also are affected by
the return people expect to earn from different activities. If the income of university graduates rises relative to that of people
with only a high school leaving certificate, people have a greater incentive to attend university.
When economists study the behaviour of people or firms, they look at the incentives being faced. Sometimes these incentives
are straightforward. Increasing the number of courses required to major in biology reduces the incentive to pick that major. In
other circumstances, they may not be so obvious. For example, building safer cars may create incentives to drive faster.
Identifying the incentives, and disincentives, to take different actions is one of the first things economists do when they want
to understand the choices individuals or firms make. Decision-makers respond to incentives; for understanding choices,
incentives matter.
5: Exchange
Somehow, decisions that are made — by individuals, households, firms and government as they face trade-offs and respond
to incentives — together determine how the economy’s limited resources, including its land, labour, machines, oil and other
natural resources, are used. The key to understanding how this happens lies in the role of voluntary exchange in markets.
Long before the rise of modern industrial societies, the benefits of exchange were well understood. Coastal societies with
access to fishing resources, for example, would trade some of their fish to inland societies in return for red meat. The coastal
group sought red meat that was worth more to them than the fish they gave up; the inland group likewise exchanged red meat
for fish. Both groups benefited from voluntary exchange.

CASE IN POINT
Auction sites

An auction is one form of market that used to require potential buyers to be physically present in a single location. Now,
auctions are held over the internet, and can involve participants from around the world. Some sites, such as eBay
(www.ebay.com.au) and Grays Online (www.graysonline.com), offer just about everything for sale. Other sites specialise.
For example, Wine Auction House (www.wineauctionhouse.com.au) enables people to buy and sell wine online, and
Pickles (www.pickles.com.au) is an online vehicle auction site.

In modern societies, millions of exchanges take place. Few individuals produce any of the goods and services they
themselves want to consume. Instead, teachers, police officers, lawyers and building workers sell their labour to a school, a
government, a client or a home builder and then exchange the income they earn for all the various goods and services they
wish to consume that are produced by others. An important insight in economics is the recognition that both parties in a
voluntary exchange gain. Whether it takes place between two individuals, between an individual and a firm or between
residents of two different countries, exchange can improve the wellbeing of both parties.
Economists describe any situation in which exchange takes place as a market. For thousands of years, societies have
established physical locations such as village markets or periodic trading fairs where people have brought their products,
haggled over terms of exchange and reaped the benefits of trade. The economic concept of markets covers any situation in
which exchange takes place, though this exchange may not necessarily resemble a traditional village market or a modern
stock exchange. In department stores and shopping malls, customers rarely haggle over the price. When manufacturers
purchase the materials they need for production, they give in exchange money, not other goods. Most goods, from cameras to
clothes, are not sold directly from producers to consumers. Instead they are sold from producers to distributors, from
distributors to retailers, and from retailers to consumers. All of these transactions are embraced by the concept of markets
and a market economy.
In a market economy like that of Australia, most exchanges take place through markets, and these exchanges are guided by
the prices of the goods and services involved. The goods and services that are scarcer, or require more resources for their
production, come at a higher price. Cars are more expensive than paper cups; lawyers charge more than cleaners. As a result,
markets enable consumers and firms to make choices that reflect scarcity, and therefore lead to efficient uses of resources.
Market economies thus rely primarily on market exchanges to resolve the most basic economic questions: What and how
much is produced? How is it produced? For whom is it produced? And who makes the economic decisions? Individuals and
firms make the decisions. Individuals make decisions that reflect their own desires as they respond to the incentives they
face. Firms make decisions that maximise their profits, and to do so they strive to produce the goods that consumers want at
the lowest possible cost. This process determines what is produced, how it is produced, and for whom. As firms compete in
the quest for profits, consumers benefit, both from the kinds of goods produced and from the prices at which they are
supplied. On the whole, markets ensure that society’s resources are used efficiently.
In some areas, however, markets lead to outcomes that society may find inadequate. There may be too much pollution, too
much inequality, and too little concern about education, health and safety. When the market is not perceived to be working
well, people often turn to government. An economy such as Australia is often called a mixed economy — one that relies
primarily but not exclusively on the free interaction of producers and consumers to determine what is produced, how, and for
whom. In some areas, the government makes the decisions; in others it imposes regulations that affect the incentives firms
and households face. In many areas, both the private sector (households and businesses) and the public sector (local, state
and federal governments) are involved (health is a good example).
Governments play a critical role in all market economies. For example, governments provide the legal structure within which
private firms and individuals operate. No one would open a store if others could simply steal things off the shelf with
impunity; the store owner needs to know there is a legal system that he can use to prosecute theft. No bank would lend
money to a family to buy a home if it could not legally require the family to repay the loan. Governments also regulate
businesses in many ways. There are regulations to ensure firms do not discriminate by race or sex, do not mislead consumers,
and are careful about the safety of their workers. In some industries, such as education and mail service, the government is a
major supplier of services. In other industries, such as the health sector, the government is the major purchaser. The
government also supplies goods and services that the private sector does not, such as the national defence, roads and
currency. Government programs provide for the elderly through social security (which pays income to retired individuals)
and Medicare (which partially funds the medical needs of the population). The government helps those who have suffered
economic dislocation, through unemployment benefits for those temporarily unemployed and disability insurance for those
who are no longer able to work. The government also provides a safety net of support for the poor, particularly children,
through various welfare programs.
One can easily imagine the government controlling the economy more directly. In countries where decision-making is
centralised and concentrated in the government, government bureaucrats might decide what and how much a factory should
produce and set the wages that should be paid. At least until recently, governments in countries such as Russia and China
attempted to control practically all major decisions regarding resource allocation. Even in Europe, not long ago many
governments ran oil companies, coalmines and the telephone system. Increasingly, however, governments have sold these
enterprises to the private sector, a process called privatisation.
Market economies in which individuals and firms make the decisions about what to produce and how much to pay have
proven adept at developing new technologies and products. It is hard to imagine government bureaucrats developing MP3
players or iPads in neon colours. Markets also generally ensure that resources are used efficiently. Exchange in markets is a
key to understanding how resources are allocated, what is produced and who earns what.

6: Information
Making informed choices requires information. After all, it is hard to weigh the costs and benefits of alternative choices if
you do not know what they are! A firm that is contemplating the purchase of a new software system needs to know not only
the costs of the various alternatives but also the capabilities and limitations of each. Information is, in many ways, like other
goods and services. Firms and individuals are willing to purchase information, and specialised institutions develop to sell it.
In many areas, separate organisations are designed solely to provide information to consumers. Choice, offered through the
Australian Consumers Association, is a prime example.1 The internet also now serves as a major source of independent
information for buyers. But there are some fundamental ways in which information differs from other goods. A car seller will
let you test-drive a vehicle, but a seller of information cannot let you see the information before you buy. Once you have seen
the information, you have no incentive to pay for it. Another way information differs from other goods is that unlike a
hamburger or ice-cream, information can be freely shared. When I tell you something, it does not subtract from what I know
(though it may subtract from the profits I might earn from that information).
In some key areas of the economy, the role of information is so critical that it affects the nature of the market. In the used car
market, buyers and sellers negotiating over the price of a vehicle may have quite different information about its quality. The
seller may have better information about the quality of the car, but also has an incentive to misrepresent its condition, since
better quality cars command higher prices. As a result, the buyer will be reluctant to trust claims that the car is in perfect
shape.
When consumers lack adequate information to make informed choices, governments frequently intervene to require that
firms provide information. We are all familiar with the mandatory nutritional information placed on food products. The
Australian Securities and Investments Commission (ASIC) that oversees the Australian share market compels firms to meet
certain reporting requirements before their shares can be listed on the Australian Stock Exchange (ASX). Such reporting
helps ensure that private investors have reliable information on which to base their investment decisions. Often, however,
these regulations do not work adequately, as the HIH scandal in the early 2000s clearly illustrates. The insurance company
HIH had cooked its books to overstate its profitability in its mandated reports.2 One outcome of HIH’s subsequent financial
collapse was the introduction of new regulations designed to improve the reliability of the information that companies must
provide to the public. Governments also regulate the safety of products. The Therapeutic Goods Administration (TGA) must
approve new pharmaceutical drugs before they can be sold. The need for such oversight was driven home in 2005, when the
drug manufacturer Merck had to pull its pain relief drug Vioxx off the market after studies suggested it increased the risk of
heart attacks and strokes.3
Even in the absence of regulation, firms have incentives to signal to buyers that their products are of high quality. One way
they do this is to offer guarantees that a producer of low-quality goods could not afford to offer.
Imperfect information also can interfere with incentives. Employers want to create incentives for employees to work hard.
One way to do this is to base pay on a measure of how productive each worker is. Often, however, it is difficult to measure a
worker’s productivity. Under such conditions, it is difficult to link pay to performance. For example, a recent major debate in
Australia concerns tying teacher salaries to student performance as measured by the NAPLAN test results. Because it is hard
to measure teaching performance, the pay of most teachers is based primarily on how long they have been teaching.
Information, or its absence, plays a key role in determining the shape of markets and the ability of private markets to ensure
that the economy’s scarce resources are used efficiently.

7: Distribution
The market economy determines not only what goods are produced and how they are produced but also for whom they are
produced. Many people find unacceptable the way the market distributes goods among households. Like bidders at an
auction, what market participants are willing and able to pay depends on their income. Incomes differ markedly across
occupations. Some groups of individuals — including those without skills that are valued by the market — may receive such
a low income that they cannot feed and educate their children without outside assistance. Government provides the assistance
by taking steps to increase income equality.
Steps that soften the distributional impact of markets may blunt economic incentives. While welfare payments provide an
important safety net for the poor, the taxation required to finance them may discourage people from working and saving. If
the government takes one out of every two or three dollars that an individual earns, that individual may not be inclined to
work as much. And if the government takes one out of every two or three dollars a person earns from interest on savings, the
person may decide to spend more and save less. Thus, efforts by the government to redistribute income may come at the cost
of reduced economic efficiency.
The primary reliance on private decision-making in the Australian economy reflects economists’ beliefs that this reliance is
appropriate and necessary for economic efficiency. However, economists also believe that certain interventions by
government are desirable. Like the appropriate balance between public and private sectors, the appropriate balance between
concerns about equality (often referred to as equity concerns) and efficiency is a central issue of modern economies. As
elsewhere, trade-offs must be made.

The role of markets

The market economy revolves around exchange between individuals (or households) who buy goods and services from
firms, and firms, which take inputs, the various materials of production, and produce outputs, the goods and services that
they sell. In thinking about a market economy, economists focus their attention on three broad categories of markets in which
individuals and firms interact. The markets in which firms sell their outputs to households are referred to collectively as the
product market. Many firms also sell goods to other firms; the output of the first firm becomes the input of the second.
These transactions too are said to occur in the product market.
On the input side, firms need (besides the materials they buy in the product market) some combination of labour and
machinery to produce their output. They purchase the services of workers in the labour market. They raise funds to buy
inputs in the capital market. Traditionally, economists also have highlighted the importance of a third input, land, but in
modern industrial economies land is of secondary importance. For most purposes, it suffices to focus attention on the three
major markets — product, labour and capital — and this text will follow that pattern (see figure 6.1).

FIGURE 6.1 The three markets

To economists, people wear different hats. They are usually consumers in the product market, workers in the labour market, and borrowers or lenders
in the capital market.

As figure 6.1 shows, individuals participate in all three markets. When individuals buy goods and services, they act as
consumers in the product market. When people act as workers, economists say they ‘sell their labour services’ in the labour
market. When people buy shares in a firm, deposit money in a savings account or lend money to a business, they are
participating in the capital market as investors.
Though the term market is used to conjure up an image of a busy marketplace, there is no formal marketplace for most goods
and services. There are buyers and sellers, and economists analyse the outcomes as if there were a single marketplace in
which all transactions occur. For example, economists analyse the ‘market for books’, even though the buyers and sellers in
the market for books interact in thousands of individual bookstores and online selling locations.
Moreover, economists often talk about the ‘market for labour’ as if all workers are identical. But workers differ in countless
ways. In some cases, these differences are important. We might then talk about the ‘market for skilled workers’ or the
‘market for computer engineers’. In other cases — such as when we are talking about the overall state of the economy and
focusing on the overall unemployment rate (the proportion of workers who are looking for jobs but cannot find them) —
these differences can be ignored.
When newspapers refer to the capital market, they mean the bond traders and sharebrokers and the companies they work for.
When economists use the term capital market, they have in mind a broader concept that includes all the institutions
concerned with raising funds, including banks and insurance companies.
The term capital is used in still another way — to refer to the machines and buildings used in production. To distinguish this
particular usage, in this book we refer to machines and buildings as capital goods. The term capital markets thus refers to
the markets in which funds are raised, borrowed and lent. Capital goods markets refers to the markets in which capital goods
are bought and sold.

Microeconomics and macroeconomics

We have already seen the terms ‘micro environment’ and ‘macro environment’ in the context of marketing. Economists do
something similar. Economists have developed two different ways to look at the economy. The detailed study of the
decisions of firms and households, and of prices and production in specific industries, is called microeconomics.
Microeconomics (micro is derived from the Greek word meaning ‘small’) focuses on the behaviour of the units — the firms,
households and individuals — that make up the economy. It is concerned with how the individual units make decisions and
what affects those decisions.
By contrast, macroeconomics (macro is derived from the Greek word meaning ‘large’) looks at the behaviour of the
economy as a whole, in particular the behaviour of such aggregate measures as the overall rates of unemployment, inflation
and economic growth and the balance of trade. The aggregate numbers do not tell us what any one firm or household is
doing. They tell us what is happening in total, or on average. In a dynamic economy, there are always some industries
expanding and others contracting. For instance, the mining boom in the 2000s and continuing to 2014 saw rapid growth in
mining-related industries, while retail firms contracted. But there are times when overall growth in an economy slows and
times when the level of economic activity actually declines, not just in an isolated industry but seemingly across all or almost
all industries.
In macroeconomics, we also look at the behaviour of the general level of prices, interest rates, and exchange rates. Why do
prices of almost all goods and services seem to rise at rapid rates during some periods, while at other times they remain
stable? Why do interest rates fluctuate? And what determines the value of the dollar relative to other currencies?
In approaching these questions, it is important to remember that the behaviour of the economy as a whole is dependent on the
decisions made by the millions of households and firms in the economy, as well as the decisions made by the government.
Micro and macro perspectives are simply two ways of looking at the same thing. Microeconomics is the bottom-up view of
the economy; macroeconomics is the top-down view.
We will be focusing on microeconomics in the following chapters. That is, we will examine how a competitive market
functions (using a demand-supply model) and will examine how individual firms make decisions in various market
structures.

 6 Economics, demand and supply 6.2 Economics as a science 

6.2 ECONOMICS AS A SCIENCE
Learning objective 2
understand the science behind economics

Economics is sometimes called (mostly by economists themselves) the ‘Queen of the Social Sciences’. What does it mean to
say that economics is a social science? First and foremost, it means that it is interested in understanding the social world by
investigating it in a systematic, objective manner. These days, this mostly involves the following: constructing models and
then testing them as rigorously as possible by a comparison with statistical data.

The meaning of ‘model’

What do we mean by models? Here is a helpful analogy: an architect will construct a model of a building before constructing
the actual building. The model is obviously not exactly the same as the building. It leaves out a lot of real-world details, but
it is intended that the model represents some essential features of the real building in order get an idea about how (and if) the
real building would ‘work’.
Similarly, economists often construct models of the things they are interested in, except that their models almost always only
exist in the realm of thought: they are discursive (symbolic) theoretical constructs, rather than physical ones. These
theoretical constructs are supposed to represent (in symbolic form) some essential features of real-world economic
phenomena. They are not fully descriptively accurate because they exclude (‘abstract’ from) a lot of real-world details that
the model-builders think are not essential. As to what an economist thinks are ‘essential’ characteristics of the thing or
process being modelled depends largely on a combination of ‘acceptable’ assumptions, empirical knowledge and some
inspired imagination. For example, some commonly made assumptions when constructing a model of a firm are that it seeks
to maximise economic profit, it must employ some combination of labour and capital, and it is constrained by ‘given’
technological knowledge.
Most economic models posit hypothesised causal relationships between [in principle] quantitative variables (e.g., an increase
in household income causes some increase in consumption spending), and for this reason economic models are usually
expressed mathematically and often illustrated graphically. (It is not very common these days for economists to express a
model exclusively in verbal terms, and it is extremely rare for economists to literally build physical models of economic
phenomena.)
After ‘constructing’ a model of something, economists will then play around with it to see what outcomes it produces.
‘Playing around’ basically means that they will alter [hypothesised] causal variables in the model to try to deduce what will
happen as a result. It can also mean, for example, adding a new variable to see what impact it has on the model’s results. For
complex phenomena (such as a whole economy), mathematical models will often be embedded in computer programmes,
which makes it easier to conduct multiple simulations (more playing around).
So one of the most important purposes of a model is to enable economists to get an intellectual grip on how some aspect of
the real-world might be functioning. Another way of saying this is that a model’s purpose is to provide a logically coherent
[hypothetical] causal account of the actual and possible behaviour of some real-world phenomena.

Testing a model
That’s not a model’s only purpose. It is also serves as a kind of template that guides the empirically orientated economist: the
model indicates what kind of real-world information one needs to examine, and what kinds of relationships between
variables one should look for in the real-world. Comparing relevant patterns of data with what the model predicts provides a
means of ‘testing’ the model: one can then (hopefully) make some judgements about how well the model ‘matches’ the real-
world that it purports to represent.
If a model’s predictions about the real-world turn out to be false, then a reasonable person would probably suspect the model
is a bad representation of what is actually happening. As to why it might be a poor representation is a trickier question to
answer. The model may require some slight modifications to its assumptions; the model may have ignored some important
causal factor that is operating in the real-world; or the model might be so false in so many ways that the economist may as
well start from scratch.
If, on the other hand, the model is a good predictor of what occurs in the real-world, then one might be inclined to conclude
that the model accurately represents the phenomenon it is designed to understand. That seems reasonable, but we should be
cautious about making bold claims to have discovered ‘the truth’. Just as a matter of pure logic, a model can be entirely false
and yet can make accurate predictions. (For example, take this simple silly illustration: my model assumes that all cumquats
will become President of the US, and that Donald Trump is a cumquat. Thus my model predicts that Donald Trump will
become President of the US. Here we get an accurate prediction, but due to an insanely false model.) Also, a model that
predicts well now might be a terrible predictor in the future because, say, it has ignored (by assumption) some important
causal factor that only makes its presence felt at some future date. Arguably, this is why, when the global financial crisis
occurred in 2007–2008, the most popular model of the macroeconomy failed to predict it. The model ignored the housing
bubble in the US and the massive build-up of private debt that fuelled it. The model predicted smooth sailing right up to
2007, but in hindsight (almost) no one would say the model accurately represented all the important forces at work in the US
economy.
In sum, while we might reasonably say that there is something wrong with a model if it makes false predictions, we should
be inordinately cautious about saying that a model is really true if it makes accurate predictions!

Inherent problems with economic science

So, just because economics aspires to be scientific, it doesn’t follow that it is problem free, or there aren’t inherent
difficulties in studying economic phenomena, or that there are no fundamental disputes in economics. Probably the two
greatest obstacles to discovering ‘the truth’ in economics (as is the case in all social sciences) are the following.

1. The ‘gold standard’ for testing theories and models in the sciences is experimentation. This is where scientists set up a
strictly controlled environment to eliminate the million-and-one things happening simultaneously in the world, and then
manipulate just one variable (a hypothesised causal factor) to see if it has the precise effects that are predicted.
Unfortunately, it is usually impossible to set up real experiments in economics (e.g. we can’t ‘freeze’ the whole economy
and then see what happens when we manipulate just the price of oil). For this reason, mostly, economists are stuck with a
second-best approach: trying to conduct statistical analyses to try to find empirical relationships in a world where
everything is changing all the time. This is not useless, but it is not ideal either. Because economists are forced to rely on
statistical analysis in an uncontrolled world, it means that the ‘findings’ are never really ‘proofs’ of what is really
happening. One can always say, for example, ‘You have found a correlation between variables X and Y, but that does not
prove that X causes Y. Perhaps both X and Y are caused by another unnoticed factor, Z.’ For example, in the 1970s in
Australia, the demand for large cars started to fall and the demand for small cars started to rise. The correlation was
statistically significant. But that doesn’t prove that one is causing the other. In fact, both of these phenomena were due to
a rise in the price of petrol in the 1970s, which caused drivers to switch from large cars to smaller, more fuel-efficient
cars.
2. Economics, more so than other social sciences, is used to formulate laws, government policies and regulations. This
means that economics can become a highly politically charged discipline which various interest groups in society — such
as business lobbies, unions, charities, community groups and so on — sometimes try to influence. Also, because
economic policies and regulations are partly motivated by people’s political ideologies (right-wing and left-wing) about
how society should be organised and run, and since economists are people too, economics as a science can be influenced
by economists’ own ideological ‘worldviews’. As such, debates within economics are often not just about whether a
model is logically coherent or whether a model is well-supported by ‘the facts’, etc.; rather, the ‘scientific’ evaluations of
models and findings can be influenced by whether a model or finding supports a right-wing or a left-wing ideology. This
is another way in such economic science is often inherently politically charged. For example, debates over the effect on
minimum wage legislation are not just about what the effects are, but also the moral importance of those effects. The
same goes for debates over whether corporations have and should have ‘social and environmental responsibilities’. And
so it goes for debates over corporate taxation, federal budget deficits, trade restrictions, government funding of education
and R&D, government responses to climate change, going to war, and so on and so forth.

 6.1 What is economics? 6.3 Demand 

6.3 DEMAND
Learning objective 3
understand what a demand curve is, explain why it slopes downwards, and describe sources of shifts in demand curves

Choice in the face of scarcity is the fundamental concern of economics. But if scarcity is such a concern for economists, why is it that
whenever we go to the local Coles or Woolworths it has all the tomatoes we want to buy? Bananas might be more expensive one week and
less expensive the next, but they are always available. In what sense are bananas scarce? The same is true for most goods most of the time;
as long as I am willing to pay the market price, I can buy the good. A key economic insight is that when the forces of supply and demand
operate freely, the price of a good measures its scarcity.
If bad weather destroys almost all of the banana crop like Cyclone Yasi did in February 2011 when it hit the Innisfail district (where 90 per
cent of Australia’s bananas are produced),4 then bananas become very scarce, and their price will rise to reflect that condition. In a short
time, they went from $1 per kilogram to $12–15 per kilogram.5 But price does more than simply measure scarcity. Prices also convey
critical economic information. When the price of a resource — such as land, labour or capital — used by a firm is high, the company has a
greater incentive to economise on its use. When the price of a good that the firm produces is high, the company has a greater incentive to
produce more of that good, and its customers have an incentive to economise on its use. Thus, prices provide our economy with incentives
to use scarce resources efficiently, and a major objective of economists is to understand the forces that determine prices.
The price of a good or service is what must be given in exchange for the good. Usually we identify the price of something with how much it
costs in dollars. But price can include other factors — for example, if you have to wait to buy something, the total price includes the value
of your time spent in line. For most of our discussion, however, we will keep things simple and just think of the price as the number of
dollars paid to obtain a good or service.
Economists use the concept of demand to describe the quantity of a good or service that a household or firm chooses to buy at a given
price. The concept of demand is easily managed — unlike wants, of which there are many, and are unlimited for any individual. It is
important to understand that economists are concerned not just with what people desire but with what they choose to buy given the spending
limits imposed by their budget constraint and given the prices of various goods. In analysing demand, the first question economists ask is
how the quantity of a good purchased by an individual changes as the price changes, when everything else is kept constant (ceteris
paribus).

The individual demand curve

Think about what happens as the price of a chocolate bar changes. At a price of $5, you might never buy one. At $3, you might buy one as a
special treat. At $1.25, you might buy a few; and if the price declined to $0.50, you might buy a lot. The table in figure 6.2 summarises the
weekly demand of one individual, Alex, for chocolate bars at these different prices. We can see that the lower the price, the larger the
quantity demanded. We can also draw a graph that shows the quantity Alex demands at each price. The quantity demanded is measured
along the horizontal axis, and the price is measured along the vertical axis. The graph in figure 6.2 plots the points.
FIGURE 6.2 An individual’s demand curve
This demand curve shows the quantity of chocolate bars that Alex consumes at each price. Notice that quantity demanded increases as the price falls, and the demand
curve slopes down.

A smooth curve can be drawn to connect the points. This curve is called the demand curve. The demand curve gives the quantity
demanded at each price. Thus, if we want to know how many chocolate bars a week Alex will demand at a price of $1, we simply look
along the vertical axis at the price $1, find the corresponding point A along the demand curve, and then read down the horizontal axis. At a
price of $1, Alex buys six chocolate bars each week. Alternatively, if we want to know at what price he will buy just three chocolate bars,
we look along the horizontal axis at the quantity three, find the corresponding point B along the demand curve, and then read across to the
vertical axis. Alex will buy three chocolate bars at a price of $1.50.

As the price of chocolate bars increases, the quantity demanded decreases. This can be seen from the numbers in the table in figure 6.2 and
in the shape of the demand curve, which slopes downwards from left to right. This relationship is typical of demand curves and makes
common sense: the cheaper a good is (the lower down we look on the vertical axis), the more of it a person will buy (the farther right on the
horizontal axis); the more expensive, the less a person will buy.

The market demand curve

Suppose there was a simple economy made up of two people, Alex and Jane. Figure 6.3 illustrates how to add up the demand curves of
these two individuals to obtain a demand curve for the market as a whole. We ‘add’ the demand curves horizontally by taking, at each price,
the quantities demanded by Alex and by Jane and adding the two together. Thus, in the figure, at the price of $0.75, Alex demands nine
chocolate bars and Jane demands eleven, so that the total market demand is twenty chocolate bars. The same principles apply no matter how
many people there are in the economy. The market demand curve gives the total quantity of the good that will be demanded at each price.
The table in figure 6.4 summarises the information for our example of chocolate bars; it gives the total quantity of chocolate bars demanded
by everybody in the economy at various prices. If we had a table like the one in figure 6.2 for each person in the economy, we would
construct figure 6.4 by adding up, at each price, the total quantity of chocolate bars purchased. Figure 6.4 tells us, for instance, that at a
price of $3 per chocolate bar, the total market demand for chocolate bars is 1 million chocolate bars, and that lowering the price to $2
increases market demand to 3 million chocolate bars.

FIGURE 6.3 Deriving the market demand curve

The market demand curve is constructed by adding up, at each price, the total of the quantities consumed by each individual. The curve here shows what market
demand would be if there were only two consumers. Actual market demand, as depicted in figure 6.4, is much larger because there are many consumers.

FIGURE 6.4 The market demand curve

The market demand curve shows the quantity of the good demanded by all consumers in the market at each price. The market demand curve is downward sloping, for
two reasons: at a higher price, each consumer buys less, and at high enough prices, some consumers decide not to buy at all — they exit the market.

Figure 6.4 also depicts the same information in a graph. As in figure 6.2, price lies along the vertical axis, but now the horizontal axis
measures the quantity demanded by everyone in the economy. Joining the points in the figure together, we get the market demand curve. If
we want to know what the total demand for chocolate bars will be when the price is $1.50 per chocolate bar, we look on the vertical axis at
the price $1.50, find the corresponding point A along the demand curve, and read down to the horizontal axis; at that price, total demand is 4
million chocolate bars. If we want to know what the price of chocolate bars will be when the demand equals 20 million, we find 20 million
along the horizontal axis, look up to find the corresponding point B along the market demand curve, and read across to the vertical axis; the
price at which 20 million chocolate bars are demanded is $0.75.
Notice that just as when the price of chocolate bars increases, the individual’s demand decreases, so too when the price of chocolate bars
increases, market demand decreases. At successively higher prices, more and more individuals exit the market. Thus, the market demand
curve also slopes downwards from left to right. This general rule holds both because each individual’s demand curve is downward sloping
and because as the price is increased, some individuals will decide to stop buying altogether. In figure 6.2, for example, Alex exits the
market — consumes a quantity of zero — at the price of $5, at which his demand curve hits the vertical axis.

Shifts in demand curves

When the price of a good increases, the demand for that good decreases — when everything else is held constant (ceteris paribus). But in
the real world, everything is not held constant. Any changes other than in the price of the good in question shift the (whole) demand curve
— that is, they alter the amount that will be demanded at each price. How the demand curve for chocolate bars has shifted as Australians
have become more health conscious provides a good example. Figure 6.5 shows hypothetical demand curves for chocolate bars in 1960 and
in 2015. We can see from the figure that the demand for chocolate bars at a price of $0.75 has decreased from 20 million chocolate bars
(point E1960) to 10 million (point E2015), as people have reduced their taste for chocolate.

FIGURE 6.5 Shifts in the demand curve

A leftward shift in the demand curve means that a lesser amount will be demanded at every given market price.

Sources of shifts in demand curves

Two of the factors that shift the demand curve — changes in income and in the price of other goods — are specifically economic factors. As
an individual’s income increases, they normally purchase more of any good. Thus, rising incomes shift the demand curve to the right, as
illustrated in figure 6.6. At each price, more of the good is consumed.
FIGURE 6.6 A rightward shift in the demand curve
If, at each price, there is an increase in the quantity demanded, then the demand curve will shift to the right, as depicted. An increase in income, an increase in the price
of a substitute or a decrease in the price of a complement can cause a rightward shift in the demand curve.

Changes in the price of other goods, particularly closely related goods, will also shift the demand curve for a good. For example, when the
price of margarine increases, some individuals will substitute butter. Two goods are substitutes if an increase in the price of one increases
the demand for the other. Butter and margarine are thus substitutes. When people choose between butter and margarine, one important factor
is the relative price — that is, the ratio of the price of butter to the price of margarine. An increase in the price of butter and a decrease in the
price of margarine increase the relative price of butter. Thus, both induce individuals to substitute margarine for butter.
Fruit bars and muesli bars can also be considered substitutes, as the two goods satisfy a similar need. Thus, an increase in the price of
muesli bars makes fruit bars relatively more attractive, and, hence, leads to a rightward shift in the demand curve for fruit bars. Sometimes,
however, an increase in a price of other goods has just the opposite effect. Consider an individual who has sugar in his coffee. In deciding
on how much coffee to demand, he is concerned with the price of a cup of coffee with sugar. If sugar becomes more expensive, he will
demand less coffee. For this person, sugar and coffee are complements; an increase in the price of one decreases the demand for the other.
A price increase for sugar shifts the demand curve for coffee to the left: at each price, the demand for coffee is less. Similarly a decrease in
the price of sugar shifts the demand curve for coffee to the right.
Market demand curves can also be shifted by non-economic factors. The major ones are changes in tastes, cultural factors and changes in
the composition of the population. The chocolate example discussed earlier reflected a change in tastes. Other taste changes in recent years
in Australia include shifts in food choices as a result of new health information or (often short-lived) fads associated with diets. Health
concerns led to a shift from high-cholesterol to low-cholesterol foods, and the CSIRO Wellbeing diet (which is a higher protein, low-fat,
nutritious diet) facilitates sustainable weight loss and is supported by scientific evidence. Cultural factors also affect demand curves. During
the late twentieth century, increasing numbers of women entered the workforce as attitudes toward married middle-class women working
outside the home shifted; and, with this change, the demand curves for childcare services shifted.
Population changes that shift demand curves are often related to age. The demand for new houses and flats/apartments is closely related to
the number of new households, which, in turn, depends on the number of adult individuals. The Australian population has been growing
older, on average, because life expectancies are increasing and more single-person households have been formed. So, in recent years, there
has been a shift in the demand for new houses and flats/apartments. Economists working for particular firms and industries (particularly in
the construction and furnishing sectors) spend considerable energy ascertaining such demographic effects on the demand for the goods
their firms sell.
Sometimes demand curves shift as the result of new information. The shifts in demand for alcohol and meat — and even more strongly for
cigarettes — are related to improved consumer information about health risks. The introduction of new plain packaging for cigarettes,
accompanied by graphic pictures of the effects of smoking, became compulsory by law in Australia from 1 December 2012.
Changes in the cost and availability of credit can also shift demand curves — for goods such as cars and houses that people typically buy
with the help of loans. When interest rates rise and borrowing money becomes more expensive, the demand curves for cars and houses shift;
at each price, the quantity demanded is less.
Finally, what people expect to happen in the future can shift demand curves. If people think they may become unemployed, they will reduce
their spending. In this case, economists say that their demand curves depend on expectations.

CASE IN POINT
Petrol prices and the demand for 4WDs

When demand for several products is intertwined, conditions affecting the price of one will affect the demand for the other. Changes in
petrol prices in Australia, for example, have affected the types of cars Australians buy.
International oil prices soared twice in the 1970s, once when the Organisation of Petroleum Exporting Countries (OPEC) shut off the
flow of oil to Western countries in 1973, and again when the overthrow of the Shah of Iran in 1979 led to a disruption in oil supplies.
Australia was insulated from the first event, but in 1978 import parity pricing of oil was introduced and the price of petrol at the pump
rose from $0.10 a litre in 1978 to $0.35 a litre by 1981. In response to the price increases, Australians cut back demand. But how could
they conserve on petrol? The distance from home to office was not going to shrink, and people had to get to their jobs. One solution was
for drivers to replace their old cars with smaller cars that offered more kilometres to the litre.
Analysts classify car sales according to car size, and usually the smaller the car, the better the petrol consumption. Before the first rise in
petrol prices, Australians most commonly bought large cars. By 1985, consumer behaviour had changed dramatically. Large cars were
still the biggest sellers, but there was a definite shift towards smaller, more fuel-efficient cars being sold. The large cars were mainly
Australian made, while the smaller cars were mainly imports from Japan or manufactured in Australia by Japanese companies. The
demand curve for any good (like cars) assumes that the price of complementary goods (like petrol) is fixed. The rise in petrol prices
caused the demand curve for smaller cars to shift out to the right and the demand curve for large cars to shift back to the left.
By the late 1980s and early 1990s, the price of petrol had fallen significantly from its peak in 1981, but in the 1990s, petrol prices again
rose markedly. However, incomes were also rising significantly. When petrol prices were adjusted for inflation, the real price of petrol
— the price of petrol relative to the prices of other goods — was lower in the 1990s than it had been before the big price increases of the
1970s. As a consequence, the demand curve for large cars shifted back to the right. This time, the change in demand was reflected in
booming sales of four-wheel drive vehicles, or 4WDs.6

CRITICAL THINKING
What will happen to the demand curve for both small and large cars (4WDs) if new technology allows for further improvements in fuel
economy in all cars (ceteris paribus)?

Shifts in a demand curve versus movements along a demand curve

The distinction between changes that result from a shift in the demand curve and changes that result from a movement along the demand
curve is crucial to understanding economics. A movement along a demand curve is simply the change in the quantity demanded as the price
changes. Figure 6.7A illustrates a movement along the demand curve from point A to point B; given a demand curve, at lower prices, more
is consumed. Figure 6.7B illustrates a shift in the demand curve to the right; at a given price, more is consumed.
FIGURE 6.7 Movement along the demand curve versus a shift in the demand curve
Panel A shows an increase in quantity demanded caused by a lower price — a movement along a given demand curve. Panel B illustrates an increase in quantity
demanded caused by a shift in the entire demand curve, so that a greater quantity is demanded at every market price. Panel C shows a combination of a shift in the
demand curve (the movement from point A to B) and a movement along the demand curve (the movement from B to C).
 Movement along vs. a shift in the demand curve
Drag the price slider to view the change in quantity demanded as the price changes (movement along the curve).
Assume then a change in a factor that influences demand (other than a change in price) occurs, which causes an
increase in quantity demanded at each price. Click 'New demand curve' and drag the slider to see the possible
increases in quantity (shift in the curve). Drag the price slider again to see the movement along the new demand
curve.

Increase in price:
PRICE OF CHOCOLATE BARS (p)

New demand curve

Increase in quantity:

QUANTITY OF CHOCOLATE BARS (Q)

In practice, both effects are often present. Thus, in figure 6.7C, the movement from point A to point C — where the quantity demanded has
been increased from Q0 to Q2 — consists of two parts: a change in quantity demanded resulting from a shift in the demand curve (the
increase in quantity from Q0 to Q1) and a movement along the demand curve due to a change in the price (the increase in quantity from Q1
to Q2).
The distinction will be important for understanding how quantities and prices are determined once we combine our analysis of demand with
an analysis of supply. For example, along a given demand curve for petrol, a rise in the price of petrol causes a reduction in the quantity
demanded. In contrast, the introduction of a new rapid bus system (such as the development of the busway in Brisbane over the past decade)
shifts the demand curve for petrol to the left; in this example, at each price of petrol, the quantity demanded would be less because
alternative transportation services are available.

 6.2 Economics as a science 6.4 Supply 

6.4 SUPPLY
Learning objective 4
understand what a supply curve is, explain why it slopes upwards, and describe sources of shifts in supply curves

Economists use the concept of supply to describe the quantity of a good or service that a household or firm would like to sell
at a particular price. Supply in economics refers to such seemingly disparate choices as the number of chocolate bars a firm
wants to sell and the number of hours a worker is willing to work. As with demand, the first question economists ask is,
‘How does the quantity supplied change when price changes, if everything else is kept the same (ceteris paribus)?’
Figure 6.8 shows the number of chocolate bars that a chocolate company would like to sell, or supply to the market, at each
price. If the price of a chocolate bar is only $0.75, the firm does not find it profitable to produce and sell any chocolate bars.
At a higher price, however, the firm can make a profit. If the price is $2, the firm wants to sell 85 000 chocolate bars. At an
even higher price — for example, $5 per chocolate bar — it wants to sell even more chocolate bars, 100 000.

FIGURE 6.8 One firm’s supply curve

The supply curve shows the quantity of a good a firm is willing to produce at each price. Normally a firm is willing to produce more as the price
increases, which is why the supply curve slopes upwards.

Figure 6.8 also depicts these points in a graph. The curve drawn by connecting the points is called the firm’s supply curve. It
shows the quantity that the chocolate company will supply at each price, when all other factors are held constant. For this
curve, like the demand curve, we put the price on the vertical axis. Thus, we can read point A on the curve as indicating that
at a price of $1.50, the firm would like to supply 70 000 chocolate bars.
In direct contrast to the demand curve, the typical supply curve slopes upwards from left to right; at higher prices, firms will
supply more. This is because higher prices yield suppliers higher profits — giving them an incentive to produce more.

Market supply
The market supply of a good is the total quantity that all the firms in the economy are willing to supply at a given price.
Similarly, the market supply of labour is the total quantity of labour that all the households in the economy are willing to
supply at a given wage. Figure 6.9 tells us, for instance, that at a price of $2, firms will supply 70 million chocolate bars,
while at a price of $0.50, they will supply only 5 million.

FIGURE 6.9 The market supply curve

The market supply curve shows the quantity of a good all firms in the market are willing to supply at each price. The market supply curve is normally
upward sloping, both because each firm is willing to supply more of the good at a higher price and because higher prices entice new firms to produce.

Figure 6.9 also shows the same information graphically. The curve joining the points in the figure is the market supply
curve. The market supply curve gives the total quantity of a good that firms are willing to produce at each price. Thus, we
read point A on the market supply curve as showing that at a price of $0.75, the firms in the economy would like to sell 20
million chocolate bars.
As the price of chocolate bars increases, the quantity supplied increases, other things being equal. The market supply curve
slopes upwards from left to right for two reasons: at higher prices, each firm in the market is willing to produce more; and at
higher prices, more firms are willing to enter the market to produce the good.
The market supply curve is calculated from the supply curves of the different firms in the same way that the market demand
curve is calculated from the demand curves of the different households: at each price, we add horizontally the quantities that
each of the firms is willing to produce.

Shifts in supply curves

Just as demand curves can shift, supply curves too can shift, so that the quantity supplied at each price increases or decreases.
Suppose a drought hits the wheat-producing states of eastern Australia. Figure 6.10 illustrates the situation. The supply curve
for wheat shifts to the left, which means that at each price of wheat, the quantity firms are willing to supply is smaller.
FIGURE 6.10 Shifting the supply curve to the left
A drought or other disaster (among other possible factors) will cause the supply curve to shift to the left, so that at each price, a smaller quantity is
supplied.

Sources of shifts in supply curves

There are several sources of shifts in market supply curves, just as we saw for market demand curves. One is changing prices
of the inputs used to produce a good. Figure 6.11 shows that as wheat becomes less expensive, the supply curve for Weetbix
shifts to the right. Producing Weetbix costs less, so at every price, firms are willing to supply a greater quantity. That is why
the quantity supplied along the curve S1 is greater than the quantity supplied, at the same price, along the curve S0.
FIGURE 6.11 Shifting the supply curve to the right
An improvement in technology or a reduction in input prices (among other possible factors) will cause the supply curve to shift to the right, so that at
each price, a larger quantity is supplied.

Another source of shifts is changes in technology. The technological improvements in the computer industry over the past
three decades have led to a rightward shift in the market supply curve. Yet another source of shifts is nature. The supply
curve for agricultural goods may shift to the right or left depending on weather conditions, insect infestations or animal
diseases.
Firms often borrow to obtain inputs needed for production, and a rise in interest rates will increase the cost of borrowing.
This increase too will induce a leftward shift in the supply curve. Finally, changed expectations can also lead to a shift in the
supply curve. If firms believe that a new technology for making cars will become available in two years, they will discourage
investment today, leading to a temporary leftward shift in the supply curve.

Shifts in a supply curve versus movements along a supply curve

Distinguishing between a movement along a curve and a shift in the curve itself is just as important for supply curves as it is
for demand curves. In figure 6.12A, the price of chocolate bars has gone up, with a corresponding increase in quantity
supplied. Thus, there has been a movement along the supply curve.
FIGURE 6.12 Movement along the supply curve versus a shift in the supply curve
Panel A shows an increase in quantity supplied caused by a higher price — a movement along a given supply curve. Panel B illustrates an increase in
quantity supplied caused by a shift in the entire supply curve, so that a greater quantity is supplied at every market price.

By contrast, in figure 6.12B, the supply curve has shifted to the right, perhaps because the price of cocoa (the main
input/ingredient) has fallen, making it cheaper to produce chocolate bars. Now, even though the price does not change, the
quantity supplied increases. The quantity supplied in the market can increase either because the price of the good has
increased, so that for a given supply curve, the quantity produced is higher; or because the supply curve has shifted, so that at
a given price, the quantity supplied has increased.

 6.3 Demand 6.5 Market equilibrium 

6.5 MARKET EQUILIBRIUM
Learning objective 5
explain how demand and supply curves can be used to determine the market equilibrium price and quantity of a good

It was asserted earlier in this chapter that supply and demand work together to determine the market price in competitive
markets. Figure 6.13 puts a market supply curve and a market demand curve on the same graph to show how this happens.
The price actually paid and received in the market will be determined by the intersection of the two curves. This point is
labelled E0, for equilibrium, and the corresponding price ($0.75) and quantity (20 million) are called, respectively, the
equilibrium price and the equilibrium quantity.

FIGURE 6.13 Supply and demand equilibrium

Equilibrium occurs at the intersection of the demand and supply curves, at point E0. At any price above E0, the quantity supplied will exceed the
quantity demanded, the market will be out of equilibrium, and there will be excess supply. At any price below E0, the quantity demanded will exceed
the quantity supplied, the market will be out of equilibrium, and there will be excess demand.

Since the term equilibrium will recur throughout the book, it is important to understand the concept clearly. Equilibrium
describes a situation where there are no forces (reasons) for change. No one has an incentive to change the result — the price
or quantity consumed or produced, in the case of supply and demand.
Physicists also speak of equilibrium in describing a weight hanging from a spring. Two forces are working on the weight.
Gravity is pulling it down; the spring is pulling it up. When the weight is at rest, it is in equilibrium, with the two forces just
offsetting each other. If someone pulls the weight down a little bit, the force of the spring will be greater than the force of
gravity, and the weight will spring up. In the absence of any further interventions, the weight will bob back and forth and
eventually return to its equilibrium position.
An economic equilibrium is established in the same way. At the equilibrium price, consumers get precisely the quantity of
the good they are willing to buy at that price, and producers sell precisely the quantity they are willing to sell at that price.
The market clears. To emphasise this condition, economists sometimes refer to the equilibrium price as the market clearing
price. In equilibrium, neither producers nor consumers have any incentive to change.
Consider the price of $1 in figure 6.13. There is no equilibrium quantity here. First, find $1 on the vertical axis. Now look
across to find point A on the supply curve, and read down to the horizontal axis; point A tells you that at a price of $1, firms
want to supply 34 million chocolate bars. Now look at point B on the demand curve. Point B shows that at a price of $1
consumers want to buy only 13 million chocolate bars. Like the weight bobbing on a spring, however, this market will work
its way back to equilibrium in the following way. At a price of $1, there is excess supply. As producers discover that they
cannot sell as much as they would like at this price, some of them will lower their prices slightly, hoping to take business
from other producers. When one producer lowers prices, his competitors will have to respond, for fear that they will end up
unable to sell their goods. As prices come down, consumers will also buy more, and so on until the market reaches the
equilibrium price and quantity.
Similarly, assume that the price is lower than $0.75, say $0.50. At the lower price, there is excess demand: individuals want
to buy 30 million chocolate bars (point C), while firms want to produce only 5 million (point D). Consumers unable to
purchase all they want will offer to pay a bit more; other consumers, afraid of having to do without, will match these higher
bids or exceed them. As prices start to increase, suppliers will also have a greater incentive to produce more. Again, the
market will tend toward the equilibrium point.
To repeat for emphasis: at equilibrium, no purchaser and no supplier has an incentive to change the price or quantity. In
competitive market economies, actual prices tend to be the equilibrium prices at which demand equals supply. This is called
the law of supply and demand. Note: this law does not mean that at every moment of time the price is precisely at the
intersection of the demand and supply curves. Like the weight on a spring described above, the market may bounce around a
little bit when it is in the process of adjusting. What the law of supply and demand does say is that when a market is out of
equilibrium, there are predictable forces for change.

Using demand and supply curves

The concepts of demand and supply curves — and market equilibrium as the intersection of demand and supply curves —
constitute the economist’s basic model of demand and supply. This model has proved to be extremely useful. It helps explain
why the price of a given commodity is high, and that of some other commodity is low. It also helps predict the consequences
of certain changes. Its predictions can then be tested against what actually happens. One of the reasons that the model is so
useful is that it gives reasonably accurate predictions.
Figure 6.14 repeats the demand and supply curve for chocolate bars. But assume now that cocoa becomes more expensive.
As a result, at each price the amount of chocolate firms are willing to supply is reduced. The supply curve shifts to the left, as
in panel A. There will be a new equilibrium, at a higher price and a lower quantity of chocolate consumed.
FIGURE 6.14 Using supply and demand curves to predict price changes
Initially the market for chocolate bars is in equilibrium at E0. An increase in the cost of cocoa shifts the supply curve to the left, as shown in panel A.
At the new equilibrium, E1, the price is higher and the quantity consumed is lower. A shift in taste away from chocolate results in a leftward shift in
the demand curve as shown in panel B. At the new equilibrium, E2, the price and the quantity consumed are lower.

Alternatively, assume that Australians become more health conscious, and, as a result, at each price fewer chocolate bars are
consumed: the demand curve shifts to the left, as shown in panel B. Again, there will be a new equilibrium, at a lower price
and a lower quantity of chocolate consumed.
This illustrates how changes in observed prices can be related either to shifts in the demand curve or to shifts in the supply
curve. To take a different example, there have been wars in the oil-producing regions of the Middle East (like Iraq in 2003).
The model predicted the result: an increase in the price of oil. This increase was the natural outcome of the law of supply and
demand.

Consensus on the determination of prices

The law of supply and demand plays such a prominent role in economics that there is a joke about teaching a parrot to be an
economist simply by training it to say ‘supply and demand’. That prices are determined by the law of supply and demand is
one of the most longstanding and widely accepted ideas of economists. In competitive markets, prices are determined by the
law of supply and demand. Shifts in the demand and supply curves lead to changes in the equilibrium price.
Similar principles apply to the labour and capital markets, although the impact in the more regulated labour market varies.
The price for labour is the wage, and the price for capital is the interest rate.

 6.4 Supply 6.6 The price elasticity of demand 

6.6 THE PRICE ELASTICITY OF DEMAND
Learning objective 6
describe what is meant by the concept of price elasticity of demand

Prices are the way participants in the economy communicate with one another. During the long eastern Australia drought from the early
2000s to 2010, the supply of many agricultural products was reduced. Households might have needed to lower their consumption of some
milk products like yoghurt as production dropped, or there would not be enough to go around. But how would they know this?
Suppose newspapers across the country ran an article informing people they would have to consume less yoghurt because of the drought.
What incentive would they have to pay attention to it? How would each family know how much it ought to reduce its consumption?
Alternatively, consider the effect of an increase in the price of yoghurt. The higher price conveys all the relevant information. It
simultaneously tells families yoghurt is scarce and provides incentives for them to consume less of it. Consumers do not need to know
anything about why yoghurt is scarce, nor do they need to be told how much to reduce their consumption of it.
In this chapter, we develop some of the concepts needed to make these sorts of predictions. In addition, we examine what happens when
governments intervene with the workings of competitive markets. High rents and expensive food may seem to block poor people’s access to
adequate housing and nutrition, farmers may feel that the prices of their crops are too low, and Australian manufacturing workers may
object to competing with labourers producing similar goods in low-wage countries, like China. Political pressures are constantly brought to
bear on government to intervene on behalf of groups that feel disadvantaged by the workings of the market. Finally, we track some of the
consequences of these political interventions.
To predict the effects of a tax on petrol on how much people drive or of a carbon tax on the price of electricity, we must start by asking what
substitutes exist for the good in question. If the price of petrol rises, consumers have an incentive to buy less petrol and to drive less, walk,
ride a bike or catch public transport instead. If a new tax pushes up the price of petrol, drivers have an incentive to reduce their consumption
of petrol; but doing so may be difficult for those who have to drive to work in cars with conventional engines. Some may be able to catch
public transport, but many will be hard-pressed to find an alternative means of transportation. And switching to an electric or hybrid vehicle
can be costly.
As these examples illustrate, substitutes exist for almost every good or service, but substitution will be more difficult for some goods and
services than for others. When substitution is difficult, an increase in the price of a good will not cause the quantity demanded to decrease
by much, and a decrease in the price will not cause the quantity demanded to increase much.
When substitution is easy, as in the case of orange juice, an increase in price may lead to a large decrease in the quantity demanded. Ice-
cream is another example of a good with many close substitutes. A price increase for ice-cream means that frozen yogurt, gelato and similar
products become relatively less expensive, and the demand for ice-cream would, thus, significantly decrease. The demand curve for a good
with many substitutes will be relatively flat: changes in price cause large changes in the quantity demanded.
For many purposes, economists need to be precise about how steep or how flat the demand curve is. They therefore use the concept of the
price elasticity of demand (for short, the price elasticity or the elasticity of demand), which is defined as the percentage change in the
quantity demanded divided by the percentage change in price. In mathematical terms,

percentage change in quantity demanded
elasticity of  demand = .
percentage change in price

If the quantity demanded changes 8 per cent in response to a 2 per cent change in price, then the elasticity of demand is 4. (Price elasticities
of demand are really negative numbers; that is, when the price increases, quantities demanded are reduced. But the convention is to simply
give the elasticity’s absolute value with the understanding that it is negative.)
It is easiest to calculate the elasticity of demand when there is just a 1 per cent change in price. Then the elasticity of demand is just the
percentage change in the quantity demanded. In the telescoped portion of figure 6.15A, we see that increasing the price of orange juice from
$2 a litre to $2.02 — a 1 per cent increase in price — reduces the demand from 100 million litres to 98 million, a 2 per cent decline. So the
price elasticity of demand for orange juice is 2.
By contrast, assume that the price of petrol increases from $2 a litre to $2.02 (again, a 1 per cent increase in price), as shown in the
telescoped portion of figure 6.15B. This reduces demand from 100 million litres per year to 99.8 million. Demand has gone down by 0.2 per
cent, so the price elasticity of demand is therefore 0.2. Larger values for price elasticity indicate that demand is more sensitive to changes in
price. Smaller values indicate that demand is less sensitive to price changes.
FIGURE 6.15 Elastic versus inelastic demand curves
Panel A shows a hypothetical demand curve for orange juice. Note that the quantity demanded changes greatly with fairly small price changes, indicating that demand
for orange juice is elastic. The telescoped portion of the demand curve shows that a 1 per cent rise in price leads to a 2 per cent fall in quantity demanded. Panel B
shows a hypothetical demand curve for petrol. Note that the quantity demanded changes very little, regardless of changes in price, indicating that demand for petrol is
inelastic. The telescoped portion of the demand curve shows that a 1 per cent rise in price leads to a 0.2 per cent fall in quantity demanded.

Elastic versus inelastic demand curves

Drag the sliders to view how much the quantity demanded changes with the same price increases for two
goods — one for which demand is elastic (A) and one for which demand is inelastic (B).
PRICE ($)

PRICE ($)
0

0
82

90

10

98
99
10

LITRES OF ORANGE JUICE (MILLIONS) LITRES OF PETROL (MILLIONS)

Price elasticity and revenues

The revenue received by a firm in selling a good is its price times the quantity sold. We can write this definition in a simple equation.
Letting R denote revenues, p price, and Q quantity:
R = pQ.
Thus, when price goes up by 1 per cent, the effect on revenues depends on the magnitude of the decrease in quantity. If quantity decreases
by more than 1 per cent, then total revenues decrease; by less than 1 per cent, they increase. We can express this result in terms of the
concept of price elasticity. When the elasticity of demand is greater than 1, the change in quantity more than offsets the change in prices; we
say that the demand for that good is relatively elastic, or sensitive to price changes, and revenues decrease as price increases and increase
as price decreases. For example, the demand for different brands of personal computers is judged to be relatively elastic.
In the case in which the price elasticity is 1, the decrease in the quantity demanded just offsets the increase in the price, so price increases
have no effect on revenues. This is called unitary elasticity. Many basic food products and entertainment activities, such as going to the
movies, are considered to have unitary elasticities of demand. If the price elasticity is less than 1, then a 1 per cent increase in the price of a
good will reduce the quantity demanded by less than 1 per cent. Since demand falls little when elasticities are in this range, between 0 and
1, price increases for such goods will increase revenues. And price decreases will decrease revenues. We say the demand for these goods is
relatively inelastic, or insensitive to price changes.
Business firms must pay attention to the price elasticity of demand for their products. Suppose a cement producer, the only one in town, is
considering a 1 per cent increase in price. The firm hires an economist to estimate the elasticity of demand so that it will know what will
happen to sales after the increase. The economist tells the firm that its demand elasticity is 2. This means that if the price of cement rises by
1 per cent, the quantity sold will decline by 2 per cent.
The firm’s executives will not be pleased by the findings. To see why, assume that initially the price of cement was $1000 per ton, and 100
000 tonnes were sold. To calculate revenues, you multiply the price times the quantity sold. So, initially revenues were $1000 × 100 000 =
$100 million. With a 1 per cent increase, the price will be $1010. If the elasticity of demand is 2, then a 1 per cent price increase results in a
2 per cent decrease in the quantity sold: sales drop to 98 000 tonnes. Revenues are down to $98.98 million ($1010 × 98 000), a fall of just
slightly over 1 per cent. Because of the high elasticity, this cement firm’s price increase leads to a decrease in revenues.
The price elasticity of demand works the same way for price decreases. Suppose the cement producer decided to lower the price of cement 1
per cent, to $990. With an elasticity of demand of 2, sales would then increase 2 per cent, to 102 000 tonnes. Thus, revenues would increase
to $100 980 000 ($990 × 102 000) — that is, by a bit less than 1 per cent.
There are two extreme cases that deserve attention. One is that of a flat demand curve — a curve that is perfectly horizontal. We say that
such a demand curve is perfectly elastic, or has infinite elasticity, since even a slight increase in the price results in demand dropping to
zero. The demand curve facing a firm that produces computer memory chips is perfectly elastic; if the manufacturer tried to charge a
slightly higher price for its chips, sales would fall to zero as buyers would simply buy their memory chips elsewhere. The other extreme
case is that of a demand curve that is perfectly vertical. We say that such a demand curve is perfectly inelastic, or has zero elasticity, since,
whatever the price, demand remains the same. The rabid sports fan’s demand for an AFL or NRL grand final ticket may in effect be
perfectly inelastic; no matter how much it costs, the fan will buy a ticket. Table 6.1 summarises the different cases that we have discussed,
together with some illustrative examples of goods with differing elasticities of demand.

TABLE 6.1

Price elasticity of demand

ELASTICITY DESCRIPTION EFFECT ON QUANTITY DEMANDED OF EFFECT ON REVENUES OF 1% EXAMPLES

1% INCREASE IN PRICE INCREASE IN PRICE

Zero Zero elasticity (vertical Zero (no effect) Increased by 1% AFL or NRL grand
demand curve) final tickets

Between 0 and Relatively inelastic Reduced by less than 1% Increased by less than 1% Petrol
1

1 Unitary elasticity Reduced by 1% Unchanged Going to the movies

Greater than 1 Relatively elastic Reduced by more than 1% Reduced; the greater the elasticity, the Brands of PCs
more revenue is reduced

Infinite Infinite elasticity Reduced demand to zero Reduced to zero Brands of memory
(horizontal demand curve) chips

The following figures of demand curves illustrate the different categories of price elasticity of demand using demand curves. Note that the
flatter the demand curve gets; the more price elastic demand becomes. (Aside: the slope of a demand curve is not price elasticity of demand
per se.)
THINKING LIKE AN ECONOMIST
Price changes and differences
Price changes and differences present interesting problems and puzzles. Between 1998 and 2008, inflation was about 36 per cent and
house property prices increased by more than 300 per cent in all Australian capital cities except Melbourne (up 280 per cent) and Sydney
(up 180 per cent).7 Why? During the same period, the price of computers fell dramatically, while the price of bread rose, but at a much
slower rate than the price of Australian housing. Why? The ‘price’ of labour is just the wage or salary that is paid. Why does a medical
specialist earn three or four times as much as a university professor, although the university professor may have performed better in the
university courses they took together? Why is the price of water, without which we cannot live, very low in most cases, but the price of
diamonds very high? The simple answer to all these questions is that in market economies like that of Australia, price is determined by
supply and demand. Changes in prices are determined by changes in supply and demand.
Understanding the causes of changes in prices and being able to predict their occurrence are not just matters of academic interest. One of
the events that precipitated the French Revolution was the rise in the price of bread, for which the people blamed the government.
Similarly, in Australia, large electricity price increases in the three years prior to the introduction of the carbon tax on 1 July 2012 were a
topic of hot political debate (and the price of electricity remained a hot topic following the repeal of the carbon tax by the Abbott Liberal
government in 2014).
Why are doctors, on average, paid more than lawyers? And why are lawyers paid more than school teachers? Why does a university
lecturer make more than a lightly skilled fast food worker? And why has the wage gap between university graduates and those with only
a lower high school education widened in recent years? The concepts of demand and supply developed earlier in the chapter can help us
answer these questions. Moreover, these concepts help us predict what will happen if the government increases the tax on cigarettes or
the tax on alcohol. But economists are usually interested in more specific predictions. They want to know how much the tax on
cigarettes would need to be raised if the goal is to lower tobacco consumption by, say, 10 per cent, or how much flooding in vegetable-
growing areas in Queensland will reduce vegetable production and increase the price of vegetables.

CRITICAL THINKING
What influence does the elasticity of demand for a good like vegetables have on the large price variations evidenced in vegetable prices
throughout a year?

 6.5 Market equilibrium Summary 

SUMMARY
Learning objective 1: explain key concepts that define core ideas in economics
Economics is the study of how individuals, firms and governments within our society make choices. Choices and
trade-offs are unavoidable because desired goods, services and resources are inevitably scarce. Making choices
requires information. Limited or imperfect information can interfere with incentives and affect the ability of the private
market to ensure an efficient use of society’s scarce resources. The opportunity cost is the cost of using any resource. It
is measured by looking at the next-best use to which that resource could be put.
Exchange occurs in markets. Voluntary exchange can benefit both parties. The term ‘market’ is used to describe any
situation where exchange takes place. In the market economy, individuals, firms and government interact in product
markets, labour markets and capital markets.
The two major branches of economics are microeconomics and macroeconomics. Microeconomics focuses on the
behaviour of the firms, households and individuals that make up the economy. Macroeconomics focuses on the
behaviour of the economy as a whole.
Learning objective 2: understand the science behind economics
Economics can be considered a social science. It is interested in understanding the social world by investigating in a
systematic and objective manner. This is done by constructing and testing models.
Learning objective 3: understand what a demand curve is, explain why it slopes downwards, and describe
sources of shifts in demand curves
An individual’s demand curve gives the quantity demanded of a good at each possible price. It normally slopes down,
which means that the person demands a greater quantity of the good at lower prices and a lesser quantity at higher
prices. The market demand curve gives the total quantity of a good demanded by all individuals in an economy at each
price. As the price rises, demand falls, both because each person demands less of the good and because some people
exit the market.
Learning objective 4: understand what a supply curve is, explain why it slopes upwards, and describe sources of
shifts in supply curves
A firm’s supply curve gives the amount of a good the firm is willing to supply at each price. It is normally upward
sloping, which means that firms supply a greater quantity of the good at higher prices and a lesser quantity at lower
prices. The market supply curve gives the total quantity of a good that all firms in the economy are willing to produce
at each price. As the price rises, supply rises, both because each firm supplies more of the good and because some
additional firms enter the market.
Learning objective 5: explain how demand and supply curves can be used to determine the market equilibrium
price and quantity of a good
The law of supply and demand says that in competitive markets, the equilibrium price is that price at which quantity
demanded equals quantity supplied. It is represented on a graph by the intersection of the demand and supply curves.
Learning objective 6: describe what is meant by the concept of price elasticity of demand
The price elasticity of demand describes how sensitive the quantity demanded of a good is to changes in the price of
the good. When demand is inelastic, an increase in the price has little effect on the quantity demanded and the demand
curve is steep; when demand is elastic, an increase in the price has a large effect on the quantity demanded and the
curve is flat. The price elasticity of supply describes how sensitive the quantity supplied of a good is to changes in the
price of the good. If price changes do not induce much change in supply, the supply curve is very steep and is said to
be inelastic. If the supply curve is very flat, indicating that price changes cause large changes in supply, supply is said
to be elastic.

Review questions
1. Why are trade-offs unavoidable? Why are incentives important in understanding choices?
2. After a voluntary exchange, why are both parties better off?
 3. Why might there be a trade-off between equity and efficiency?
4. What is a mixed economy? Describe some of the roles government might play, or not play, in a mixed economy.
5. Name the three main economic markets, and describe how an individual might participate in each one as a buyer or a
seller.
6. Give two examples of economic issues that are primarily microeconomic and two examples that are primarily
macroeconomic. What is the general difference between microeconomics and macroeconomics?
7. Why does an individual’s demand curve normally slope down? Why does a market demand curve normally slope down?
8. Why does a firm’s supply curve normally slope up? Why does a market supply curve normally slope up?
9. What is the significance of the point where supply and demand curves intersect?
10. Explain why, if the price of a good is above the equilibrium price, the forces of supply and demand will tend to push the
price toward equilibrium. Explain why, if the price of the good is below the equilibrium price, the market will tend to
adjust toward equilibrium.
11. Name some factors that could shift the demand curve out to the right.
12. Name some factors that could shift the supply curve in to the left.
13. What is meant by the elasticity of demand and the elasticity of supply? Why do economists find these concepts useful?
14. Is the slope of a perfectly elastic demand or supply curve horizontal or is it vertical? Is the slope of a perfectly inelastic
demand or supply curve horizontal or is it vertical? Explain.
15. If the elasticity of demand is 1, what happens to total revenue as the price increases? What if the demand for a product is
very inelastic? What if it is very elastic?
16. Under what condition will a shift in the demand curve result mainly in a change in quantity? In price?
17. Under what condition will a shift in the supply curve result mainly in a change in price? In quantity?

Problems
1. Characterise the following events as microeconomic, macroeconomic, or both.
a. Unemployment increases this month.
b. A pharmaceutical company invents and begins to market a new medicine.
c. A bank lends money to a large company but turns down a small business.
d. Interest rates decline for all borrowers.
e. A union negotiates for higher pay and better health insurance.
f. The price of petrol increases.
2. Characterise the following events as part of the labour market, the capital market or the product market.
a. An investor tries to decide which company to invest in.
b. With practice, the workers on an assembly line become more efficient.
c. The opening up of economies in Eastern Europe offers new markets for Australian products.
d. A big company that is losing money decides to offer its workers special incentives to retire early, hoping to reduce its
costs.
e. A consumer roams around a shopping mall looking for birthday.pngts.
f. The federal government uses a surplus to pay off some of its debt.
3. During 2011, some economists argued that the Reserve Bank of Australia should undertake policies to slow the economic
expansion in Australia as a result of the mining boom in order to ensure low inflation. Other economists are opposed to
such policies, arguing that the dangers of inflation were exaggerated and attempts by the Reserve Bank to slow the
economy would lead to higher unemployment. Is this a disagreement about positive economics, or about normative
economics? Explain.
4. Suppose an underground reservoir of coal seam gas is located under properties owned by several different individuals. As
each well is drilled, it reduces the amount of coal seam gas that others can take out. Compare how quickly the coal seam
gas is likely to be extracted in this situation with how quickly it would be extracted if one person owned the property
rights to drill for the entire seam of coal gas.
5. Kathy, a university student, has $20 a week to spend. She spends it either on junk food at $2.50 a snack, or on petrol at $2
per litre. Draw Kathy’s opportunity set. What is the trade-off between junk food and petrol? Now draw each new budget
 constraint she would face if:
a. a kind relative started sending her an additional $10 per week
b. the price of a junk food snack fell to $2
c. the price of petrol rose to $2.50 per litre.
In each case, how does the trade-off between junk food and petrol change?
6. Why is the opportunity cost of going to medical school likely to be greater than the opportunity cost of studying science
at university? Why is the opportunity cost of a woman with a university education having a child greater than the
opportunity cost of a woman with just a high school education having a child?
7. Suppose a severe drought hits the sugarcane crop. Predict how this will affect the equilibrium price and quantity in the
market for sugar and the market for honey. Draw supply and demand diagrams to illustrate your answers.
8. Imagine that a new invention allows each mine worker to mine twice as much coal. Predict how this will affect the
equilibrium price and quantity in the market for coal and the market for heating oil. Draw supply and demand diagrams
to illustrate your answers.
9. Australian tastes have shifted away from beef and towards chicken and seafood. Predict how this change has affected the
equilibrium price and quantity in the market for beef, the market for chicken and the market for seafood. Draw supply
and demand diagrams to illustrate your answers.
10. In 2011, the Japanese became very concerned about eating potentially contaminated food following the Fukushima
nuclear reactor meltdown. What would this concern do to the demand curve for Japanese‐produced food products? To the
demand curves for overseas imports of the same foods? And to the equilibrium price of Japanese‐produced food
products?
11. Many advanced industrialised countries (except Australia) subsidise farmers. Assume that the effect of the subsidy is to
shift the supply curve of agricultural products by farmers in those subsidising countries to the right. Why might Australia
and other non‐subsidising countries be unhappy with such policies?
12. Suppose the price elasticity of demand for petrol is 0.2 in the short run and 0.7 in the long run. If the price of petrol rises
28 per cent, what effect on quantity demanded will this have in the short run? In the long run?
13. Imagine that the short‐run price elasticity of supply for a farmer’s corn is 0.3, while the long-run price elasticity is 2. If
prices for corn fall 30 per cent, what are the short‐run and long‐run changes in quantity supplied? What are the short‐ and
long‐run changes in quantity supplied if prices rise by 15 per cent? What happens to the farmer’s revenues in each of
these situations?
14. Assume that the demand curve for cigarettes is highly inelastic and the supply curve for cigarettes is highly elastic. If the
tastes of the public shift away from smoking (say, due to federal government plain‐packaging laws), will the effect be
larger on price or on quantity? If the federal government decides further to impose a tax on manufacturers of cigarettes,
will the effect be larger on price or on quantity? What is the effect of an advertising program that succeeds in
discouraging people from smoking? Draw diagrams to illustrate each of your answers.

 6.6 The price elasticity of demand Endnotes 

ENDNOTES
1. Choice website, www.choice.com.au.
2. HIH Royal Commission, www.hihroyalcom.gov.au.
3. J Holmes (2005), ‘Total recall’, Four Corners, ABC TV, www.abc.net.au/4corners.
4. S Elks & J Owens (2011), ‘Cyclone Yasi to see banana prices stay high till midwinter’, The Australian, 4 April,
www.theaustralian.com.au.
5. ‘Growing’, Australian Bananas website, www.australianbananas.com.au.
6. WA Donnelly (1982), ‘The regional demand for petrol in Australia’, Economic Record, vol. 58, no. 4, pp. 317–27; and R
Breunig & C Gisz (2009), ‘An exploration of Australian petrol demand’, Economic Record, vol. 85, pp. 73–91.
7. Nigel Stapledon (2010), ‘A history of housing prices in Australia 1880–2010’, UNSW Australian School of Business
Research Paper, no. 2010 ECON 18.

 Summary 7 Profit, cost and revenue 

 CHAPTER 7

Profit, cost and revenue

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

7.1 explain why it is important to distinguish between economic and accounting profit
7.2 understand the difference between a firm’s short-run and long-run costs of production
7.3 understand total, average and marginal revenue, their curves and their relationships with each other
7.4 explain the role of the equi-marginal principle in deciding how much a rational firm will produce, and understand the
differences between profit maximising, breaking even and shutting down.

 Endnotes 7.1 Profit 

7.1 PROFIT
Learning objective 1
explain why it is important to distinguish between economic and accounting profit

Most economists agree that the central objective of businesses is to make profit from the production and sale of goods and
services. Of course, businesses may have other concerns as well — they may want to be good corporate citizens who pay
their workers well or who don’t use slave labour or who don’t pollute the environment — but if an entrepreneur or manager
doesn’t keep their eye on the prize of profit, they may face an unhappy future. An entrepreneur who doesn’t pay attention to
revenue versus costs may be driven into bankruptcy, or may find themselves being ‘out-competed’ by rivals. A company
manager who doesn’t strive to make a profit for shareholders could find themselves being sacked at the company’s next
general meeting. And in any case, most people who go into business are not doing so for laughs — they’re doing it to make
money! So the seeking of profit is taken by most economists to be absolutely essential to understanding how the majority of
businesses make the decisions they do.
In this section, we will examine what most economists mean by profit. No matter what the type of firm and no matter what
the type of the industry (i.e. market), the concepts outlined here will apply universally.

Accounting profit, economic profit and normal profit

Economists make a distinction between economic profit and accounting profit. Accounting profit is simply the total revenue
from sales over and above the total explicit cost of production.
Accounting profit = total revenue – total explicit cost
Explicit cost just means the monetary payments made to acquire the inputs needed to produce a good/service (e.g. payments
for space, equipment, workers and raw materials). (If we want, we can also include marketing costs, although strictly
speaking, this is not a cost of production per se; it is the cost of selling the output.)
Economic profit (which is also called supernormal profit), however, is the total revenue over and above the total explicit and
implicit cost of production.
Economic profit = total revenue – total explicit cost – total implicit cost
What does implicit cost mean? This is the income the entrepreneur foregoes in order to run their business. For example, to
run a café an entrepreneur may have to give up, say, $60 000 per year working for an accounting firm. Or they may have to
use a property they own to set up their café, in which case they would have to give up, say, $40 000 per year in rent they
could have obtained by leasing it to someone else. Or they may have to use their own savings to buy plant and equipment
when they start, in which case they would have to give up interest payments of, say, $10 000 per year since they no longer
have that money in the bank. From the economist’s perspective this foregone income is in fact a cost — an implicit cost — of
running the business. Economists argue that it would be irrational to ignore these implicit costs, so they include them
alongside the explicit costs.
There is one more concept that most economists include that accountants don’t: normal profit. Normal profit refers to the
amount of money needed to cover the entrepreneur’s implicit costs of running their business. It may thus be thought of as the
minimum amount of money the business would have to pay the entrepreneur in order for them to remain interested in
running the business (that is, to stay in the market) in the long-run.

Why it is rational to focus on economic profit rather than accounting profit

Figure 7.1 is a diagrammatic representation of the contrast between economic (or supernormal) profit and accounting profit.
Let’s say the entrepreneur sets up a café and it generates $3000 revenue per week. The explicit cost the business (paying
wages, rent, etc.) is $1200 per week. From the accountant’s perspective, the business is generating $1800 per week in
accounting profits. The economist, however, would say the accountant has not taken account of all the business costs. The
entrepreneur incurs an implicit cost too — the income they could have earned, but gave up, in order to run their business.
The implicit cost (the ‘salary’ the entrepreneur pays themselves as compensation for this foregone income) is $1000 per
week. So the economist would say the entrepreneur’s economic (or supernormal) profit is really only $800 per week.

FIGURE 7.1 Economic profit vs accounting profit (case 1)

One might say that this is interesting, but doesn’t have an impact on whether the entrepreneur continues to run the café: from
both perspectives, the entrepreneur is still ‘making money’. Okay, but how about the situation in figure 7.2? Let’s say that for
some reason, the café suddenly suffers a fall in its total revenue so that it now only generates $2000 per week. The costs
remain the same as before.

FIGURE 7.2 Economic profit vs accounting profit (case 2)

What would the accountant say? ‘Well, total revenue minus total explicit costs = $800 accounting profit per week, so it’s not
as good as before, but it’s okay because you’re still making money from the business.’ But from the economist’s perspective,
the business is in serious trouble. Total revenue minus total explicit and implicit costs = –$200 economic profit per week. In
other words, the business is now making an economic loss. That loss comes out of the entrepreneur’s own pocket, so to
speak. The economist would say to the entrepreneur: ‘Hang on. You gave up $1000 per week doing something else (your
implicit costs) in order to gain $800 per week in accounting profit? You’re losing $200 per week! If your objective is to
make money, and this situation persists, then you should get out of this business!’ This is why it is important for
entrepreneurs (or at least those who are interested in making money) to always keep in mind their implicit costs.
 A puzzle to think about: are some entrepreneurs irrational?
In the example above we saw that the economist argues that despite making an accounting profit of $800, the
entrepreneur is actually making an economic loss: ‘You gave up $1000 per week doing something else (your implicit
costs) in order to gain $800 per week in accounting profit? You’re losing $200 per week!’ Here’s our puzzle: Many real-
world entrepreneurs, especially in small businesses, may be in precisely this situation — i.e. they could be making more
money doing something else. But does it really follow that they are irrational for persisting with their business ventures?
What if the entrepreneurs acknowledge the fact that they are making an economic loss in the current period, but
know that in the future, revenue will rise enabling them to make economic profit in the next period? Suffering an
economic loss now could be compensated for by economic profit later. So maybe it’s not irrational for our real-
world entrepreneurs to stay in business. So far, so good. But do real-life entrepreneurs actually know for sure what
the future holds? One might say, ‘Well, no, they don’t know for sure what the future holds, but they could at least
estimate the probability (the chances) of making economic profit in the future. If they don’t like to gamble with
their future, there would have to be a high probability of future profit. If they are comfortable with gambling, the
probability of future profit could be lower. As long as they are calculating their probability of future success, and
acting according to their tolerance for gambling, then they are behaving rationally.’ Fine. But do real-world
entrepreneurs actually calculate the probability of future economic profit? If they don’t — and you can ask them
yourself (it’s an empirical question) — then we would have to conclude that entrepreneurs who persist with their
business ventures despite making economic losses in the blind hope of making compensating economic profit in
the future are indeed behaving irrationally!
Is it possible for real-world entrepreneurs to openly dispute the claim that they are in fact making the economic loss
of $200 that the economist has calculated? Yes, it is possible. Imagine the entrepreneurs say something like this: ‘It
is true that I have given up $1000 per week working for someone else, but that does not truly reflect my implicit
costs. You see, I was utterly miserable working for someone else but now I am free to be my own boss. So, yes, I
did give up $1000 per week, but I also escaped $700 ‘worth’ of psychological misery. So what I really gave up was
only $300 per week [$1000 – $700]. So let’s recalculate my situation with this information in mind: I really gave
up $300 per week doing something else (my true implicit costs) in order to gain $800 per week in accounting
profit. I am making $500 per week economic profit!’ If this is true, then these entrepreneurs might at first glance
appear to be irrational for persisting with their business ventures, but on closer inspection, they might in fact be
behaving in an entirely rational way.

From now on, we won’t talk about implicit costs anymore. Just remember that whenever we talk about total cost or average
cost (i.e. cost per unit of output) from now on, we are assuming this includes both the explicit and implicit costs.

 7 Profit, cost and revenue 7.2 A firm’s costs of production 

7.2 A FIRM’S COSTS OF PRODUCTION
Learning objective 2
understand the difference between a firm’s short-run and long-run costs of production

Types of inputs
In order to produce output (some quantity of a good or service), an entrepreneur will need to acquire and combine productive
resources (or ‘inputs’ or ‘factors of production’). These resources are: labour (workers), capital (tools, equipment, machines,
buildings), intermediate inputs (raw materials), and space (land). Since all these resources are scarce, the entrepreneur will
have to pay money to use them (i.e. they will have prices). The traditional terms for these prices are: wages for labour, rent
for premises, and interest for capital. (The price of intermediate inputs/raw materials doesn’t have a special term.) As already
discussed at the beginning of the chapter, the entrepreneur’s services will also, in a sense, have a price because the
entrepreneur has to be compensated for their own time, effort and risk taken to run the business. The entrepreneur’s
compensation-return is called normal profit.

A quick aside on classifying inputs

Often it is pretty easy to classify inputs into one of the four categories identified above: raw materials, labour, capital and
space (or the term ‘land’), but sometimes it can be a bit confusing.
A car manufacturing company will purchase or rent land (i.e. space), then pay for a building to be constructed and
purchase machinery and tools which are installed in the building. Collectively, this gives us a factory (i.e. capital). Then it
hires skilled workers on long-term contracts (i.e. labour) and buys steel, electronics, tyres, mirrors, plastics, paint, etc.
(i.e. raw materials). Easy.
But what about an internet search engine company? We can identify the resources of labour (people working on
computers), capital (computers, chairs, desks, office buildings) and space (the land on which the office building stands).
But how do we classify the software programmes and the data bases of people’s internet histories the company purchases
and uses? To clarify how to classify these things, one should remember this formulation:
labour works on capital to transform raw material into output.
So, labour works on software programmes to transform people’s internet history data into lists of links for consumers.
The software programmes are capital and people’s internet history data are the raw materials.

The meanings of ‘short-run’ and ‘long-run’

When economists talk about the short-run, they mean a situation in which the firm cannot change the quantity of at least one
of the inputs used in the production process. In other words, at least one input is fixed in quantity. Usually at least one input is
variable (i.e. it can be changed in the short-run). (Strictly speaking, it is conceivable that all of the inputs are fixed. We can
call this the very short-run or a market period.)
As to which inputs are fixed in the short-run depends on the industry we are looking at. The traditional example is
manufacturing. In the short-run, usually the factory (the capital) and the space (land) is fixed, whereas the number of workers
(labour) employed and quantity of raw materials used is variable. The firm can hire and fire workers almost instantly; it can
order or more less raw materials almost instantly; but it cannot gain access to new land and build a new factory instantly —
that takes time, so in the short-run these two inputs are fixed. For a dentist’s surgery in the short-run, however, the capital, the
space and the labour are normally fixed; only the raw materials are variable. It turns out that hiring a new dentist who meets
the particular needs of a certain dental surgery can take almost as long as setting up an additional surgery! So these inputs are
fixed in the short-run. More swabs, crowns, false teeth, filling material, etc., however, can be purchased almost instantly.
The long-run, by contrast, is a situation in which the firm is able to change the quantities of all of the inputs used in the
production process. In other words, all of the inputs are variable. In the long-run, a firm can build as many new factories as it
wants and populate them all with workers and raw materials. So in the long-run a firm can change the scale of its operations.
This is not possible in the short-run.
Note that the actual length of time of the short-run and the long-run varies from industry to industry. For example, it may take
only six months for a café entrepreneur to increase the scale of their business by setting up another café. For a car
manufacturer on the other hand, it may take three years to set up another factory.
As can be seen in table 7.1, since in the short-run there are both fixed and variable inputs, it follows that we can divide up a
firm’s costs into fixed costs and variable costs. And in the long-run, there are only variable costs since all inputs can be
varied.

TABLE 7.1

A common division of short-run versus long-run inputs and costs

SHORT-RUN

Fixed inputs Capital Total fixed cost Interest payments

Space (land) Rental payments

Variable inputs Labour Total variable cost Wage payments

Raw materials Raw materials payments

LONG-RUN

Variable inputs Capital Total variable cost = total cost Interest payments

Space (land) Rental payments

Labour Wage payments

Raw materials Raw materials payments

Short-run costs
Fixed and variable costs
Some costs associated with inputs do not vary as the firm changes the level of production. For instance, the firm may need to
hire someone to run the HR office and someone to supervise the workers, and the cost of these inputs remain constant as
production varies (within limits). These costs are called fixed costs. Whether the firm produces nothing or produces at
maximum capacity, it antes up the same fixed costs. Figure 7.3 shows how costs depend on output. Panel A depicts fixed
costs as a horizontal line — by definition, they do not depend on the level of output. As an example, consider a would-be
farmer who has the opportunity to buy a farm and its equipment for $25 000. Their fixed costs are $25 000.
FIGURE 7.3 Fixed, variable, and total cost curves
Panel A shows a firm’s fixed cost; by definition, fixed costs do not depend on the level of output. Panel B shows a firm’s variable costs, which rise
with the level of production. The increasing slope of the curve indicates that it costs more and more to produce at the margin, which is a sign of
diminishing returns. Panel C shows a total cost curve. It has the same slope as the variable cost curve but is higher by the amount of the fixed costs.

Variable costs correspond to inputs that vary with the level of production. Any cost that the firm can change during the time
period under study is a variable cost. To the extent that the costs of such items as labour and materials can go up or down as
output does, these are variable costs. If our farmer has only one input to vary, labour, then the variable cost would be, say,
$15 per hour for each worker. The variable costs corresponding to levels of output are shown in table 7.2 and plotted in
figure 7.3B. As output increases, so do variable costs, and therefore the curve slopes upward.

TABLE 7.2

Cost of producing wheat

OUTPUT LABOUR TOTAL VARIABLE COST TOTAL MARGINAL AVERAGE AVERAGE

(TONNES) REQUIRED (AT A WAGE OF $15 PER COST COST ($ PER COST ($ PER VARIABLE COST ($
(HOURS) HOUR) ($) TONNE) TONNE) PER TONNE)

950 5000 75000 100000 — 105 79

1200 6000 90000 115000 60 95 75

1400 7000 105000 130000 75 93 75

1550 8000 120000 145000 100 94 77

1650 9000 135000 160000 150 97 82

1700 10000 150000 175000 300 103 88

Total costs
Table 7.2 also includes a column labelled ‘Total cost’. Total costs are defined as the sum of fixed and variable costs, so this
column is obtained by adding the farmer’s fixed costs of $25 000 to the variable costs. Thus,
total costs = total variable costs + fixed costs.
The total cost curve, summarising these points, is shown in figure 7.3C.
A puzzle to think about: the shape of the total cost curve and the total
variable cost curve
You will notice that both the short-run total cost curve and the total variable cost curve not only slope upwards but get
steeper as more is produced. Why is that?
Answer: it is because of what is called the law of diminishing marginal returns (‘marginal returns’ is also called ‘marginal
output’ or ‘marginal product’). This is a physical law of production that applies only in the firm’s short-run period. The
law says:
after some point, each additional unit of a variable input will contribute less to total output than the previous unit of that
type of input.
If we assume (for simplicity) that labour is the only variable input, the law can be more informally stated like this: after
some point, each new worker produces less than the previous worker employed. The table and figure below illustrate the
law’s effect on a wheat farm’s production.

Why does the law of diminishing marginal returns occur? It is not because each new worker is lazier or stupider than the
previous worker; we assume all the workers are the same. The real reason is that the farm is operating in the short-run,
which means it has a fixed amount of equipment and land. If the farmer keeps adding more and more workers to their
farm, then at some point, the next worker employed is simply going to have less to do than the previous worker, and so
they will contribute less to an increase in wheat production. (That doesn’t mean the farmer won’t hire them. It would still
be worth employing additional less-productive workers so long as the revenue generated by their contribution to output is
greater than the cost of hiring them.)
This law is just a physical law of production. How does it impact on the cost curves? Well, if each additional worker
produces less than the previous worker, it follows that if the farmer wants to increase output by constant increments, they
 will need to employ ever larger numbers of these ever less productive workers. And since each worker has to be paid the
same wage, the total wage bill (the total variable costs) will get larger and larger at an ever-growing rate. In other words,
the total variable costs will not just rise, but they will rise faster and faster. Graphically, this is represented by the total
variable cost curve getting steeper and steeper.
Now, since total costs are made of total variable costs + total fixed costs, the shape of the total cost curve copies the total
variable cost curve. Ta da!

Marginal cost and the marginal cost curve

Having come this far in studying economics, you know that rational decision-making depends on evaluating trade-offs in
terms of marginal costs and marginal benefits. If you have the opportunity to work more hours at your part-time job, you
need to evaluate the marginal cost — the other things you could do during those extra hours you will be working (like
studying economics, perhaps) — against the marginal benefit, here the extra income you will earn. Firms apply this same
logic in their decision-making: they focus on marginal costs and benefits. Thus, one of the most important cost concepts is
marginal costs, which are defined as the extra cost corresponding to each additional unit of production.
In the case of the wheat farmer’s costs (see table 7.2), as they increase labour input from 7000 hours to 8000 hours, output
increases from 1400 tonnes to 1550 tonnes. Thus, the marginal product of the extra 1000 hours of labour is 150 tonnes. If the
wage is $15 per hour, the cost of increasing output by 150 tonnes is $15 000 ($15 × 1000 extra hours). The marginal cost of
the extra 150 tonnes is $15 000. To determine the marginal cost per bushel, we divide the change in cost (C) by the change in
output (Q):

ΔC $15 000
  =     =  $100 per tonne.
ΔQ 150

The marginal cost curve traces out the marginal cost for each additional unit of output. To derive the marginal cost curve
using a graph, we start with the total cost curve. The marginal cost is the change in total cost (movements along the vertical
axis) resulting from each unit increase in output (movements along the horizontal axis). This is shown in panel A of figure
7.4. Panel B of figure 7.4 shows the same relationship in a different way. The slope of the line tangent to the total cost curve
at Q1 gives the marginal cost of Q1. Thus, the marginal cost curve represents the slope of the total cost curve at each quantity
of output.
FIGURE 7.4 Marginal cost and the marginal cost curve
Marginal cost is the change in total cost resulting from a one-unit increase in output, as illustrated in panel A. Thus, marginal cost is the slope of the
total cost curve at any given point (ΔC/ΔQ) (panel C). Panel C shows the marginal cost curve for the wheat farm example. Like the total cost curve,
the marginal cost curve is upward sloping, reflecting diminishing marginal returns. In this figure, only the rising portion of the marginal cost curve is
shown.

Panel C of figure 7.4 shows the marginal cost curve for the wheat farm example. Note that the curve is upward sloping, like
the total cost curve, which reflects the fact that as more is produced, it becomes harder and harder to increase output further.
This is an application of the familiar principle of diminishing marginal returns. In our wheat farm example, suppose the
farmer is considering increasing production by 10 tonnes. If his current level of output is 1400 tonnes, the marginal cost of
this increase will be $100. But if his current level of output is 1550 tonnes, increasing production by 10 tonnes will entail a
marginal cost of $150. At the higher level of output, the marginal cost is greater because of diminishing marginal returns to
labour.

Average cost and the average cost curve

A business firm also is concerned with its average cost. This is the total cost (TC) divided by output (Q), or
average cost = TC/Q.
The average cost curve gives average costs corresponding to different levels of output. Figure 7.5 shows the average cost
curve for our wheat farm example (along with the marginal cost curve, for reasons indicated below). Working from the total
cost curve (see figure 7.4C and table 7.2), we derive the average cost curve by dividing total costs (TC) by quantity (Q) at
each level of output. Thus, since it takes 7000 hours of labour to produce 1400 tonnes of wheat, and the wage is $15 per
hour, the total cost is $105 000 + $25 000 (the fixed cost), for an average cost of $93 per tonne ($130 000/1400 tonnes).
When output increases to 1550 tonnes, costs increase to $145 000, for an average cost of $94 per tonne.

FIGURE 7.5 Marginal and average cost curves

This figure shows the marginal cost curve and average cost curve for the wheat farm example of table 7.2. With diminishing returns to an input,
marginal costs increase with the level of output, giving the marginal cost curve its typical, upward-sloping shape. Average costs initially fall with
increased output, as fixed costs are spread over a larger amount of output, and then begin to rise as diminishing returns to the variable input become
increasingly important. Thus, the average cost curve is typically U-shaped. With a U-shaped average cost curve, the marginal cost curve will cross the
average cost curve at its minimum. In this figure, only the rising portion of the marginal cost curve is shown.

The typical average cost curve is U-shaped, like the one in figure 7.5. To understand why, we need to think about the two
parts of total costs — fixed costs and variable costs. Just to start production usually requires a significant expense on inputs.
These fixed costs do not vary with the level of output. As output increases, these costs are spread over more units of output,
so the average cost of each unit of output that is due to the firm’s fixed costs will fall. If these were the only costs the firm
faced, average costs would decline as output increases.
Firms also face variable costs. Because of diminishing returns, beyond some level of output the firm requires more and more
labour to produce each additional unit of output. Eventually, it may be almost impossible to increase output. This is why the
production function flattens out as output rises and the total cost curve in figure 7.4C becomes steeper as output increases.
Just as we defined average costs as total costs divided by output, we define average variable costs as total variable costs
divided by output:
total variable costs
average variable costs  =   .
output

Average variable costs increase with output as the law of diminishing returns sets in strongly. The final column of table 7.2
gives the average variable costs associated with producing wheat. At low levels of output, the falling average fixed costs
dominate, and average total costs decline. But once a high-enough level of output is achieved, rising average variable costs
start to dominate and average total costs increase. The result is the typical U-shape of the average cost curve, as shown in
figure 7.5.
Even if the average cost curve is U-shaped, the output at which average costs are lowest may be very great — so high that
there is not enough demand to justify producing that much. As a consequence, the industry will produce at an output level
below that at which average costs are lowest. When the average cost curve is U-shaped, average costs are declining at output
levels that are less than the minimum average cost level of production. Thus, an industry producing less than the output that
results in minimum average costs will be operating in the region where average costs are declining. When economists say
that an industry has declining average costs, they usually do not mean that average costs are declining at all levels of output.
Instead, they typically mean that costs are declining at the output levels at which the industry is currently producing.

Relationship between average and marginal cost curves

The relationship between average costs and marginal costs is reflected in figure 7.5. The marginal cost curve intersects the
average cost curve at the bottom of the U — the minimum average cost. To understand why the marginal cost curve will
always intersect the average cost curve at its lowest point, consider the relationship between average and marginal costs. As
long as the marginal cost is below the average cost, producing an extra unit of output will pull down average costs. Thus,
everywhere the marginal cost is below the average cost, the average cost curve is declining. If the marginal cost is above the
average cost, then producing an extra unit of output will raise average costs. So everywhere that the marginal cost is above
the average cost, the average cost curve must be rising.

Changing input prices and cost curves

The cost curves shown thus far are based on the fixed prices of the inputs (factors) the firm uses. An increase in the price of a
variable input like labour would shift the total, average, and marginal cost curves upward, as shown in figure 7.6. An
increase in fixed costs, such as an increase in the cost of the wheat farmer’s land, shifts the total cost and average cost curves
upward. Since fixed costs do not vary with output (by definition), a change in fixed costs does not affect the marginal cost
curve.
FIGURE 7.6 How changing input prices affect cost curves
An increase in the price of a variable factor shifts the total, average and marginal cost curves upwards. In this figure, only the rising portion of the
marginal cost curve is shown.

Changing production technology and cost curves

The way in which the inputs are combined in the firm depends on the knowledge of the production techniques available.
Economists call this production technology. So remember: ‘technology’ doesn’t mean silicon chips or physical things like
that; it means knowledge of techniques for combining inputs (although, of course, the known techniques for combining
labour and capital does depend on the kind of capital and the kind of labour available to a firm). Economists generally
assume that [rational] entrepreneurs will choose the least costly techniques available to them (i.e. that they know of).
Sometimes economists also assume, for reasons of simplification, that a firm’s technology is ‘given’ (i.e. fixed) for a period
of time.
Technological progress in production (also called technical progress in production) is when new knowledge of how to more
efficiently combine inputs is discovered and used; i.e. when a new production method is discovered which enables a firm to
produce more output with the same amount of inputs as before, or conversely, produce the same amount of output as before
using fewer inputs. There are various sources of technological progress (e.g. from R&D within one’s own firm, a rival firm, a
totally different industry, government research bodies or universities). Whatever the source, it almost always begins with the
invention of some new kind of equipment or new skills or new management techniques, and then innovation (i.e., the
productive application of the invention), as was discussed in the first two chapters. (Incidentally, technological progress in
production is very often accompanied by innovation in the nature of the product being produced for sale. For example,
technological innovation in car manufacturing [the production process] has also resulted in a technological innovation in the
kinds of cars produced [the output].)
In everything we’ve looked at so far with respect to cost curves, we have assumed that there is no innovation in production
technology. How would we graphically represent technological progress? Well, if there is technological progress so that a
firm is able to produce the same amount of output as before using fewer inputs, then it follows that (assuming nothing else
changes), no matter what amount of output is produced, the firm will not need to purchase as many inputs as before. And
because of that, the firm’s costs will be lower at every level of output. If the technology is ‘labour saving’ (and labour is the
main variable input), then the average total cost curve and the marginal cost curve will shift vertically downwards. This is
shown in figure 7.7 below.
FIGURE 7.7 How technological innovation in production affects cost curves

This is a ‘big deal’ for firms because it means that if they have the capacity and the wherewithal to engage in R&D to come
up with a technological innovation, they can effectively decrease their own costs relative to their competitors, and thus make
relatively more profit. As to whether they retain this cost advantage depends largely on the law of the land. If there are strong
patent and copyright laws, then a company may be able to prevent competitors from using ‘their’ technology. If there aren’t
such laws, rivals will eventually acquire that technology for themselves and use it to lower their own costs too. It has been
argued, for example, that many of the technologies developed by US companies have been ‘acquired’ by Chinese companies
to decrease their costs because they are not bound by US patent law.

Long-run costs
Recall that the short-run is a period during which a firm is unable to alter at least one of its inputs (i.e. at least one input is
fixed in quantity). The long-run is a situation where the firm is able to alter all of its inputs — the amount of labour, raw
materials, space/land and factories can all be increased or decreased. Although at any given moment a firm will be operating
in the short-run, it can plan its overall scale of operations over the long-run.
Obviously when a firm increases its scale, it is capable of producing significantly larger quantities of output. But that’s not
all: an increase in the scale of operations can have substantial effects on the firm’s short-run average cost.

Economies of scale
As a firm increases its scale, it is possible that good things can occur in terms of costs. First, there could be improvements in
the productivity of its inputs. Why?

1. As a firm gets larger, it tends to specialise the tasks to be performed by workers and creates a division of labour — i.e.
particular workers are divided up and assigned very specific tasks/jobs to do on a semi-permanent basis in the firm.
When workers specialise, rather than being a ‘jack of all trades’, they get very, very good at their job, and as a result, they
become more productive. The same number of workers can then produce more than they could before the increase in
scale of operations and subsequent specialisation.
2. As a firm gets larger, it can better utilise its existing fixed capital. For example, a firm may have a warehouse that is
under-utilised, but as the firm increases its scale, it can more fully use this resource without having to rent more space.
Another example is computer equipment. Often the computing-power of a firm’s software and hardware is under-utilised,
 but as the firm’s scale increases it can put this computing power to use without having to buy more computers and
software. Furthermore, as a firm increases its scale, it may be able to acquire new, more productive capital that further
increases the firm’s overall productive capacity relative to when it was smaller (think, for example, of the powerful,
sophisticated computing capital used by large bank versus the laptop computer that a small business uses).

Second, in addition to improved productivity of inputs, as a firm gets larger it may also be able to take advantage of lower
input prices compared to when it was smaller in scale. A very large firm usually needs vast quantities of inputs from raw
materials suppliers, and thus ‘buys in bulk’. Such firms can usually get a discount on the price of the raw materials —
something small-scale firms cannot do. The same applies when borrowing money to finance new factories and the like. A
large corporation can usually negotiate a lower interest rate on a loan than can a small-scale firm.
All these factors contribute to a fall in a firm’s short-run average total costs as it increases in scale and produces more output.
We call this phenomenon economies of scale. In the long-run, the firm’s average total costs — its long-run average total
costs — decrease. We can see this graphically in figure 7.8. This shows the short-run average total cost curves shift
rightwards and downwards as the firm’s scale increases. The long-run average total cost curve is the lowest points on these
short-run curves.

FIGURE 7.8 Long-run ATC curve with economies of scale

As we can see in figure 7.8, as the firm gets larger (shown by more factories), its short-run average cost curves shift
rightwards and downwards reflecting the economies of scale. If the firm is planning to produce output of Q1, it can choose
between doing it with one factory (with ATC(1 factory) curve) or two factories (with ATC(2 factories) curve). As you can see, it
is less costly to produce Q1 using two factories rather than one. The same applies if the firm is planning to produce Q2. And
so on. For this reason, when making long-run decisions about scale, the firm will only ever be interested in the lowest points
on the short-run ATC curves, as indicated by the ‘thick’ line in the graph. This line is the long-run ATC curve. And thanks to
the economies of scale, it is negatively sloped. It is also ‘lumpy’. If we wanted to make it nice and smooth, we would need
intermediate short-run ATC curves like shown in figure 7.9.
FIGURE 7.9 Smooth long-run ATC curve with economies of scale

Diseconomies of scale
But it’s not all good news. It is possible for a firm to get ‘too big for its boots’, so to speak. This means a firm could become
so large in scale that it starts to experience increases in its average total costs. Again, there are two types of factors at work
here. The first is the negative impact on input productivity.

1. As a firm becomes very large and takes advantage of the specialisation and division of labour, workers may start to feel
alienated from their jobs and the company for whom they work. This is especially the case if their jobs are boring,
repetitive and devoid of meaning; or if they are put under considerable pressure to maintain high output levels by cruel
and indifferent managers. In such circumstances workers lose motivation and look for ways of avoiding work. As a
result, labour productivity falls.
2. There are also management coordination problems associated with increasing a firm’s scale. Assuming that the number
of managers in a firm remains constant, as a firm’s scale of operations increase it becomes more and more difficult to
efficiently coordinate and control the production process. Not only does it become difficult to keep an eye on workers
(who, due to alienation, seek to avoid work), but all of the other managerial decisions associated with running a large-
scale firm start to become overwhelming. Managers start to suffer from ‘cognitive overload’, make poor decisions, and
thus become less productive. One might say that the obvious solution to this problem is to simply increase the number of
managers to match the increased scale of the firm’s overall operations. Yes, that does happen, but there is now another
problem lying in wait. Managers need supervision too, so one would need to hire more managers to manage them. But
what about these managers-of-managers? Who will manage them? Well, more managers, of course. In short, a
bureaucracy starts to grow within the firm. And one of the characteristics of bureaucracies is that they tend to grow like a
cancer by inventing ever-more ‘fictitious’ work for themselves, which contributes nothing to the firm’s output.

The second negative impact on a firm’s average total costs due to increasing scale relates to higher input prices. How so?
When a firm becomes very large and thus has a large workforce which is alienated, workers may band together to form a
union. ‘United we stand, divided we fall’ is not just a slogan — it’s also true! As a union, workers have greater bargaining
power when it comes to wage negotiations and as a result can push up the price of labour (wage rates). This causes the firm’s
average total costs to rise. (This may help explain why large businesses often lobby governments to legally restrict union
recruitment and strikes.) Furthermore, as a firm becomes very large, there is often a separation of ownership and control: the
people who actually run the firm are not the owners (e.g. shareholders) who obtain the dividend-profits, but rather, are hired
‘senior’ managers (CEOs and the like) who receive salary packages. Now, the owners rely on the senior managers to ‘do the
right thing’ by making the largest profits possible, but they don’t actually know whether this is occurring or not. It is entirely
possible for senior managers, who are apparently in short supply, to start to paying themselves exorbitant salaries and
bonuses (basically ‘skimming’ some of the would-be profits) far in excess of anything they have actually done. This is
sometimes called rent-seeking behaviour due to asymmetric information (‘asymmetric’ because the managers have all the
information about what is really going on and the owners have none). This also increases the average total costs of
production.
All these factors contribute to a rise in a firm’s short-run average total costs as it increases in scale and produces more output.
We call this phenomenon diseconomies of scale. In the long-run, the firm’s average total costs — its long-run average total
costs — increase. We can see this graphically in figure 7.10. This shows the short-run average total cost curves shift
rightwards and upwards as the firm’s scale increases. The long-run average total cost curve is the lowest points on these
short-run curves.

FIGURE 7.10 Long-run ATC curve with diseconomies of scale

Figure 7.11 shows a ‘smooth’ long-run ATC curve.

FIGURE 7.11 Smooth long-run ATC curve with diseconomies of scale

Constant costs to scale

Now it is possible that neither economies of scale nor diseconomies of scale occur as a firm increases the scale of its
operations. Or there may be some economies of scale factors that are ‘cancelled out’ by some diseconomies of scale factors.
In this situation, we say that a firm can increase its scale and increase its output without any change in vertical level of its
short-run average total costs. Thus, in the long-run, the firm’s average total costs (its long-run average total costs) remain
constant. We can see this graphically in figure 7.12. This shows the short-run average total cost curves shifting rightwards
only as the firm’s scale increases. The long-run average total cost curve is the lowest points on these short-run curves.
FIGURE 7.12 Long-run ATC curve with constant costs to scale

Figure 7.13 shows a ‘smooth’ long-run ATC curve.

FIGURE 7.13 Smooth long-run ATC curve with constant costs to scale

The traditional ‘envelope’ cost curve

When graphically representing a firm’s long-run costs of production, it is traditional to put together economies of scale,
constant returns to scale and diseconomies of scale. Why? The usual explanation goes like this: initially, as a firm increases
its scale, it will be able to take advantage of economies of scale. Thus at relatively ‘low’ levels of output, the long-run
average cost curve will be downward sloping. But eventually this effect will peter-out (after all, there are physical limits to
the productive capacities of labour and capital, and there are lower limits on input prices — no inputs are ever free!). Thus,
the firm may enter a phase where there are constant returns to scale: as the firm further increases its scale, its long-run
average total costs remain constant (they don’t rise or fall). But thereafter, as the firm gets even larger, at some point it begins
to experience the effects of diseconomies of scale, and so the long-run average cost curve will be upward sloping. This is
called an ‘envelope curve’ because it enwraps or ‘envelopes’ all of the short-run ATC curves. Figure 7.14 shows this
(without the short-run ATC curves).
FIGURE 7.14 A traditional long-run average total cost curve (the ‘envelope’ curve)

It should be noted that a firm’s long-run average total cost curve doesn’t have to look like this a big grin. It is theoretically
possible for a firm to initially experience constant returns to scale and then diseconomies of scale (with no economies of
scale), so its long-run average cost curve would be shaped a bit like a backwards ‘L’. It is also possible that a firm might be
able to solve its management coordination problems, force its workforce to maintain its productivity and eliminate any union
activity so that it doesn’t experience any diseconomies of scale at all. In this case, the long-run average total cost curve
would be continuously downward sloping. (Incidentally, this doesn’t mean the firm would produce an infinite amount of
output — it would still be constrained by there being a limited, even if large, demand for its product.)

 7.1 Profit 7.3 A firm’s revenue 

7.3 A FIRM’S REVENUE
Learning objective 3
understand total, average and marginal revenue, their curves and their relationships with each other

A generally accepted assumption is that firms are interested in maximising profit. That means we need to know about a
firm’s revenue and its cost at various levels of production. In a previous section, we dealt with firms’ short-run and long-run
costs and have seen the shapes of their cost curves, so we won’t go over that again. What we need to deal with now is a
firm’s revenue. After that, we can move on to seeing how to choose the optimal output for a firm.

Total, average and marginal revenue

Total revenue (TR) is simply the amount of money generated by selling some quantity of output (Q) at some price (P):
TR = P × Q
For example, if a café produces 100 cups of coffee and sells them at $4 each, the café’s total revenue would be $400.
Average revenue (AR) is simply the amount of money generated per unit by selling some quantity of output. It is the total
revenue (TR) divided by the quantity sold (Q):
AR = TR / Q
For example, if a café produces 100 cups of coffee and generates $400 total revenue, its revenue per cup (its average
revenue) would be $4.
But wait! We can simplify this because we could re-write AR = TR / Q
as: AR = P × Q / Q. Since Q / Q = 1, so we would be left with AR = P × 1, or more simply:
AR = P
Intuitively, that makes sense: if consumers are paying a price of $4 per cup of coffee then the café is generating, on average,
$4 revenue per cup of coffee. So whenever we talk about ‘average revenue’ from the perspective of the firm, it is
simultaneously the ‘price per unit’ from the perspective of the consumer. We can switch between the labels ‘AR’ and ‘P’
whenever we like since they represent the same amount of money.
Lucky last, we have a firm’s marginal revenue. This refers to the amount of money generated from the sale of an additional
small increment of output (note that this is not the same concept as average revenue). In other words, it is the amount of
money added to total revenue due to the sale of an additional small increment of output. It is thus calculated by:
MR = ΔTR / ΔQ
The delta ‘Δ’ symbolises ‘change in’, so ΔTR = new TR – original TR, and ΔQ = new Q – original Q.
For example, if a café increases output from 100 to 101 cups of coffee, and this causes total revenue to increase from $400 to
$402, the marginal revenue from that additional 101st cup of coffee would be $2.
Sometimes you will see MR represented this way:
MR = dTR / dQ
The italicised ‘d’ symbolises ‘differential of’ or ‘vanishingly small change in’. We won’t use this.

Total, average and marginal revenue curves

Above we saw how to calculate total revenue, marginal revenue and average revenue (or price). But what’s more interesting
and important is the patterns they can exhibit at different levels of output. Let’s say that a firm faces the law of demand: by
lowering its price, it is able to sell more of its product. Table 7.3 shows a firm progressively decreasing its price by amounts
of $15. It starts at a price of $450 and sells nothing, but when it decreases its price to $435, it sells one unit. And when it cuts
its price again to $420, it sells 2 units. And when it cuts its price again to $405, it sells 3 units — and so on and so forth.
Since TR = P × Q, we can see that the total revenue generated starts at $0, but then increases to $435 (selling one unit @
$435) and then to $840 (selling 2 units @ $420) and then to $1,215 (selling 3 units @ $405) — and so on and so forth. We
can also calculate the firm’s marginal revenue from selling each additional unit. Since MR = ΔTR / ΔQ, we can see that the
first unit sold generates extra revenue of $435 (TR increases from $0 to $435). The second unit generates extra revenue of
$405 (TR increases from $435 to $840). And the third unit generates extra revenue of $375 (TR increases from $840 to
$1215) — and so on and so forth.

TABLE 7.3

TR, AR (price) and MR data (case 1)

Q P($)=AR TR($) MR($)

0 450 0 --

1 435 435 435

2 420 840 405

3 405 1215 375

4 390 1560 345

5 375 1875 315

6 360 2160 285

7 345 2415 255

8 330 2640 225

9 315 2835 195

10 300 3000 165

11 285 3135 135

12 270 3240 105

13 255 3315 75

14 240 3360 45

15 225 3375 15

16 210 3360 -15

17 195 3315 -45

18 180 3240 -75

19 165 3135 -105

20 150 3000 -135

Let's now graph the data in the table to see what patterns emerge. This is shown in figure 7.15.
FIGURE 7.15 TR, AR (price) and MR curves

The first thing to note about figure 7.15 is that the AR curve is actually the firm's own demand curve: it shows the
relationship between the prices the firm can charge and the quantities that buyers are willing and able to purchase.
The next thing to note about the two graphs is that the TR curve reaches its peak at approximately 15 units and the MR curve
hits zero at the same output. This makes sense: since MR is the additional revenue generated from producing an additional
increment of output, when TR reaches its peak (it stops increasing) this implies that no additional revenue is being generated
(in other words, MR will be zero).
The third thing to note about the graphs is that as price (AR) is falling by $15 per unit as each new unit is sold, the MR curve
falls by $30 for each additional unit of output sold. Mathematically, it will always be the case that if price (AR) falls then
marginal revenue will fall twice as much. In other words, as can be seen in the graph, the price (AR) curve is half as steep as
the MR curve — or conversely, the MR curve is twice as steep as the price (AR) curve.
Graphically, this means that the flatter [or steeper] the AR curve is, the flatter [or steeper] the MR will also be, but no matter
what, the MR curve will still have double the slope of the AR curve. In the extreme case where the AR curve is horizontal,
the MR curve will also be horizontal — after all if the AR curve is perfectly flat, it has zero slope, so the MR curve will also
have zero slope because doubling zero equals zero. And at the other extreme, where the AR is vertical, the MR curve will be
vertical too — a vertical AR curve is infinitely steep, so the MR curve will also be infinitely steep because doubling infinity
equals infinity. Here are some graphs in figure 7.16 to illustrate these points (of course, the upper lines are the AR curves and
the lower lines are the MR curves).

FIGURE 7.16 Various AR and MR curves

A puzzle to think about: relationship between MR and AR
Is it just a coincidence that the firm’s MR curve is twice as steep as (has double the slope of) its AR(P) curve (i.e. its
demand curve)?
It’s not a coincidence. It’s a mathematical necessity. In fact, this relationship between ‘marginals’ and ‘averages’ doesn’t
just apply to marginal revenue and average revenue; it also applies to marginal cost and average cost. It also applies to
your marginal marks and your average marks. And so on and so forth.
Because this is a mathematical relationship, we need to do a bit of maths to see it. Let’s use some of the data from table
7.3 and figure 7.15. First we need an equation for the AR (= P) curve. Since P is $450 when output sold is zero, we can
see that this is the ‘start’ of our AR curve (the point at which it ‘cuts’ the vertical axis — its vertical intercept). We can
also see that price (AR) has to decrease by $15 per unit in order to sell one additional unit of output. So the slope of the
AR curve (the ‘rise over the run’) is –15/1 = –15. With this information, we can write an equation to represent the AR
curve:
AR = P = 450 – 15 × Q
Q stands for quantity of output sold. In words, the equation says: at zero output, the price [P] starts at $450, but thereafter
we deduct [minus] $15 from this original price, per unit of output sold [total Q]. So far so good. To get to the equation for
MR, however, we have to go through TR (since MR is the change in TR due to increasing the Q sold by a small
increment). Here’s the equation for TR:
TR = P × Q
Now, we already have an equation for price, P = 450 – 15 × Q, so let’s substitute that into the TR equation:
TR = (450 – 15 × Q) × Q
…which we can expand (multiply 450 by Q and multiply 15 × Q by Q) to get:

TR = 450 × Q – 15 × Q2
To get MR from this TR equation, we need to do a bit of calculus (we differentiate TR with respect to Q). Unfortunately,
we don’t have time to go through the intricacies of differentiation, so here is a ‘short-cut’ rule: multiply each constant by
the power associated with its Q and then minus 1 from that power. For the first ‘part’ of the TR equation which is 450 ×
Q = 450 × Q1, we get 450 × 1 × Q1-1 = 450 × 1 × Q° = 450 × 1 × 1 = 450. And for the second ‘part’ of the TR equation
which is 15 × Q2, we get 15 × 2 × Q2-1 = 30 × Q1 = 30 × Q. Doing this gives us the MR equation:
MR = 450 – 30 × Q
Now, recall that the price (AR) equation was P = 450 – 15 × Q, and -15 represented the slope of the AR curve (the rate at
which AR was decreasing as Q increased by 1). Compare that to the MR equation we just obtained: MR = 450 – 30 × Q.
As you can see, the slope of the MR curve here is represented by –30. Voilà! We have shown that the MR curve is twice
as steep as (has double the slope of) the AR curve (in absolute terms, 30 is twice the size of 15). Oh, and we can also see
that the MR curve and the AR curve should actually have the same ‘start’ point (vertical intercept) of 450. (In the graph
and the table above this is not the case, but that’s because they are not as mathematically precise as the equations.) In
abstract terms (leaving out specific numbers), we can thus algebraically represent linear (straight line) AR and MR curves
as follows:
AR = a – bQ
Average revenue = vertical intercept a – slope b of curve × quantity sold
MR = a – 2bQ
Marginal revenue = vertical intercept a – 2 × slope b of average revenue curve × quantity sold

 7.2 A firm’s costs of production 7.4 Choosing the optimal amount to produce 
7.4 CHOOSING THE OPTIMAL AMOUNT TO PRODUCE
Learning objective 4
explain the role of the equi-marginal principle in deciding how much a rational firm will produce, and understand the
differences between profit maximising, breaking even and shutting down

Now that we know about how cost and revenue can behave when a firm increases its output (as illustrated by cost and
revenue curves), we are ready to state at the conditions or rules for rationally choosing the optimal (ideal) amount for a firm
to produce. These conditions are general: they can be applied to all types of firms in all types of markets so along as the
entrepreneurs running the firms are seeking to make as much profit as they can. Recall that economic profits = total revenue
minus total costs. So, we will assume that firms have one overriding goal: maximise the positive gap between total revenue
and total cost; that is, they seek to maximise their economic profit (and failing that, break-even, and failing that, at least
minimise their losses in the short-run).

The equi-marginal principle

The main principle for determining the optimal output for any firm (except in a special situation) is the equi-marginal
principle: the optimal output is where the revenue from the next increment sold (marginal revenue) is just equal to the cost of
producing that increment (marginal cost) (i.e. optimal Q is where MR = MC for that ‘last’ additional increment of Q
produced).
The reasoning for the equi-marginal principle goes like this: if a firm is producing an amount of output where the revenue
from the next unit sold (marginal revenue) is greater than the cost of producing that unit (marginal cost), then it is adding
more to its total revenue than it is adding to its total cost. It would be rational to continue increasing output whilst ever this is
the case: with each extra unit produced, total revenue will be increasing faster than total cost. It should only stop increasing
its output when it is no longer the case that the next unit adds more to total revenue compared to total cost — i.e. it should
stop increasing output when marginal revenue just equals marginal cost (MR = MC). At that point, there is no reason to keep
increasing output because there would be no additional gain in total revenue over and above total cost.
We can see the equi-marginal principle in operation by looking at a graph. Let's say our firm faces a downward sloping
demand curve — or in other words, a downwards sloping average revenue curve. We now know that therefore the marginal
revenue curve will also be downwards sloping (with double the slope). Let's also say that our firm is operating in the short-
run and faces a (roughly) ‘J-shaped’ marginal cost curve. As we can see in figure 7.17, for every extra unit of output up to
6.9 units of output, the MR is greater than MC. This means that for each additional increment of output produced and sold,
the firm gains more in total revenue than is being added to total cost — the firm ‘benefits’ from producing incrementally
more and more. However, as we can see from the graph, the gap between MR and MC gets smaller and smaller: the
additional benefit to the firm of producing each additional increment of output gets smaller and smaller. And at 6.9 units, MR
= MC, so there is no additional benefit to be gained by producing more than that quantity. This is thus the optimal level of
output for this firm.
FIGURE 7.17 Equi-marginal principle determines optimal output
 How rational can you get?
For very many economists, the equi-marginal principle (sometimes also called the cost-benefit principle) is the principle
that essentially characterises rational decision-making. Since it is usually assumed that entrepreneurs are rational, it
follows that this rule of thought governs the production decisions of entrepreneurs. But why stop at entrepreneurs? If it's
true for business people, why wouldn't it be true for consumers too? And why wouldn't it also be true of, say, joggers?
And prospective parents? And so on and so forth. The equi-marginal principle could, it is sometimes said, be used to
characterise the behaviour of all decision makers, no matter who they are (on the assumption that they are rational). For
example:
How many slices of pizza will a rational consumer eat? They will keep eating while ever the benefit (to them) from
the next slice of pizza is greater than the cost (to them) of the next slice. The optimal number of slices will be
where the benefit (to them) from the next slice just equals the cost (to them) of that slice.
How many laps of the oval will the rational jogger make? They will keep jogging while ever the benefit (to them)
of running the next lap is greater than the cost (to them) of the next lap. The optimal number of laps will be where
the benefit (to them) of the next lap just equals the cost (to them) of that lap.
How many kids will rational parents choose to have? They will keep having kids while ever the benefit (to them) of
the next kid is greater than the cost (to them) of the next kid. The optimal number of kids will be where the benefit
(to them) from the next kid just equals the cost (to them) of that kid.
You might think that this is pretty weird. You might object that most ‘flesh-and-blood’ human beings (aside from
economists) don't think like this at all. However, many economists would reply: ‘Okay, so why do businesses limit their
production? Why do pizza eaters stop eating delicious, delicious pizzas before they explode? Why don’t joggers just keep
running around that oval until they die of old age? And why do parents limit the number of kids they have? If you’ve got
a different principle for decision-making that could explain all of these different types of behaviour, we’d love to hear it.
Until then, we’re going to continue using our equi-marginal principle to make sense of people’s behaviour.’ A minority of
economists agree with the layperson that many choices, or behaviours, are not really consciously calculated in accordance
with the equi-marginal principle. They argue that many behaviours are determined by social conventions and norms, or
idiosyncratic semi-conscious habits, or even downright irrational personal beliefs. At this stage, however, they don’t have
a universal principle expressible in a mathematical form that could be used to (hypothetically) explain all behaviour (as
the equi-marginal principle is purported to do). And the majority of economists want just such a universal principle.

Making economic profit, breaking even, shutting down and leaving the
market
Now, if it turns out that at the optimal Q the average revenue (the price per unit) is greater than the average total cost (the cost
per unit) — i.e. AR > ATC — then not only is profit being made from this Q, but the firm is making the maximum economic
profit possible in these circumstances. There is no other Q where profit could be larger.
Incidentally, with information about the AR and ATC at the optimal Q, it is easy to calculate the total economic profit (Π)
being maximised. In abstract terms:
(AR – ATC) × Q = Π
For example, if at the optimal output of 6.9, the firm’s AR = $350 and the firm’s ATC = $300, then the firm would make $50
economic profit per unit. Multiply that by the number of units produced and you’ll obtain the firm’s total economic profit:
($350 – $300) × 6.9 = $50 × 6.9 = $345.
What if, however, it turns out that at the optimal Q the average revenue (the price per unit) is the same as the average total
cost (cost per unit) — i.e. AR = ATC? In this that case, the firm is breaking even at this optimal Q (i.e., it is making zero
economic profit). In the circumstances, this is the best the firm can do; at any other Q the firm would be making a loss.
For example, if at the optimal output of 6.9, the firm’s AR = $250 and the firm’s ATC = $250, then the firm would make $0
profit per unit. Multiply that by the number of units produced and you’ll obtain the firm’s total economic profit: ($250 –
$250) × 6.9 = $0 × 6.9 = $0.
Note that the firm would still be covering the entrepreneur’s implicit costs (included in the ATC) — i.e. they would still be
making normal profit — so the entrepreneur is still being sufficiently compensated and would not shut down the firm.
What if it turns out that the price (average revenue) is less than the average total cost? Obviously, the firm would be making
an economic loss. In the long-run, the entrepreneur would leave the industry altogether and go looking for greener pastures
(some industry to invest in which would at the very least make normal profit).
But if we are looking at the short-run situation (i.e., where the entrepreneur cannot as yet leave the industry because, say, the
lease on the location they are renting has not yet run out), then the entrepreneur will have to choose whether to (1) stay open
(produce the Q where MR = MC) or (2) shut down (i.e., stop producing and shut their doors, even though they are still
technically ‘in’ the industry).

1: Stay open
It is rational for the entrepreneur to stay open (produce the optimal Q) in the short-run if average revenue (the price per unit)
is greater than (or at the limit just equal to) the average variable cost (variable cost per unit) — i.e., AR ≥ AVC. To see why
this is so, it is easiest to express this situation in terms of total revenue and total costs, as per figure 7.18 below. Recall that in
the short-run, there are fixed costs (let’s say the costs of capital) and variable costs (let’s say the costs of labour). In this
situation, if the firm stays open and continues to produce and sell stuff, the total revenue covers all the variable costs and a
bit of the fixed costs — but not all the fixed costs, so the firm is making a loss. The remainder of the fixed costs would have
to be paid out of the entrepreneur’s own pocket. But what, by contrast, if the entrepreneur shut down the business? Then
there would be no variable costs (no wages have to be paid because the workers are sent home) but there would also be no
revenue (because nothing is being produced). And there would still be the fixed costs to be paid (the monthly interest on
loans and the monthly rent for the space used). All of the fixed costs would have to be paid out of the entrepreneur’s own
pocket! Which generates a smaller economic loss for the entrepreneur? Staying open to produce the optimal Q (where MR =
MC), rather than shutting down, is the rational option here.

FIGURE 7.18 Staying open (producing) versus shutting down (case 1)

2: Shut down
It is only rational for the entrepreneur ignore the equi-marginal principle (‘produce where MR=MC’) in the special short-run
situation where average revenue (the price per unit) falls so far that it is less than the average variable cost (variable cost per
unit) — i.e. AR < AVC. In this situation, the entrepreneur loses less by shutting down, rather than staying open. So shutting
down would be rational option in this special case. This can be seen in figure 7.19 (using totals rather than averages).
FIGURE 7.19 Staying open (producing) vs shutting down (case 2)

Summary of conditions for an entrepreneur’s decision-making

      Short-run

For Q, MR = MC If AR > ATC …then maximising profit at optimal Q

If AR = ATC …then breaking even at optimal Q

If ATC > AR ≥ AVC …then minimising loss at optimal Q

If AR < AVC Then minimising loss by shutting down

      Long-run

For Q, MR = MC If AR > ATC …then maximising profit at optimal Q

If AR = ATC …then breaking even at optimal Q

If AR < ATC …then leave the industry altogether

The next chapter

As was said earlier, the concepts of revenue, cost, and economic profit, as well as the ‘rules’ of optimal production choice,
are assumed by many economists to apply to all firms in all markets. In chapter 8, we will be deploying these concepts and
rules to understand the behaviour of firms’ in different types of market structures. So, when reading chapter 8, it may be
necessary for you to periodically come back to this chapter to remind yourself about the concepts being applied.

 7.3 A firm’s revenue Summary 

SUMMARY
Learning objective 1: explain why it is important to distinguish between economic and accounting profit
Accounting profit is the total revenue from sales over and above the total explicit cost of production. Economic profit,
however, is the total revenue over and above the total explicit and implicit cost of production. Implicit cost refers to
the income the entrepreneur foregoes in order to run their business (e.g. they may have given up working in a higher
paid role).
Learning objective 2: understand the difference between a firm’s short-run and long-run costs of production
Short-run refers to a situation in which the firm cannot change the quantity of a least one of the inputs used in the
production process (i.e. at least one input is fixed in quantity). In contrast, long-run is a situation in which the firm is
able to change the quantities of all of the inputs used in the production process (i.e. the inputs are variable).
Learning objective 3: understand total, average and marginal revenue, their curves and their relationships with
each other
Total revenue (TR) is the amount of money generated by selling some quantity of output (Q) at some price (P).
Average revenue (AR) is simply the amount of money generated per unit by selling some quantity of output. It is the
total revenue (TR) divided by the quantity sold (Q). Marginal revenue refers to the amount of money generated from
the sale of an additional small increment of output (note that this is not the same concept as average revenue).
The flatter or steeper the AR curve is, the flatter or steeper the MR will also be. But no matter what, the MR curve will
still have double the slope of the AR curve. In the extreme case where the AR curve is horizontal, the MR curve will
also be horizontal — after all if the AR curve is perfectly flat, it has zero slope, so the MR curve will also have zero
slope because doubling zero equals zero. At the other extreme, where the AR is vertical, the MR curve will be vertical
too — a vertical AR curve is infinitely steep, so the MR curve will also be infinitely steep because doubling infinity
equals infinity.
Learning objective 4: explain the role of the equi-marginal principle in deciding how much a rational firm will
produce, and understand the differences between profit maximising, breaking even and shutting down.
The equi-marginal principle is the optimal output where the revenue from the next increment sold (marginal revenue)
is just equal to the cost of producing that increment (marginal cost). For example, if a firm is producing an amount of
output where the revenue from the next unit sold (marginal revenue) is greater than the cost of producing that unit
(marginal cost), then it is adding more to its total revenue than it is adding to its total cost. It would be rational to
continue increasing output. It should only stop increasing its output when it is no longer the case that the next unit adds
more to total revenue compared to total cost.

Review questions
1. What is meant by these various concepts of cost: total, average, average variable, marginal and fixed? What are the
relationships between these costs? What are short‐run and long‐run costs? What is the relationship between them?
2. Why are short‐run average cost curves frequently U‐shaped? Assume that the average cost curve is U‐shaped: What is
the relationship between the average and marginal costs? What does the total cost curve look like?
3. What happens to average, marginal and total costs when the price of an input rises?
4. If a firm has a number of variable inputs and the price of one of them rises, will the firm use more or will it use less of
this input? Why?
5. In a competitive market, what rule determines the profit‐maximising level of output? What is the relationship between a
firm’s supply curve and its marginal cost curve?
6. What determines firms’ decisions to enter a market? To exit a market? Explain the role of the average variable cost curve
in determining whether firms will exit the market.
7. Why is the long‐run supply curve more elastic than the short‐run supply curve?
8. What is the relationship between the way accountants use the concept of profits and the way economists use that term?
Problems
1. Tom and Dick, who own the Tom, Dick and Hairy Barbershop, need to decide how many barbers to hire. The production
function for their barbershop looks like this:

NUMBER OF BARBERS HAIRCUTS PROVIDED PER DAY MARGINAL PRODUCT

0 0

1 12

2 36

3 60

4 72

5 80

6 84

Calculate the marginal product of hiring additional barbers, and fill in the last column of the table. Over what range is the
marginal product of labour increasing? Constant? Diminishing? Graph the production function. By looking at the graph,
you should be able to tell at what point the average productivity of labour is highest. Calculate average productivity at
each point to illustrate your answer.
2. The overhead costs of the Tom, Dick and Hairy Barbershop are $160 per day, and the cost of paying a barber for a day is
$80. With this information, and the information in problem 5, make up a table with column headings in this order:
Output, Labour required, Total variable cost, Total cost, Marginal cost, Average variable cost and Average cost. If the
price of a haircut is $10 and the shop sells 80 per day, what is its daily profit?
3. Using the information in problems 1 and 2, draw the total cost curve for the Tom, Dick and Hairy Barbershop on one
graph. On a second graph, draw the marginal cost curve, the average cost curve and the average variable cost curve. Do
these curves have the shape you would expect? Do the minimum and average cost curves intersect at the point you
expect?
4. Suppose a firm has the choice of two methods of producing: one method entails a fixed cost of $10 and a marginal cost of
$2; the other entails a fixed cost of $20 and a marginal cost of $1. Draw the total and average cost curves for both
methods. At what levels of output will the firm use the low‐fixed‐cost technology? At what levels of output will it use the
high‐fixed‐cost technology?
5. Suppose the market price for painting a house is $10 000. The Total Cover‐up House‐Painting Company has fixed costs
of $4000 for ladders, brushes and so on, and the company’s variable costs for house painting follow this pattern:

Output (houses painted) 2 3 4 5 6 7 8 9 10

Variable cost (in thousands of dollars) 26 32 36 42 50 60 72 86 102

Calculate the company’s total costs, and graph the revenue curve and the total cost curve. Do the curves have the shape
you expect? Over what range of production is the company making profits?
6. Calculate and graph the marginal cost, the average costs and the average variable costs for the Total Cover‐up House‐
Painting Company. Given the market price, at what level of output will this firm maximise profits? What profit (or loss)
is it making at that level? At what price will the firm no longer make a profit? Assume its fixed costs are sunk; there is no
market for used ladders, brushes, etc. At what price will the company shut down?
7. Draw a U‐shaped average cost curve. On your diagram, designate at what price levels you would expect entry and at
what price levels you would expect exit if all the fixed costs are sunk. What if only half the fixed costs are sunk? Explain
your reasoning.
8. Frank is a skilled electrician at a local company, a job that pays $50 000 per year, but he is considering quitting to start
his own business. He talks it over with an accountant, who helps him to draw up the following chart with their best
predictions about costs and revenues.
 PREDICTED ANNUAL COSTS PREDICTED ANNUAL REVENUES

Basic wage $20 000 $75 000

Rent of space $12 000

Rent of equipment $18 000

Utilities $2 000

Miscellaneous $5 000

The basic wage does seem a bit low, the accountant admits, but she tells Frank to remember that as owner of the business,
Frank will get to keep any profits as well. From an economist’s point of view, is the accountant’s list of costs complete?
From an economist’s point of view, what are Frank’s expected profits?

 7.4 Choosing the optimal amount to produce 8 Market structures 

 CHAPTER 8

Market structures

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

8.1 understand what economists mean by ‘competition’ and ‘market structures’ and the relationship between them
8.2 identify when a perfectly competitive firm will maximise profit, break-even and shut down in the short-run
8.3 explain why perfectly competitive firms will tend to break-even in the long-run
8.4 understand the operation of a market where there is no competition at all (i.e. monopoly)
8.5 understand imperfect competition and explain the model of monopolistic competition
8.6 understand the model of oligopoly and how it helps to explain the operation of imperfectly competitive markets where
there are only a few firms.

 Summary 8.1 Competition and market structures 

8.1 COMPETITION AND MARKET STRUCTURES
Learning objective 1
understand what economists mean by ‘competition’ and ‘market structures’ and the relationship between them

When we speak of ‘competition’ we often think of a contest — like a fight or a race — between rivals. Whether it is two or
ten rivals, it doesn’t matter. Competition in this case is a verb: it is about the act or process of competing for some prize/goal.
For real-world firms, this usually boils down to a fight for customers by offering lower prices or better quality products or
entirely new products or persuasive advertising campaigns. However, when most economists take about ‘competitive’
markets, they are not referring to fighting. Rather they are referring to how many rivals there are and how evenly matched
they are. Thus, for most economists, a market with only two rivals is less competitive than a market with one hundred rivals.
And a market in which there are a five small firms and one large dominant firm is less competitive than a market in which
there are six equally matched firms.
Economists have constructed theoretical models fornumerous different of market structures. Market structure basically refers
to a cluster of essential features that characterise a certain kind of a market. These featuresinclude: [1] the number of sellers
and buyers in the market, [2] the degree of differentiation between the goods/services offered by sellers, [3] the degree of
knowledge possessed by sellers and buyers, and [4] the extent of barriers/freedom to entry to and exit from a market faced by
sellers and buyers. Table 8.1 summarises the four market structures that we will focus on. For each of these four structures it
is assumed that there are ‘many’ buyers. There are other market structures too (such as duopoly, monopsony and bilateral
monopoly), but for simplicity’s sake we’ll ignore them.

TABLE 8.1

Four market structures

NAME OF NUMBER OF FREEDOM OF KNOWLEDGE RIVALS’ EXAMPLE

STRUCTURE FIRMS ENTRY PRODUCT

Perfect competition Many Unrestricted Complete Identical International rice market

Monopolistic Many/several Unrestricted Complete Slightly different Local restaurant industry

competition

Oligopoly Few Restricted Complete or Identical or Australia’s national supermarket

imperfect different industry

Monopoly One Blocked Complete — NSW Railway market

Roughly speaking, as one goes down the table, each structure is less competitive (in the economic sense) than the previous
one.

Perfectly competitive market defined

From the economist’s perspective, perfect competition is the most competitive market one could possibly imagine because
there are so many firms and they are all perfectly equally matched. As the table above indicates, a perfect competitive market
possesses the following characteristics.
There are very many sellers and buyers in the market. Each seller’s market-share is vanishingly small, and so is each
consumer’s purchases relative to total spending by all consumers.
Each seller produces a good/service that is identical to every other firm in the market. In other words, the good/service
is ‘homogeneous’ across the firms. There is no product differentiation by the firms (no ‘heterogeneity’ across the
firms’ products).
All sellers and buyers have perfect knowledge of all market conditions (there is no ignorance, no secrets and no
mistakes). This implies that there is no advertising because consumers know everything already — spending money on
 advertising would be pointless.
There are no barriers to existing firms leaving the market or new firms entering the market in the long-run period. The
costs associated with simply entering and exiting the market are zero.
As a result of these characteristics, it is concluded that no firm has any market power (i.e. no single firm has any ability to
influence the market price in its favour by increasing or decreasing its output). All firms are thus said to be price-takers.

Debate over the use of the perfectly competitive market model

There is much debate over the use of this kind of theoretical model of markets. A traditional criticism is that the
characteristics defining perfect competition are highly unrealistic — it is difficult to find a real-world example of a
market that literally has all of the characteristics listed above. The usual examples given in textbooks are national or
international agricultural markets and stock exchange markets, but even these markets are not really perfectly competitive
(e.g. no one is really omnipotent in these markets, there is almost always some small degree of product differentiation,
and sometimes they do have barriers to entry). So, if this theoretical model is false, and false models can’t give true
explanations of the real-world, then this model should not be applied to real-world markets.
Nonetheless, many economists still use this theoretical model. Different defences of its use have been offered: [1] there
are some markets which are pretty close to perfect competition, even if they are not literally identical to it; [2] if the
model enables us to make accurate predictions about real market prices and output, then it is still worth using for that
purpose; [3] all other models that more accurately represent real markets are very complicated, so in the interests of
simplicity and tractability, the perfectly competitive model is preferred (especially when doing a ‘quick and dirty’
analysis of a single market, or when one is trying to analyse many interlocking markets simultaneously); [4] the model is
really a ‘theoretical benchmark’ that should be used for making comparisons between real-world markets and the ‘ideal
case’ (like comparing a feather falling in a perfect vacuum and falling from the top of Trump Tower). Critics often reply
that these defences look suspiciously like ad hoc excuses designed to ‘save’ the model despite its lack of ‘realistic-ness’.
But whichever side you come down on, these defences at least implicitly concede that one must offer some kind of
justification for applying a [literally] false model to real world markets. One should never apply the perfectly competitive
model (or any other model) uncritically or indiscriminately, otherwise one would be violating the spirit of scientific
enquiry. And most economists are very keen to say that economics really does aspire to be a genuine science.

 8 Market structures 8.2 Perfectly competitive firms in the short-run 

8.2 PERFECTLY COMPETITIVE FIRMS IN THE SHORT-RUN
Learning objective 2
identify when a perfectly competitive firm will maximise profit, break-even and shut down in the short-run

When a firm is a price-taker, its marginal revenue (revenue generated by the sale of each additional unit of output) is
identical to the market price (which from the individual firm’s perspective, is fixed): MR = P at every level of output. Recall
that the MR curve always has double the slope of the AR curve. Now in the case of perfect competition, the firm’s AR(P)
curve is horizontal (because the price is fixed no matter what Q is produced), and therefore the MR curve will also be
horizontal — after all if the AR curve is perfectly flat, it has zero slope, so the MR curve will also have zero slope because
doubling zero equals zero. As we can see below in figure 8.1, the equilibrium market price directly determines the firm’s
optimal Q (where MR = MC). In the graphs below, we can see that the equilibrium market price is $5. Thus an individual
firm’s marginal revenue (and average revenue) will be $5 at every level of output as indicated by the horizontal marginal
revenue curve. And since a firm’s optimal Q is where MR = MC (where the marginal cost and marginal revenue curves
intersect), the entrepreneur (assuming they are rational) will choose to produce 25 units.

FIGURE 8.1 Price-taking and the firm’s optimal output

 A puzzle to think about: why would a firm just accept the market price?
We have said that a firm in a perfectly competitive market is a price-taker — i.e. it just sells whatever it can produce at
the ‘given’ equilibrium market price. But why is that? Surely the entrepreneur of a single firm in the market can legally
choose to charge a price that is greater than or less than that charged by all the other firms in the market. So why don’t
they? Why are they, in a sense, compelled to simply accept the market price?
Imagine our rebel entrepreneur — let’s say they are selling oranges at the local ‘mega’ fruit market — decided to
charge a higher price than all the other orange suppliers in the market. From the buyers’ perspective, why would
they buy any oranges from the rebel? They can buy any quantity they like at a lower price from the oodles of other
sellers in the market. Assuming our consumers are rational, they will avoid the rebel’s stall, who will thus sell no
oranges, and thus make no revenue, and thus make an economic loss (since they’ll still have costs to pay). The
rebel would be crazy to charge a price higher than the equilibrium market price. Either the rebel will stop charging
a higher price than everyone else, or they’ll persist in their craziness and eventually be bankrupted.
‘Ah-ha!’ I hear you squeal with glee, ‘but the above scenario doesn’t apply if the rebel entrepreneur lowers their
price a bit below the market price that everyone else is charging. They wouldn’t lose customers now, so they
wouldn’t be dooming themselves to bankruptcy.’ Well, yes, but our rebel, assuming they are interested in
maximising their revenue relative to their cost, would never do this! Why? It is because they can already sell any
quantity they want at the market price. If they lower their price, they can still sell the same quantity — except now
at a lower price, thereby would generate less revenue. For example, let’s say the maximum the rebel can make
available at their orange stall is 1000 oranges. They could sell them for the market price of $2 per orange,
generating $2000 total revenue, or they could discount their price to $1 per orange and generate $1000 total
revenue. Which price would profit-maximising entrepreneur choose? The market price!
So, we can conclude the rational entrepreneur operating in a perfectly competitive market will never choose to raise their
price above the market price (because that would result in an economic loss), nor will they choose to lower their price
below the market price (because that would result in lower profits than they could have otherwise acquired). The
entrepreneur, compelled by their quest for maximum economic profit, will always choose to charge the price ‘given’ to
them by the market as a whole.

To see whether the individual firms in a perfectly competitive market are maximising their economic profit, breaking even,
minimising their losses, or shutting down in the short-run, we need to add in our representative firm’s average cost curves.

Making economic profit, breaking even, and shutting down in the short-
run
In figure 8.2, we see the firm is maximising its economic profit. The price (average revenue) is fixed at $8, so the marginal
revenue is $8. The optimal Q (where MR = MC) is 32.5 units. At that output, we can see that the average total cost of
production is $5.50. Thus we can work out the total economic profit: (AR – ATC) x Q = ($8 – $5.50) x 32.5 = $2.5 x 32.5 =
$81.25.
FIGURE 8.2 A profit-making (and maximising) situation

In figure 8.3, we see the firm is breaking even (only making normal profit; i.e. making zero economic profit). The price
(average revenue) is fixed at $5.40, so the marginal revenue is $5.40. The optimal Q (where MR = MC) is 28 units. At that
output, we can see that the average total cost of production is also $5.40 (the lowest point on the average total cost curve).
Thus we can work out the total economic profit: (AR – ATC) x Q = ($5.40 – $5.40) x 28= $0 x 28 = $0.

FIGURE 8.3 A break-even situation

In figure 8.4, we see the firm is minimising its economic loss. The price (average revenue) is fixed at $4, so the marginal
revenue is $4. The optimal Q (where MR = MC) is 25 units. At that output, we can see that the average total cost of
production is $5.50. Thus, we can work out the total economic profit: (AR – ATC) x Q = ($4 – $5.50) x 25 = –$1.5 x 25 = –
$37.50.The average revenue covers all of the average variable cost, but not all of its average total cost; i.e. ATC ($5.50) >
AR ($4) > AVC ($3.50). We know that in this case, the firm will stay open despite the loss because shutting down would be
even worse (i.e. the loss would be larger).
FIGURE 8.4 A loss minimising situation

In figure 8.5, we see it is rational for the firm to shut down because its average revenue does not cover its average variable
cost (let alone any of its average fixed cost) at any output level, i.e., AR < AVC – even at the Q where MR = MC.

FIGURE 8.5 A shut down situation

The short-run marginal cost curve is the firm’s own supply curve
Interestingly(!?), from all this (above) we can divine the perfectly competitive firm’s own individual supply curve. As can be
seen in figure 8.6, as the market pricefalls, the MR curve (and the AR curve) shifts downwards, thus resulting in a smaller
optimal Q supplied by the firm. Thus, given the price, the MC curve dictates the optimal Q the rational firm will supply to
the market. In other words, the MC curve effectively functions as an individual firm’s short-run supply curve (down to the
lowest point on the AVC curve — recall that when AR < AVC the firm will shut down in the short-run). The individual
firm’s own short-run supply curve is indicated in figure 8.6 by the thick line running along the MC curve.
FIGURE 8.6 The firm’s own supply curve

Note that we have shown that the MC curve functions as the perfectly competitive firm’s own individual supply curve in the
short-run. This is not true for firms which are not perfectly competitive.

 8.1 Competition and market structures 8.3 Perfectly competitive firms in the long-run 
8.3 PERFECTLY COMPETITIVE FIRMS IN THE LONG-RUN
Learning objective 3
explain why perfectly competitive firms will tend to break-even in the long-run

Now onto the long-run. Recall that the long-run is a situation where all the inputs used can be varied (firms can hire
more/less labour and can acquire more/fewer machines and locations for factories or outlets). This enables firms to increase
(or decrease) their scale. (See chapter 7, section 7.2, on long-run average cost curves.)
The most interesting thing about a perfectly competitive market is its long-run outcome. Unfortunately for the entrepreneurs,
but happily for the consumers, a perfectly competitive market leads to a situation where all firms in a market end up
producing output at the lowest possible price they can afford — i.e. they all end up breaking even. Why is that so? The
explanation goes like this.
Let’s say initially the equilibrium market price is sufficiently high that all the firms in the market are making economic
profit. Now, recall that there are no barriers to entry into perfectly competitive markets in the long-run, so when firms
outside the market see that economic profit is being generated there, they enter this market in an attempt to get a piece of the
pie, so to speak. However, when new sellers enter a market, this causes the overall supply to increase. This is shown by the
market S curve shifting rightward. This in turn causes the equilibrium price to fall. And since all the individual firms in the
market are price-takers, the price they have to charge also falls, and with it, so does marginal and average revenue. This is
shown by the firms’ AR (MR) curve shifting downwards. The firms have to recalculate their now lower optimal Q, which
will unfortunately generate less economic profit (the gap between AR and ATC will get ‘squeezed’). This process keeps
happening while-ever the firms are making economic profit (even if it is only tiny). This process only stops when there is no
more economic profit being made by any firm. (With no economic profit, there is no incentive for new firms to enter the
market.) This process is illustrated in figure 8.7.

FIGURE 8.7 The long-run tendency to break-even (case 1)

What if the equilibrium price is initially very low so that the firms are actually making economic losses in the long-run?
Well, the same process as described above occurs, except ‘in reverse’. Since firms in the market are making economic losses,
some of the entrepreneurs will choose to exit the market altogether in search of profits elsewhere. As a result, the market
supply will decrease, reflected in the market S curve shifting leftward. This will cause the equilibrium market price to rise,
which in turn causes the AR (MR) curve to shift upwards. This decreases the economic losses being made by the remaining
firms. This process will continue until the equilibrium market price has risen just enough to cover the minimum long-run
average total costs — i.e. they will be breaking even. At that point, since all the remaining firms will be breaking even, there
will no longer be any incentive on the part of entrepreneurs to leave the market. This is illustrated in figure 8.8.
FIGURE 8.8 The long-run tendency to break-even (case 2)

So, in the long-run, whether firms are initially making an economic profit or an economic loss, they will all end up breaking
even.
To repeat: the long-run outcome in a perfectly competitive market is that firms are ultimately forced to charge a break-even
price — i.e. P will equal ATC at the final optimum Q. This isn’t a total disaster for the entrepreneurs because, as you’ll recall,
each firm’s cost includes compensation for the entrepreneur’s implicit costs (the so-called normal profit). But it does mean
that there is no economic profit. On the other hand, zero economic profit for entrepreneurs is great news for consumers
because it means that firms (in the long-run) will be charging is lowest possible price they can. Note on the graph above that
the P equals in minimum ATC — i.e. firms are producing output at the lowest possible cost per unit and charging a price that
just covers that cost.

 8.2 Perfectly competitive firms in the short-run 8.4 Monopoly 

8.4 MONOPOLY
Learning objective 4
understand the operation of a market where there is no competition at all (i.e. monopoly)

Economists’ concerns about monopolies and other forms of restricted competition stem mainly from their observation that the output, or
supply, of firms within these market structures is less than that of firms that face perfect competition, and prices are higher as well. To
understand these concerns, we consider a monopolist that charges the same price to all its customers, and show how it decides on its level of
output.
A monopolist, just like a competitive firm, will try to maximise profits. Both compare the marginal revenue and the marginal cost of
producing more. For both, the basic principle for determining output is the same. Each produces at the output level at which marginal
revenue equals marginal cost. The key difference lies in their marginal revenue. When a competitive firm decides on its output level, it takes
the market price as given. Such a firm faces a horizontal demand curve — it can sell as much as it wants at the market price. In contrast, the
monopolist is the sole supplier to the market, so its demand is defined by the market demand curve. As market demand curves are
downward sloping, the monopolist can thus increase its sales only by lowering its price.
Because the monopolist faces a downward-sloping demand curve, its marginal revenue is not equal to the market price. To understand why,
we can break the marginal revenue a monopolist receives from producing one more unit into two separate components. First, the firm
receives revenue from selling the additional output. This additional revenue is just the market price. But to sell more, the monopolist must
reduce its price. Unless it does so, it cannot sell the extra output. Marginal revenue is the price it receives from the sale of the one additional
unit minus the loss in revenue from the price reduction on all other units. Thus, for a monopolist, the marginal revenue for producing one
extra unit is always less than that unit’s price.
Figure 8.9 shows the relationship between the demand curve and the marginal revenue of the monopolist. If the monopolist wants to sell the
quantity Q1, the market price must be p1. Marginal revenue is less than price, so the marginal revenue curve lies below the demand curve.
At the quantity Q1, marginal revenue is MR1, less than the price p1.

FIGURE 8.9 Demand curve and marginal revenue curve for a monopolist
Because the monopolist faces a downward-sloping demand curve, marginal revenue is less than price. To sell an extra unit of output, the monopolist must accept a
lower price on every unit sold. At the quantity Q1, the market price is p1 and the marginal revenue is MR1.1
 Demand curve and marginal revenue curve for a monopolist
Drag the slider to view the relationship between the demand curve and the marginal revenue of a monopolist.
Notice how marginal revenue is less than price and also the effect on price if the monopolist wants to sell at a
higher quantity.
PRICE (p)

QUANTITY (Q)

Panel A of figure 8.10 shows the output decision of a competitive firm. Marginal revenue is just equal to the market price, P*. The
competitive firm produces at Q*, where marginal cost is equal to the market price. Panel B shows the output decision of a monopolist.
Marginal revenue is always less than price. The monopolist produces an output of Qm, since at that output level, marginal cost is equal to
marginal revenue. Both the monopolist and the competitive firm maximise profits by producing where marginal cost equals marginal
revenue. The difference is that for the monopolist, marginal revenue is less than price.

FIGURE 8.10 Marginal revenue equals marginal cost

A perfectly competitive firm gains or loses exactly the market price (p*) when it changes the quantity produced by one unit. To maximise profits, the firm produces the
quantity where marginal cost equals marginal revenue, which in the competitive case also equals price. Panel B shows the downward-sloping marginal revenue curve
for a monopolist. A monopolist also chooses the level of quantity where marginal cost equals marginal revenue. For a monopolist, however, marginal revenue is lower
than price.
Note that in the case of a monopolist, since marginal revenue is less than price and marginal revenue is equal to marginal cost, marginal cost
is less than price. The price is what individuals are willing to pay for an extra unit of the product; it measures the marginal benefit to the
consumer of an extra unit. Thus, the marginal benefit of an extra unit exceeds the marginal cost of producing that extra unit. This is the
fundamental reason why monopolies reduce economic efficiency.
The extent to which output is curtailed depends on the magnitude of the difference between marginal revenue and price. This, in turn,
depends on the shape of the demand curve. When demand curves are very elastic (relatively flat), prices do not fall much when output
increases. As shown in panel A of figure 8.11, marginal revenue is not much less than price. The firm produces at Qm, where marginal
revenue equals marginal cost. Qm is slightly less than the competitive output, Qc, where price equals marginal cost. When demand curves
are less elastic, as in panel B, prices may fall a considerable amount when output increases, and then the extra revenue the firm receives
from producing an extra unit of output will be much less than the price received from selling that unit.

FIGURE 8.11 Monopoly and the elasticity of demand

In panel A, a monopoly faces a very elastic market demand; prices therefore do not fall much as output increases, and monopoly price is not much more than the
competitive price. In panel B, showing a monopoly that faces a less elastic market demand, price falls quite a lot as output increases, and the monopolist maximises
profit at a price substantially above the competitive price.
 Monopoly and the elasticity of demand
Drag the slider to change the elasticity of demand for a monopolist to view the effects on monopoly price,
competitive price and output for a very elastic market demand and a less elastic market demand.

Elasticity of demand:
PRICE (p)

Less elastic Very elastic

QUANTITY (Q)

The larger the elasticity of demand, the smaller the discrepancy between marginal revenue and price.

An example: the ABC-ment Company

Table 8.2 gives the demand curve facing the ABC-ment Company, which has a monopoly on the production of cement in its area. There is a
particular price at which it can sell each level of output. As it lowers its price, it can sell more cement. Local builders will, for instance, use
more cement and less wood and other materials in constructing a house.

TABLE 8.2

Demand curve facing the ABC-ment Company

CUBIC METRES (THOUSANDS) PRICE TOTAL REVENUES MARGINAL REVENUES TOTAL COSTS MARGINAL COSTS

1 $10 000 $10 000 $8000 $15 000 $2000

2 $9 000 $18 000 $6000 $17 000 $3000

3 $8 000 $24 000 $4000 $20 000 $4000

4 $7 000 $28 000 $2000 $24 000 $5000

5 $6 000 $30 000 0 $29 000 $6000

6 $5 000 $30 000   $35 000  

For the sake of simplicity, we assume cement is sold in units of 1000 cubic metres. At a price of $10 000 per unit (of 1000 cubic metres),
the firm sells 1 unit; at a price of $9000, it sells 2 units; and at a price of $8000, 3 units. The third column of the table shows the total
revenues at each of these levels of production. The total revenues are just price multiplied by quantity. The marginal revenue from
producing an extra unit (of 1000 cubic metres) is just the difference between, say, the revenues received at 3 units and 2 units or 2 units and
1 unit. Note that in each case, the marginal revenue is less than the price.
Figure 8.12 shows the firm’s demand and marginal revenue curves, using data from table 8.2. At each level of output, the marginal revenue
curve lies below the demand curve. As can be seen from the table, not only does price decrease as output increases, but so does marginal
revenue.

FIGURE 8.12 Demand and marginal revenue

At each level of output, the marginal revenue curve lies below the demand curve.

The output at which marginal revenue equals marginal cost — the output chosen by the profit-maximising monopolist — is denoted by Qm.
In our example, Qm = 4000 cubic metres. When the number of cubic metres increases from 3000 to 4000, the marginal revenue is $4000,
and so is the marginal cost. At this level of output, the price, pm, is $7000 (per 1000 cubic metres), which is considerably in excess of
marginal costs, $4000. Total revenues, $28 000, are also in excess of total costs, $24 000.2

Monopoly profits
Monopolists maximise their profits by setting marginal revenue equal to marginal cost. The total level of monopoly profits can be seen in
two ways, as shown in figure 8.13. Panel A shows total revenues and total costs (from table 8.2) for each level of output of the ABC-ment
Company. The difference between revenues and costs is profits — the distance between the two curves. This distance is maximised at the
output Qm = 4000 cubic metres. We can see that at this level of output, profits are $4000 ($28 000 − $24 000). Panel B calculates profits
using the average cost diagram. Total profits are equal to the profit per unit multiplied by the number of units produced. The profit per unit
is the difference between the unit price and the average cost, and total monopoly profits is the shaded area ABCD. Again, the sum is $4000:
($7000 − $6000) × 4.

FIGURE 8.13 Price exceeding average cost leads to profit

Panel A shows profits to be the distance between the total revenue and total cost curves, maximised at the output Qm = 4000 cubic metres. Profits occur when the
market price is above average cost, as in panel B, so that the company is (on average) making a profit on each unit it sells. Monopoly profits are the area ABCD, which
is average profit per unit times the number of units sold.
A monopolist enjoys an extra return because it has been able to reduce its output and increase its price from the level that would have
prevailed under competition. This return is called a pure profit. Because these payments do not elicit greater effort or production on the
part of the monopolist (in fact, they derive from the monopolist’s reducing the output from what it would be under competition), they are
also called monopoly rents.
It is important to note that while a firm that is a monopoly may make a pure profit — and sustain it over the long run because of barriers to
entry that allow the firm to retain the monopoly — this is not necessarily the case. If the demand for the product were lower and/or the cost
of producing it higher (so that the revenue and cost curves illustrated in figure 8.13 were respectively lower and/or higher), while the firm’s
profit-maximising output would be the same, this would result in a loss rather than a profit. The firm’s ‘profit-maximising’ output would
then be its loss-minimising output. So there is no point in a firm having a monopoly if there is weak demand for the product or the cost of
producing it is very high!

Price discrimination
The basic objective of monopolists is to maximise profits, and they accomplish this by setting marginal revenue equal to marginal cost, so
price exceeds marginal cost. Monopolists can also engage in a variety of other practices to increase their profits. Among the most important
is price discrimination: that is, charging different prices to different customers or in different markets.
Figure 8.14 shows a monopolist setting marginal revenue equal to marginal cost in Australia and in Japan. The demand curves in the two
countries are different. Therefore, though marginal costs are the same, the firm will charge different prices for the same good in the two
countries. (By contrast, in competitive markets, price equals marginal cost, so that regardless of the shape of the demand curve, price
remains the same except for the different costs of delivering the good to each market.) Because prices in the two countries differ, middleman
firms will enter the market, buying the product in the country with the low price and selling it in the other country. A company may attempt
to thwart the middlemen — as many Japanese companies do — by, for instance, having distinct labels on the two products and refusing to
provide service or honour any guarantees outside the country in which the good is originally delivered.

FIGURE 8.14 Price discrimination

A monopolist that sells products in two different countries may find itself facing different demand curves. Though it sets marginal revenue equal to the same marginal
cost in both countries, it will charge different prices.

Within a country, a monopolist can also practise price discrimination if resale is difficult and if it can distinguish between buyers with high
and low elasticities of demand. Because the retransmission of electricity is restricted, an electricity company can make its charge for each
kilowatt hour depend on how much electricity the customer uses. If the company worries that large customers charged the same high prices
as its small customers might install their own electric generators, or switch to some other energy source, it may lower the price to them. An
airline with a monopoly on a particular route may not know whether a customer is buying a ticket for business purposes or for a holiday
trip, but by charging more for refundable tickets or tickets purchased at the last minute, it can effectively discriminate between business
travellers and vacationers. Business customers are more likely to need the flexibility of a refundable ticket or to make their travel plans at
the last minute, while vacationers have many alternatives. They can travel elsewhere, on another day, or by car or train. Such business
practices enable the monopolist to enjoy greater profits than it could if it charged a single price in the market. Firms facing imperfect
competition also engage in these practices. Airlines again provide a telling example.

Natural monopoly
The technology needed to produce a good can sometimes result in a market with only one or very few firms. For example, it would be
inefficient to have two firms construct power lines on each street in a city, with one company delivering electricity to one house and another
company to the house next door. Likewise, in most locales, there is only one gravel pit or concrete plant. These situations are called natural
monopolies.

INTERNATIONAL PERSPECTIVE
South Africa, AIDS and price discrimination
In perfectly competitive and well-functioning markets, goods cannot be sold at two different prices. Those who purchased the good at
the low price could resell the good in the high-price market, making a pure profit. But, in some markets, reselling the good is difficult; in
others, governments prohibit or limit resale.

Research and testing account for the major cost of producing drugs. These are fixed costs that the drug manufacturers recoup by
charging prices that are considerably in excess of the manufacturing costs. If they can practise price discrimination, the price they charge
in each market will depend on the price elasticity in that market. But if they worry about resale, they may charge the same price in all
markets.
Drug companies have developed some effective remedies against AIDS — not cures but treatments that can substantially prolong life.
They charge $10 000 and more a year for treatment, a cost few in the developing countries can afford. The actual cost of manufacturing
the drugs is much, much less. However, the drug companies have been reluctant to sell the drugs at lower prices in these countries for
two reasons. They worried that it would lower profits in those countries; and, probably more importantly, they worried about resale,
which would lower profits in their own home markets (the United States, Europe). But charging high prices in, say, South Africa — the
country with one of the highest incidences of HIV infection in the world — in effect condemned millions in that country to a premature
death. Naturally, South Africa balked. It passed a law allowing the importation of drugs at lower prices, drugs possibly made by
manufacturers that had ignored standard patent protections. The drug companies sued on the grounds that the law violated their basic
economic rights. However, protesters around the world argued that intellectual property rights must be designed to balance the rights of
potential users and the rights of producers, and that the benefits to the poor in Africa far outweighed the loss in profits.

CRITICAL THINKING
In this example, what are the reasons that might lead to price discrimination, and what limits are imposed on the ability of a firm to adopt
this practice?

A natural monopoly occurs whenever the average costs of production for a single firm decline as output increases up to levels equal to, or
beyond, the foreseeable total market demand — that is, where there are economies of scale, a concept introduced earlier in this E-Text. In
figure 8.15, the demand curve facing a monopoly intersects the average cost curve at an output level at which average costs are still
declining. At large enough outputs, average costs might start to increase; but that level of output is irrelevant to the actual market
equilibrium. For instance, firms in the cement industry have U-shaped average cost curves, and the level of output at which costs are
minimised is quite high. Accordingly, in smaller, isolated communities, there is a natural monopoly in cement.
FIGURE 8.15 Natural monopoly
In a natural monopoly, average cost curves are downward sloping in the relevant range of output. A firm can charge the monopoly price pm. If the market is contestable,
potential competition prevents the firm from charging a price higher than average costs. The equilibrium price is pr.

A natural monopolist is protected by the knowledge that it can undercut its potential rivals. Since entrants typically are smaller and average
costs decline with size, the average costs of new firms are higher. Therefore, the monopolist feels relatively immune from the threat of entry.
So long as it does not have that worry, it acts like any other monopolist, setting marginal revenue equal to marginal cost.
In some cases, even when a market is occupied by a natural monopolist, competition can still exist for the market. Competition to be that
single supplier is so keen that price is bid down to average cost, at pr. If the firm were to charge a slightly higher price, another firm would
enter the market, steal the entire market with its lower price, and still make a profit. Markets for which there is such fierce competition are
said to be contestable. Contestability requires that sunk costs be low or zero. If they are significant, a firm that entered the market could be
undercut by the incumbent firm, which might lower price to its marginal cost (since so long as price exceeds marginal cost, it makes a profit
on the last unit sold). The lower prices that result are sometimes referred to as a price war, and the result of a price war is that the entrant
encounters a loss — when set equal to marginal cost, price is substantially below average cost. The entrant knows that even if it leaves at
this juncture, it loses its sunk costs, which are, by definition, the expenditures that are not recovered when the firm shuts down. But,
anticipating this outcome, the potential rival does not enter the market. Thus, despite sustained current profits, other firms may choose not to
enter the market. In fact, sunk costs appear to be sufficiently important that few markets are close to perfectly contestable. Even in the
airline industry, where sunk costs are relatively low — airlines can fly new planes into markets that seem profitable or out of markets that
seem unprofitable — they act as a sufficiently large barrier to entry that there are sustained profits in certain routes, especially those out of
major centres. Just as most markets are not perfectly competitive, so most natural monopolies are not perfectly contestable, though the
threat of competition (or potential competition) may limit the extent to which an incumbent monopolist exercises its monopoly power.
Whether a particular industry is a natural monopoly depends on the size of the output at which average costs are minimised relative to the
size of the market.
The size of the market depends largely on transportation costs. If, somehow, the cost of transporting cement were lowered to close to zero,
then there would be a national cement market. Many firms then would be competing against each other — the size of the national market is
far larger than the output at which average costs are minimised.
The size of output at which costs are minimised depends in part on the magnitude of fixed costs (i.e. those costs which are incurred
regardless of the level of output produced). Since research is a fixed cost, its growing importance in many industries has increased the size
of output at which average costs are minimised. At the same time, new technologies and business arrangements are enabling many firms to
reduce their fixed costs. Today, firms need not have a personnel department for routine matters like paying salaries; they can contract for
such services as needed.
Because both technology and transportation costs can change over time, the status of an industry as a natural monopoly also can change.
Telephone service used to be a natural monopoly. Telephone messages were transmitted over wires, and installing and using duplicate lines
would have been inefficient. As the demand for telephone services increased, and as alternative technologies such as satellites and mobile
phones developed, telephone services ceased to be a natural monopoly. Today, consumers in most communities can choose from among
several firms that provide telephone service.

CASE IN POINT
Is Australia Post a monopoly?

The Australian Postal Corporation Act 1989 gives Australia Post (which is wholly owned by the government) the sole right over
carriage and delivery of ordinary mail, in particular letters of 250 grams or less. These are termed ‘reserved services’. To this extent, the
firm is an example of a legislated monopoly — in other words, one that is conferred upon the firm by government. In return, the
legislation imposes certain obligations (referred to as Community Service Obligations) on the firm. These include the requirement to
deliver mail anywhere in Australia at a single uniform rate and for the firm to meet certain performance standards, defined in the Act in
terms of ‘the social, industrial and commercial needs of the community’.
Some services provided by Australia Post — including parcel delivery, courier services and express delivery services — are open to
competition from other firms. But, in respect of those services over which the firm does have a monopoly, Australia Post is thus able to
set the price of its product (in practice, ‘the cost of a stamp’) at a price that is higher than that which would prevail under competition.
The question is: is this only what is necessary to cover the community service obligations imposed on Australia Post (for example, to
carry a letter whether it be from one suburb of Sydney to another or from Kalgoorlie to Camooweal at the same cost)?
When Australia Post was granted the right to increase the price of the product over which it had been granted a monopoly (to 60 cents)
the firm noted, in welcoming the increase, that it made ‘no profit from its reserved letter services, with the cost of providing the basic
postage service exceeding what many Australians pay. For example, to send a stamped letter from Brisbane to Perth costs 71 cents’.3
Australia Post also noted the changes that had been made in order to improve productivity and keep costs of production as low as
possible.

CRITICAL THINKING
How would you describe the market Australia Post is in if the monopoly over certain services were taken away from the firm?

 8.3 Perfectly competitive firms in the long-run 8.5 Monopolistic competition 

8.5 MONOPOLISTIC COMPETITION
Learning objective 5
understand imperfect competition and explain the model of monopolistic competition

Imperfect competition
Just as there are relatively few industries in the Australian economy that conform to the competitive model, so there are
relatively few that conform to the model of monopoly that was outlined in the previous section. Most industries lie
somewhere ‘between’ the extremes of perfect competition on the one hand, and monopoly (where there is no competition at
all) on the other. In other words, there is some competition but it is not ‘perfect’.
In the following sections of this chapter, we examine two models of imperfect competition: monopolistic competition and
oligopoly. These provide valuable insights into the nature of competition and the behaviour of firms in imperfectly
competitive markets. It should be emphasised, however, that all markets that diverge from the perfectly competitive model
— those where there is no competition at all (monopolies) and those where there is limited (imperfect) competition have one
key characteristic in common. This is that the firm faces a downward-sloping demand curve for its product.
In the case of a (pure) monopoly, this is because the demand curve for the product itself slopes downwards. (Because the
monopoly firm is the only firm producing and supplying the product, the firm’s demand curve is identical to the market
demand curve.) As noted in the previous section (and illustrated in figure 8.11), demand may be more or less elastic. This
will affect the slope of the monopoly firm’s demand curve.
In the case of imperfectly competitive firms (i.e. those in markets somewhere ‘between’ the perfectly competitive and
monopolistic ‘extremes’) the slope of the firm’s demand curve will depend also on the elasticity of demand for the individual
firm’s product — that is, on the degree of monopoly power that the firm has. This will depend on factors such as the extent to
which the firm has been able to differentiate its product from that of other producers and the degree of ‘brand loyalty’ the
firm has been able to secure.
Whatever the case, however, the firm in any market that diverges from perfect competition (whether it is a pure monopoly or
one where there is imperfect competition) will face a downward-sloping demand curve. The elasticity of demand for the
firm’s product will determine the extent to which the firm is able to set a price above the price that would be established in a
competitive market and the extent to which the quantity produced is below that which would be produced in a competitive
market. (In terms of figure 8.11, it is the magnitude of the difference between pm and pc.) This will measure the degree of
monopoly power that the firm possesses.

Monopolistic competition
Where there is some, but limited, competition, the number of firms in the industry is perhaps the most important determinant
of the nature of competition. In an industry where there are a large number of producers, the products of each firm are close
but not perfect substitutes. Consequently, each firm faces a downward-sloping demand curve. This is the case of
monopolistic competition, first analysed by Edward Chamberlin of Harvard University in 1933.
The market for women’s dress shoes is one such industry. The large number of producers include Tony Bianco, Django &
Juliette, Florsheim, Nine West, and many more. No two firms produce exactly the same shoes, but the shoes made by the
different companies are close substitutes. Each producer faces a downward-sloping demand curve, but each firm has a small
portion of the overall market.
Figure 8.16 illustrates a market in which there is monopolistic competition. Assume initially that all firms are charging the
same price, say p1. If one firm were to charge a slightly lower price, it would steal some customers away from other
businesses. And if it should raise its price above that of its rivals, it would lose customers to them. Each firm assumes that
the prices charged by other firms will remain unchanged as it changes its price or the quantity it produces. The demand curve
facing each firm is thus the one shown in the figure.
FIGURE 8.16 Profit maximising for a monopolistic competitor
A monopolistic competitor chooses the quantity it will produce by setting marginal revenue equal to marginal cost (Q1), and then selling that quantity
for the price given on its demand curve (p1). In panel A, the price charged is above average cost, and the monopolistic competitor is making a profit,
enticing other firms to enter the market. As firms enter, the share of the market demand of each firm is reduced, and the demand curve facing each
firm shifts to the left. Entry continues until the demand curve just touches the average cost curve (panel B). When the firm produces the quantity Qe, it
just breaks even; there is no incentive for either entry or exit.

In deciding how much to produce, the firm sets marginal revenue equal to marginal cost. The market equilibrium is (p1, Q1),
with marginal revenue equalling marginal cost. In the equilibrium depicted in the figure, price exceeds average costs. One
can think of this situation as a sort of mini-monopoly, where each firm has a monopoly on its own brand name or its own
store location.
But if existing firms are earning monopoly profits, there is an incentive for new competitors to enter the market until profits
are driven to zero, as in the perfectly competitive model. This is the vital distinction between monopolies and firms in
monopolistic competition. In both cases, firms face downward-sloping demand curves. In both cases, they set marginal
revenue equal to marginal cost. But monopolistic competition raises no barriers to entry, which continues so long as profits
are positive. As firms enter, each firm’s share of the industry demand is reduced. The demand curve of each firm thus shifts
to the left, as depicted in panel B. This process continues until the demand curve just touches the average cost curve, at point
(pe, Q1), where profits are zero.
The figure also shows the firm’s marginal revenue and marginal cost curves. As we have said, the firm sets its marginal
revenue equal to its marginal cost. This equality occurs at exactly the level of output at which the demand curve is tangent to
the average cost curve. At any other point, average costs exceed price, so profits are negative. Only at this point are profits
zero. Accordingly, this is the profit-maximising output.
The monopolistic competition equilibrium has some interesting characteristics. Note that in equilibrium, price and average
costs exceed the minimum average costs at which the goods could be produced. Less is produced at a higher price. But there
is a trade-off here. Whereas in the perfectly competitive market every product was a perfect substitute for every other one,
the world of monopolistic competition offers variety in the products available. People value variety and are willing to pay a
higher price to obtain it. Thus, that goods are sold at a price above the minimum average cost does not necessarily indicate
that the economy is inefficient.

THINKING LIKE AN ECONOMIST

Monopolistic competition and product differentiation
The main characteristic of a firm in monopolistic competition, compared to perfect competition, is that the product of
each firm, while it is still the same product, is different to that of other firms (at least in the eyes of buyers).
What differentiates one firm’s product from that of another? Consider the ‘restaurant industry’ — often given as an
example of monopolistic competition. (Of course we’re faced — as in most instances — with ‘defining the market’.
Which firms are in competition with whom? A ‘fine dining’ restaurant may not consider itself in competition with
McDonald’s & or another fine dining restaurant in a suburb or town 40 kilometres away.)
But when we (or firms) do define the market, what then differentiates one firm’s product from that of their competitors?
The style of food; the quality of the food; price; the service; the ambience of the restaurant itself; the wine that is offered
in conjunction with the food; the ease of parking nearby &? Are there other criteria on the basis of which a consumer
decides to buy the product of (i.e. patronise) one restaurant rather than another?
It is on bases such as those just listed that firms compete. These ‘differentiating factors’ are what makes it possible for a
firm to increase its price and not lose all sales (as would be the case in perfect competition). On the other hand, one firm
lowering its price may not allow it to substantially increase sales, such as the preference of consumers for other firms that
have a distinctive product.
However, because there are few barriers to other firms entering the industry (i.e. setting up a restaurant) and producing
the sort of eating experience that allows some existing firms to make economic profits, it is difficult for any firm to
continue to make economic profits and sustain them over a period of time.

CRITICAL THINKING
In what way could a restaurant differentiate its product so as to maximise profits in the short run and sustain these over the
long run?

 8.4 Monopoly 8.6 Oligopoly 

8.6 OLIGOPOLY
Learning objective 6
understand the model of oligopoly and how it helps to explain the operation of imperfectly competitive markets where
there are only a few firms

In oligopoly there are just a few firms, so each worries about how its rivals will react to anything it does. This is true of the
airline, cigarette, aluminium and automobile industries, as well as a host of others.
If an oligopolist lowers its price, it takes the chance that rivals will do the same and deprive it of any competitive advantage.
Worse still, a competitor may react to a price cut by engaging in a price war and cutting the price still further. Different
oligopolies behave quite differently. The oligopolist is always torn between its desire to outwit competitors and the
knowledge that, by cooperating with other oligopolists to reduce output, it will earn a portion of the higher industry profits.
A firm that is part of an oligopolistic market must think strategically. In deciding what to do, it faces four key questions.

1. Should it cooperate with other firms or compete? When firms cooperate rather than compete, economists say the firms
are colluding.
2. If it cannot collude explicitly (because there are laws barring such behaviour), how can it reduce the effectiveness of
competition through restrictive practices or other means?
3. How can it deter entry? Like a monopolist, it knows that the entry of other firms will erode profits.
4. How will rivals react to whatever it does? Will they, for instance, match price decreases? In the remainder of this
chapter, we take up these questions.

Collusion and reaction

In some cases, oligopolists enter into collusion to maximise their profits. In effect, they act jointly as if they were a single
monopoly, and split up the resulting profits. The prevalence of collusion was long ago noted by Adam Smith, the founder of
modern economics: ‘People of the same trade seldom meet together, even for merriment and diversion, but the conversation
ends in a conspiracy against the public, or in some contrivance to raise prices’.4 A group of companies that formally operate
in collusion is called a cartel. The Organisation of Petroleum Exporting Countries (OPEC), for instance, acts collusively to
restrict the output of oil, thereby raising oil prices and hence the profits of member countries.
There are cases also where firms in oligopolistic industries have colluded directly in regard to prices. In the early twenty-first
century, for example, banks in the United Kingdom were found to have colluded to fix the price (the rate of interest) at which
lending between banks was undertaken, thereby affecting interest rates charged to personal or business borrowers. Australian
airline Qantas colluded with a number of other international airlines in the setting of cargo freight in Europe. Within
Australia firms producing goods as different as cardboard and electric power transformers were also found to have colluded
in the setting of prices.5
Such collusion has been made illegal. So, because the members of the cartel cannot get together openly to discuss price-
fixing or restricting output, they typically must rely on tacit collusion — each restricting output with an understanding that
the others will too. They cannot sign a contract that can be enforced in a court of law, simply because collusion to fix prices
is illegal; hence, they must rely on self-enforcement, which can be difficult and costly. Moreover, their artificially high prices
— well in excess of the marginal cost of production — tempt each firm to cheat, to expand production. The members of the
cartel may try to discipline those that cheat. They may even incur losses in the short run to punish the cheater, in the belief
that the long-run gains from ‘cooperation’ (that is, collusion) are worth the temporary sacrifice. For instance, if a firm cuts its
price or expands its output and the cheating is detected, the other firms in the cartel may match, or even more than match, the
price cuts or capacity expansions. The cheater ends up not only with lower profits than anticipated but also with lower profits
than it would have obtained had it cooperated.
A variety of facilitating practices can make collusion easier by making punishment for cheating easier. Some industries
maintain cooperative arrangements — one firm, for instance, may draw on the inventories of another, in the case of an
unanticipated shortfall — from which cheaters are excluded.
Sometimes, policies that seem to be highly competitive actually have exactly the opposite effect. Consider the ‘meeting-the-
competition clauses’ by which some members of the oligopoly commit themselves to charging no more than any competitor.
This sounds highly competitive. But think about it from the perspective of rival firms. Assume one firm is selling for $100 an
item that costs only $90 to produce, so it is making a $10 profit. Consider another firm that would like to steal some
customers away. It would be willing to sell the item for $95, undercutting its rival. But then it reasons that if it cuts its price,
it will not gain any customers, since its rival has already guaranteed to match the lower price. Further, the second firm knows
that it will make less money on each sale to its current customers. Price-cutting simply does not pay. Thus, a practice that
appears highly competitive in fact facilitates collusion.
Circumstances are always changing, necessitating adjustments in outputs and prices. The cartel must coordinate these
changes. The illegality of collusion makes this coordination particularly difficult, all the more so since the interests of the
members of the cartel may not coincide — some may find their costs lowered more than others and therefore seek a greater
expansion of output than others. Were there to be perfect collusion, in which industry profits were maximised, some might
have to contract production and others expand it, with profits of some firms actually decreasing and others increasing. The
gainers could, in principle, make payoffs to the losers and still be better off. However, these side payments are also illegal,
and thus must be subtle and hard to detect if they occur at all. While perfect coordination is seldom possible, some industries
have found a partial solution by allowing one firm to play the role of the price leader. This is particularly the case where one
firm (or perhaps a small number of large firms of approximately equal size) account for a significant share (say 60–80 per
cent) of total sales. If this firm (or firms) were to increase or decrease prices, others will follow suit. The more dominant the
position of one firm (or a small number of firms together), the more likely this is to occur.
Within Australia, it is more common for small groups of dominant firms (such as Coles and Woolworths in the case of
retailing, or the ‘big four’ banks) to be regarded as price leaders. Telstra is sometimes considered a price leader in the
provision of telecommunications services, although the firm’s dominance is becoming weaker and less secure. The more
readily other firms can compete with large existing firms, the less those firms are able to exert price leadership.

Using game theory to model collusion

Economists apply a branch of mathematics called game theory to study collusion among oligopolists. Its basic aim is to shed
light on strategic choices — that is, on how people or organisations behave when they expect their actions to influence the
behaviour of others. For instance, when executives at a major airline decide to change fares for flights on a certain route, they
have to consider how their competitors might respond to the price change. And the competitors, when deciding how to
respond, have to consider how the first airline might answer in turn. These are strategic decisions, just like those typical of
players in various sorts of games, such as chess, football, or poker.
Using game theory, the economist views the participants in a given situation as players in a game, whose rules define certain
moves. The outcomes of the game — what each participant receives — are referred to as its payoffs, and they depend on
what each player does. Each participant in the game chooses a strategy; he decides what moves to make. In games in which
each player has the chance to make more than one move (there is more than one round, or period), moves can depend on
what has happened in previous periods. Game theory begins with the assumption that each player in the game is rational and
knows that their rival is rational. Each is trying to maximise his own payoff. The theory then tries to predict what each player
will do. The actions depend on the rules of the game and the payoffs.
One example of such a game is called the prisoner’s dilemma. Two prisoners, A and B, alleged to be conspirators in a
crime, are put into separate rooms. A police officer goes into each room and makes a little speech:
Now here’s the situation. If your partner confesses and you remain silent, you’ll get five years in prison. But if your partner confesses and you
confess also, you’ll only get three years. On the other hand, perhaps your partner remains silent. If you’re quiet also, we can send you to prison for
only one year. But if your partner remains silent and you confess, we’ll let you out in three months. So if your partner confesses, you are better off
confessing, and if your partner doesn’t confess, you are better off confessing. Why not confess?
This deal is offered to both prisoners. Figure 8.17 shows the results of this deal. The upper left box, for example, shows the
result if both A and B confess. The upper right box shows the result if prisoner A confesses but prisoner B remains silent.
And so on.
FIGURE 8.17 The prisoner’s dilemma
Both prisoners would be better off if both remained silent, but their individual incentives lead each one to confess. From the standpoint of prisoner A,
confessing is the better strategy if prisoner B confesses, and confessing is the better strategy if prisoner B remains silent. The same holds for prisoner
B.

From the combined standpoint of the two prisoners, the best option is clearly that they both remain silent and each serves one
year. But the self-interest of each individual prisoner says that confession is best, whether his partner confesses or not.
However, if they both follow their self-interest and confess, they both end up worse off, each serving three years. The
prisoner’s dilemma is a simple game in which both parties are made worse off by independently following their own self-
interest. Both would be better off if they could get together to agree on a story, and to threaten the other if he deviated from
the story.
The prisoner’s dilemma game can be used to illustrate the problem of collusion among oligopolists. Let us work with the
example of a duopoly, which is a market with two firms. Figure 8.18 shows the level of profits of each if both collude and
restrict output (both get $1 billion), if neither restricts output (both get $0.5 billion), or if one restricts output and the other
does not (the one that does not gets $1.3 billion, the one that does gets $0.4 billion). As each firm thinks through the
consequences of restricting output, it will quickly realise that if the other firm restricts output, its best strategy is to expand
output; and if the other firm fails to restrict output, its best strategy is also to expand output. Thus, the firm finds that
regardless of what the other does, it pays to expand output rather than to restrict it. Since the other firm will reach the same
conclusion, both will conclude that it does not pay to restrict output. Hence, both will expand output; they do not collude to
restrict output.
FIGURE 8.18 The problem of collusion as a prisoner’s dilemma
The payoffs for the duopolists delineate a prisoner’s dilemma. Both firms would be better off if both colluded (restricted output), but their individual
incentives lead each to not collude (not restrict output).

The central point is that even though the firms see that they could both be better off colluding, the individual incentive to
cheat dictates the strategy that each follows.
So far we have considered the prisoner’s dilemma when each player makes only a single move to complete the game. But if
firms interact over time, then they have additional ways to try to enforce their agreement. For example, suppose each
oligopolist announces that it will refrain from cutting prices as long as its rival does. But if the rival cheats on the collusive
agreement, then the first oligopolist will respond by increasing production and lowering prices. This strategy is called tit for
tat. If this threat is credible — as it may well be, especially after it has been carried out a few times — the rival may decide
that it is more profitable to cooperate and keep production low than to cheat. In the real world, such simple strategies may
play an important role in ensuring that firms do not compete too vigorously in markets that have only three or four dominant
firms.
The commonness and success of such strategies have puzzled economists. The logic of game theory suggests that these
approaches would not be effective. Consider what happens if the two firms expect to compete in the same market over the
next ten years, after which time a new product is expected to come along and shift the entire configuration of the industry. It
will pay each firm to cheat in the tenth year, when there is no possibility of retaliation, because the industry will be
completely altered in the next year. Now consider what happens in the ninth year. Both firms can figure out that it will not
pay either one of them to cooperate in the tenth year. But if they are not going to cooperate in the tenth year anyway, then the
threat of not cooperating in the future is completely ineffective. Hence, in the ninth year, each firm will reason that it pays to
cheat on the collusive agreement by producing more than the agreed-on amount. Collusion breaks down in the ninth year. As
they reason backwards through time, this logic will lead collusion to break down almost immediately. However, if there is no
certain date at which the collusion will end, it is possible for collusion to carry on indefinitely. Whenever the firms
contemplate cheating, on any agreement to collude, each will compare the initial increase in profits from cheating with the
future reduction in profits when the other firm retaliates. The firms, therefore, may decide to continue colluding.
It is not just among traditional business firms that collusion occurs. For example, US universities at one time agreed to all
offer the same scholarship package to students who had been accepted by more than one of the institutions. Thus, the
universities were agreeing not to use larger financial awards to compete for these students. Their collusion helped the schools
hold down their costs. In Australia, television networks have been accused of effectively colluding by accepting another’s
film footage of a news event rather than shooting their own film.6 This reduces their costs but doesn’t allow them to compete
by creating visual images that inform consumers most fully.

Restrictive practices
Restrictive practices7 and barriers to entry were identified earlier in this E-text as reasons for there being limited competition.
But the ongoing pursuit of restrictive and entry deterrence practices are also a typical characteristic of the behaviour of firms
in an oligopolistic market. If members of an oligopoly could easily get together and collude, they would. Their joint profits
would increase. However, because open collusion is illegal, oligopolists typically resort to other ways of increasing profits.
One approach is to restrict competition.
Firms engage in a number of restrictive practices to limit competition. While these practices may not increase profits for the
firms quite as successfully as the collusive arrangements discussed above, they do raise prices. In some cases, consumers
may be even worse off than under outright collusion. Many restrictive practices are aimed at the wholesalers and retailers
who sell a producer’s goods. When one firm buys or sells the products of another, the two companies are said to have a
‘vertical’ relationship. Such restrictive practices are called vertical restrictions, in distinction to the price-fixing arrangements
among producers or among wholesalers selling in the same market, which are referred to as horizontal restrictions.
One example of a vertical restriction is the use of exclusive territories: a producer gives a wholesaler or retailer the exclusive
right to sell a good within a certain region. Another form of a restrictive practice is exclusive dealing, one common form of
which is third-line forcing. This involves the supply of goods or services on condition that the purchaser buys goods or
services from a particular third party, or a refusal to supply because the purchaser will not agree to that condition. The
Australian Competition and Consumer Commission gives two hypothetical examples of this practice:

1. a travel agent offered certain flights to London on the condition that prospective passengers also acquire travel
insurance from nominated insurance companies — that is, a prospective passenger would not be allowed to buy these
flights (product 1) from the agent unless the passenger also bought the insurance (product 2) from a certain other
business
2. a car dealer offers buyers a larger trade-in allowance on the condition that buyers obtain their financing through a
particular credit provider.

Also included in the list of practices that restrict competition is the practice of predatory pricing. This is the practice of
selling a product or service at a very low price, with the intention of driving competitors out of the market or dissuading them
from attempting to compete. Predatory pricing is an example of what is more generally termed the misuse of market power.
This occurs when a firm with substantial market power (in practice, one that accounts for a significant percentage of total
sales of the product) uses that power for the purpose of damaging a competitor or potential competitor. Another example of
the misuse of market power by an oligopoly is where a company simply refuses to supply products to another person or
company.
A final example is resale price maintenance. Under this restrictive practice, a producer insists that any retailer selling his
product must sell it at the retail price the producer specifies. Like exclusive territories, it is designed to reduce competitive
pressures at the retail level and to minimise pressure that retailers might apply to producers to reduce prices in order that
they, in turn, can lower their prices to consumers.

Consequences of restrictive practices

Firms engaging in restrictive practices claim they are doing so not because they wish to restrict competition but because they
want to enhance economic efficiency. Exclusive territories, they argue, provide companies with a better incentive to
‘cultivate’ their territory. Exclusive dealing contracts, they say, provide incentives for firms to focus their attention on one
producer’s goods.
Despite these claims, restrictive practices often reduce economic efficiency. Exclusive territories for beer, for example, have
limited the ability of very large firms, with stores in many different territories, to set up a central warehouse and distribute
beer to their stores more efficiently. Regardless of whether they enhance or hurt efficiency, restrictive practices may lead to
higher prices by limiting competitive pressures.
Some restrictive practices work by increasing the costs of, or otherwise impeding, one’s rivals. For example, an airline could
develop computer reservation systems whereby they sell seats at very attractive prices to travel agents. If the primary goal of
these systems was to serve consumers, the systems would have been designed to display all the departures near the time the
passenger desired. Instead, if the system provided a quick display for only the airline’s own flights a travel agent could find
out the flights of other airlines at the expense of additional work. Airlines benefited from these computer systems not
because they best met the needs of the consumer, but because they put competitors at a disadvantage and thereby reduced the
effectiveness of competition. Despite recent systems that allow readier access to the prices of all airlines, and enable
bookings to be made on this basis, there are costs involved and the point still applies.
An exclusive dealing contract between a producer and a distributor also exemplifies how one firm may benefit from hurting
its rivals. The contract might force a rival producer to set up its own distribution system, at great cost, when the already-
existing distributor might have been able to undertake the distribution of the second product at relatively low incremental
cost. The exclusive dealing contract increases total resources spent on distribution.

Entry deterrence
Oligopolists use restrictive practices to reduce competition and thereby increase profits. Another way to reduce competition
is to prevent other firms from entering the market. This is called entry deterrence (though practices amounting to entry
deterrence are often put under the broad heading of ‘restrictive practices’).
Entry deterrence is intended to limit the number of firms — the fewer the firms, presumably the weaker the competitive
pressure. Natural barriers to entry such as possession of a key input put some limits on competition, but they may not be so
impermeable as to block it entirely. If a firm’s position is protected by other forms of entry barrier, then the firm is likely to
engage in behaviour to maintain this barrier. If, for example, its position is protected by government, then it will take
whatever action it deems most effective (which, in its extreme form, may even amount to bribery) to ensure that the
government continues to give the firm its privileged position. If the firm’s position is protected by a patent, then it is in the
firm’s interest to ensure the patent is maintained as long as possible — and, more generally, that the patent system (which the
government controls) is as favourable to the firm as possible. Similarly, firms are affected by government policies towards
intellectual property in general, and they will attempt to influence government policies in order that their position is
protected.
More generally, a firm whose monopoly power stems from a position in the market that is protected from new competitors
‘entering’ the market is likely to pursue strategies to convince potential entrants that even though they are currently making
high levels of profits, these profits will disappear if the new firm enters the market. The practice of predatory pricing has
already been discussed. This may not only serve as a restrictive practice to limit the competition of other firms already part
of the industry, but also may be aimed at entry deterrence. The incumbent may lose money in the process, but it hopes to
recoup its losses when its dominant position is retained and it is free to raise prices back to the monopoly level. Predatory
pricing is an illegal trade practice, but changing technologies and shifting demand often make it difficult to ascertain whether
a firm has actually engaged in predatory pricing or has simply lowered its price to meet the competition.
Firms can also build more production facilities than are currently needed. By readying extra plants and equipment — excess
capacity — even if they are rarely used, the incumbent sends a signal to potential entrants that it is willing and able to engage
in fierce price competition.
These strategies are most likely to be effective if there are some sunk costs. Assume the incumbent firm has constant
marginal costs and can respond to the entry of another firm by lowering its unit price to marginal cost. A potential entrant,
with marginal costs equal to those of the incumbent, will realise that once it enters, it too must set price equal to marginal
cost — and, therefore, will be unable to recover even a small sunk cost. Hence, it chooses not to enter. And the incumbent
firm, aware of this calculation, can charge a monopoly price unchallenged.

THINKING LIKE AN ECONOMIST

Predatory pricing and misuse of economic power
There are some practices in imperfectly competitive markets that attract much popular attention and are considered to
result in undesirable social consequences.
One of these (noted in the text as both a restrictive practice and a form of entry deterrence) is predatory pricing. This is
generally considered as the practice of a firm that has the resources to do so (and, thus, is a large firm, usually accounting
for a significant proportion of total product sales) as exercising its market power to price some of its products below the
cost of production. The firm incurs a loss in so doing, but, because the firm’s prices are lower than those of its
competitors, takes business away from other firms and/or deters new firms from entering the industry.
The price predator can, thus, become even larger and more dominant in the industry and gain an even greater degree of
market power. This results in its ability to charge higher prices in the long run. (Indeed it is the intention of doing so that
defines this practice as ‘predatory’.) As a consequence, the firm recoups the losses made in the short run when it is selling
its product below the cost of production.
It is, of course, difficult to distinguish such practices from those of ‘normal’ competition. Pricing below cost may be seen
as essentially a promotional activity designed to have consumers ‘try out’ a firm’s product with the aim of establishing a
‘brand loyalty’ (and therefore be comparable to an advertising campaign, or a competition, which incurs a similar cost).
The strategy may also be linked to the firm’s policy of charging higher prices for other items purchased in conjunction
with that on which price has been reduced once customers have been attracted (for example, a restaurant attracting
customers by a substantial reduction in the cost of food while it charges much higher prices for beverages purchased at
the same time). In this way, the firm does not even suffer any short-term losses.
Ultimately, whether or not a firm will be able to (or wish to) engage in the practice of pricing below cost (whether or not
this is considered ‘predatory’) will depend partly on its financial strength (and, hence, its ability to sustain any short-term
losses), but most importantly on the barriers to entry into the industry that exist — even if it takes some period of time for
other firms to enter the industry and compete. Short-term gains for consumers arising from below-cost pricing may turn
into long-term monopoly profits for a firm only if other firms are prevented from competing for these profits.

CRITICAL THINKING
What defines a ‘price predator’? How might predatory behaviour benefit a firm in the long run, and what are the
circumstances necessary for such a benefit to be gained?

 8.5 Monopolistic competition Summary 

SUMMARY
Learning objective 1: understand what economists mean by ‘competition’ and ‘market structures’ and the
relationship between them
‘Competitive’ markets refers to how many rivals are in a market and how evenly matched they are. For instance, a
market with only two rivals is less competitive than a market with 100 rivals.
Market structure refers to a cluster of essential features that characterise a market. These features include the number
of sellers and buyers in the market, the degree of differentiation between the goods and services, the degree of
knowledge possessed by the sellers and buyers and the barriers or freedom to entry to and exit from a market.
Learning objective 2: identify when a perfectly competitive firm will maximise profit, break-even and shut
down in the short-run
When a firm is a price-taker, its marginal revenue is identical to the market price: MR = P at every level of output. To
see whether the individual firms in a perfectly competitive market are maximising their economic profit, breaking
even, minimising their losses, or shutting down in the short-run, supply curves must be determined.
Learning objective 3: explain why perfectly competitive firms will tend to break-even in the long-run
The long-run outcome in a perfectly competitive market is that firms are ultimately forced to charge a break-even price
— i.e. P will equal ATC at the final optimum Q.
Learning objective 4: understand the operation of a market where there is no competition at all (i.e. monopoly)
The ‘extreme’ opposite of perfect competition is monopoly. Both monopolists and firms in conditions of perfect
competition maximise their profits by producing at the quantity at which marginal revenue is equal to marginal cost.
However, marginal revenue for a perfect competitor is the same as the market price of an extra unit, while marginal
revenue for a monopolist is less than the market price. As a consequence, buyers of a product produced by a
monopolist pay more for the product than the marginal cost to produce it; there is less production in a monopoly than
there would be if price were set equal to marginal cost. An industry in which average costs decline over a range of
output equal to the total demand for the product, so that only one firm can operate efficiently, is called a natural
monopoly. Even in this case, when there is only one firm (or a few firms), the threat of potential competition may be
sufficiently strong that price is driven down to average costs; there are no monopoly profits. Such markets are said to
be contestable. If, however, there are sunk costs or other barriers to entry, markets will not be contestable, and
monopoly profits can persist.
Learning objective 5: understand imperfect competition and explain the model of monopolistic competition
Where there is imperfect competition between firms (i.e. there is some divergence from the competitive model),
individual firms will be able to sell a larger amount of the product they produce at a lower price. This means that a firm
will have a downward‐sloping demand curve for its product. How steeply the curve slopes downwards will reflect the
degree of monopoly power possessed by the firm. The conclusion reached about the circumstances of equilibrium in
monopoly will thus apply to all firms which are other than perfectly competitive — the steeper the downard slope, the
greater the degree of monopoly power they possess. A market where each firm’s product is slightly different to that of
other firms, but where there are a large number of firms and there are few (if any) barriers to entry is termed one of
monopolistic competition. While each firm faces a downward‐sloping demand curve (so it sets prices and makes a
profit in excess of that in a perfectly competitive market), barriers to entry are sufficiently weak that entry occurs until
profits are driven to zero.
Learning objective 6: understand the model of oligopoly and how it helps to explain the operation of imperfectly
competitive markets where there are only a few firms
A market where there are only a small number of firms is termed an oligopoly. In this case, firms can also set a price,
and make profits — that is, higher than that in perfect competition — though not as high as in the case of a (pure)
monopolist. In order to protect these profits, an oligopolistic firm will normally seek to collude with rival firms,
engage in restrictive practices, and seek to adversely affect rivals or deter potential rivals. Oligopolists must choose
whether to seek higher profits by colluding with rival firms or by competing. They must decide what their rivals will
do in response to any action they take. A group of firms that have an explicit and open agreement to collude is known
as a cartel. While the gains from collusion can be significant, important limits are posed by the incentives to cheat and
the need to rely on self‐enforcement, and by the difficulty of coordinating the responses necessitated by changing
 economic circumstances. Even when they do not collude, firms attempt to restrict competition with practices such as
exclusive territories, exclusive dealing, third line forcing, and resale price maintenance. In some cases, a firm’s profits
may be increased by raising its rival’s costs and making the rival a less effective competitor. Oliopolistic firms also
seek to maintain their monopoly power by preventing other firms from becoming competitors.

Review questions
1. What is meant by the term ‘market structure’? What are the principal criteria according to which market structure is
defined?
2. What does ‘monopoly power’ mean and what does its possession enable a firm to do?
3. List the main reasons explaining why limited (or no) competition occurs.
4. Why is price equal to marginal revenue for a perfectly competitive firm but not for a monopolist?
5. How should a monopoly choose its quantity of production to maximise profits? Explain why producing either less or
more than the level of output at which marginal revenue equals marginal cost will reduce profits. Since a monopolist
need not fear competition, what prevents it from raising its price as high as it wishes to make higher profits?
6. What is a natural monopoly?
7. Describe market equilibrium under monopolistic competition. Why does the price charged by the typical firm exceed the
minimum average cost, even though other firms may enter the market?
8. What are the gains from collusion? Why is there an incentive for each member of a cartel to cheat by producing more
than the agreed‐on amount? What is the ‘prisoner’s dilemma’ and how is it related to the problem of cheating? What are
the other problems facing cartels?
9. Name and define three restrictive practices.
10. What are barriers to entry? How can firms try to deter entry?

Problems
1. Explain how it is possible that at a high enough level of output, if a monopoly produced and sold more, its revenue would
actually decline.
2. Assume there is a single firm producing cigarettes, and the marginal cost of producing cigarettes is a constant. Suppose
the government imposes a 10‐cent tax on each packet of cigarettes. If the demand curve for cigarettes is linear (that is, Q
= a – bp, where Q = output, p = price, and a and b are constants), will the price rise by more or by less than the tax?
3. With what strategies might a furniture firm differentiate its products?
4. Under what circumstances will price be equal to average costs, so that even though there is a single firm in the market, it
earns no monopoly rents?
5. How might cooperative agreements between firms — to share research information, share the costs of cleaning up
pollution, or address shortfalls of supplies — end up helping firms to collude in reducing quantity and raising price?
6. Explain why each of the following might serve to deter entry of a competitor:
a. maintaining excess production capacity
b. promising customers that you will undercut any rival
c. selling your output at a price below that at which marginal revenue equals marginal cost
d. offering a discount to customers who sign up for long‐term contracts.
7. Explain why frequent‐flyer programs (in which airlines give credits, convertible into travel awards for each kilometre
travelled) might reduce competition among airlines. Put yourself in the role of consultant to one of the airlines in the days
before any airline had such programs. Would you have recommended that the airline adopt the program? What would
you have assumed about the responses of other airlines? Would this have been important to your assessment?
8. At various times, Nintendo has been accused of trying to stifle its competitors. Among the alleged practices have been (a)
not allowing those who produce games for Nintendo to produce games for others; and (b) discouraging stores that sell
Nintendo from selling competing games — for instance, by not fulfilling their orders as quickly, especially in periods of
shortages. Explain why these practices might increase Nintendo’s profits.
 8.6 Oligopoly Endnotes 
ENDNOTES
1. Note that (where curves are drawn on the assumption that there are very small increments in output and price) there is a
strict mathematical relationship between a firm’s demand curve (its average revenue curve) and the marginal revenue curve.
Thus, when illustrated diagrammatically (as in figure 8.9) at any price (e.g. p1) the horizontal distances between the y-axis
and the MR curve, and between the MR and demand curve, are equal.
2. In this example, the firm is indifferent to the choice between producing 3000 or 4000 cubic metres. If the marginal cost of
producing the extra output exceeds $4000 by a little, then it will produce 3000 cubic metres; if the marginal cost is a little
less than $4000, then it will produce 4000 cubic metres.
3. Australia Post (2012), media release, 28 May, www.auspost.com.au.
4. A Smith (1776), The wealth of nations, book 1, chapter 10, part 2.
5. For an analysis of collusion using the example of the air cargo cartel agreement (in which Qantas participated), see MS
LeClair (2012), ‘Exigency and innovation in collusion’, Journal of Competition Law and Economics, vol. 8, no. 2, pp. 399–
415. The Australian Competition and Consumer Commission includes discussion of the International Air Cargo Cartel in a
number of ‘Price fixing case studies’ on its website; see www.accc.gov.au.
6. M Day (2008), ‘Don’t die for privacy reforms’, The Australian (14 August), www.theaustralian.com.au.
7. Note that collusion, particularly in the form of price fixing, and some entry deterrence practices are conventionally in
Australia put under the general heading of ‘restrictive practices’ along with those considered in what follows.

 Summary Part 4 Enterprise 

 PART 4
Enterprise
 9 Entrepreneurs and opportunities
10 Entrepreneurship: definition and evolution
11 Starting an enterprise: the entrepreneurship alternatives

 Endnotes 9 Entrepreneurs and opportunities 

 Chapter 9

Entrepreneurs and opportunities

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

9.1 define business and the private enterprise system
9.2 define the various types of entrepreneurs
9.3 list the roles and characteristics of entrepreneurs
9.4 explain how entrepreneurial opportunities are formed
9.5 define the risks of a career in entrepreneurship and identify relevant performance measures for an entrepreneur
9.6 explain entrepreneurial behaviour in a social context.
 Energy production comes home
Have you heard of Southwestern Energy? Pioneer Natural Resources? Range Resources? These companies and others are
all part of a recent US news story that is very important to American business. For the first time in 25 years, the United
States is now producing more oil domestically than they are importing. Oil production increased due in large part to the
widespread adoption of two drilling technologies: horizontal drilling and fracking.
Horizontal drilling allows oil companies to get more oil from a single well as the drill bit first goes down vertically
through the overlying rock and then is turned horizontally to drill along and through the oil-rich layers. Multiple
horizontal holes can be drilled from a single site, greatly increasing the amount of oil reserves available in a single well.
Once the holes are drilled in the oil-producing layers, high-pressure water mixed with fine sand is pumped into the well to
fracture the rock and extract oil.
Fracking has also been widely used to drill into shale formations and extract natural gas, such as the Marcellus formation
in Pennsylvania, the Fayetteville formation in Arkansas, and the Bakken formation in North Dakota. The result of these
efforts has been a significant increase in the availability and reserves of domestic oil and gas.
Why is this significant to US consumers and business? First, for the past several decades one of the largest imports into
the United States has been crude oil. When the overall value of imports is reduced compared to the value of exports, the
US balance of trade becomes more favourable, which is generally a benefit to US consumers.
Second, industries such as steel, glass and cement, which are heavy consumers of energy, will be more competitive as
their cost of production decreases. Many of these industries have had a hard time competing with foreign sources due to
their lower cost basis. Lower energy costs will help these industries.
Third, because of the increased supply and reduced price of natural gas, utility companies are switching away from
burning coal to produce electricity. As a fuel, natural gas contains less carbon than coal and consequently produces less
carbon dioxide as a combustion product. This plus other conservation efforts have allowed the United States to achieve
the emission targets of the Kyoto protocol — reducing greenhouse gasses by more than 5 percent — a goal that many
experts thought impossible just a decade ago.
Increased domestic oil and gas production creates a more favourable balance of trade, more competitive domestic
industries and reduced greenhouse gas emissions. Any one of these stories would be newsworthy by itself, but together
they represent significant and positive changes for US consumers and businesses.1

Introduction
Business is the nation's engine for growth. A growing economy — one that produces more goods and services with fewer
resources over time — yields income for business owners, their employees and stockholders. So a country depends on the
wealth its businesses generate, from large enterprises such as the Walt Disney Company to tiny online start-ups, and from
venerable firms such as 160-year-old jeans maker Levi Strauss & Company to powerhouses such as Google. What all these
companies and many others share is a creative approach to meeting society's needs and wants.
Businesses solve our transportation problems by marketing cars, tires, petrol and airline tickets. They bring food to our tables
by growing, harvesting, processing, packaging and shipping everything from spring water to cake mix and frozen prawns.
Restaurants buy, prepare and serve food, and some even deliver. Construction companies build our schools, homes and
hospitals, while real estate firms bring property buyers and sellers together. Clothing manufacturers design, create, import
and deliver our jeans, sports shoes, work uniforms and party wear. Entertainment for our leisure hours comes from hundreds
of firms that create, produce and distribute films, television shows, video games, books and music downloads.
To succeed, business firms must know what their customers want so that they can supply it quickly and efficiently. That
means they often reflect changes in consumer tastes, such as the growing preference for sports drinks and vitamin-fortified
water. But firms can also lead in advancing technology and other changes. They have the resources, the know-how and the
financial incentive to bring about new innovations as well as the competition that inevitably follows, as in the case of Apple's
iPhone and Google's Android operating system.
Businesses require physical inputs such as motor vehicle parts, chemicals, sugar and electricity, as well as the accumulated
knowledge and experience of their managers and employees. Yet they also rely heavily on their own ability to change with
the times and with the marketplace. Flexibility is a key to long-term success — and to growth.

 Part 4 Enterprise 9.1 Business and the private enterprise system 

9.1 BUSINESS AND THE PRIVATE ENTERPRISE SYSTEM
Learning objective 1
define business and the private enterprise system

What comes to mind when you hear the word business? Do you think of big corporations like Telstra or Woolworths? Or
does the local deli or shoe store pop into your mind? Maybe you recall your first part-time job. The term business is a broad,
all-inclusive term that can be applied to many kinds of enterprises. Businesses provide the bulk of employment opportunities,
as well as the products that people enjoy.
Business consists of all profit-seeking activities and enterprises that provide goods and services necessary to an economic
system. Some businesses produce tangible goods, such as automobiles, breakfast cereals and smart phones; others provide
services such as insurance, hair styling and entertainment, ranging from theme parks and sports matches to concerts.
Business drives the economic pulse of a nation. It provides the means through which its citizens’ standard of living improves.
At the heart of every business endeavor is an exchange between a buyer and a seller. A buyer recognises a need for a good or
service and trades money with a seller to obtain that product. The seller participates in the process in hopes of gaining profits
— a main ingredient in accomplishing the goals necessary for continuous improvement in the standard of living.

A business, such as this mobile phone store, survives through the exchange between a buyer and a seller

Profits represent rewards earned by businesspeople who take the risks involved in blending people, technology and
information to create and market want-satisfying goods and services. In contrast, accountants think of profits as the
difference between a firm’s revenues and the expenses it incurs in generating those revenues. More generally, however,
profits serve as incentives for people to start companies, expand them, and provide consistently high-quality competitive
goods and services.
The quest for profits is a central focus of business because without profits, a company could not survive. But businesspeople
also recognise their social and ethical responsibilities. To succeed in the long run, companies must deal responsibly with
employees, customers, suppliers, competitors, government and the general public.
Not-for-profit organisations
What do Ronald McDonald House, the Australian Red Cross Blood Service, Surf Life Saving Australia and your local
library have in common? They all are classified as not-for-profit organisations, businesslike establishments that have
primary objectives other than returning profits to their owners. These organisations play important roles in society by placing
public service above profits, although it is important to understand that these organisations need to raise money so that they
can operate and achieve their social goals. Not-for-profit organisations operate in both the private and public sectors. Private-
sector not-for-profits include museums, libraries, trade associations, and charitable and religious organisations. Government
agencies, political parties and workers’ unions, all of which are part of the public sector, are also classified as not-for-profit
organisations.
Not-for-profit organisations are a substantial part of the economy. At June 2013, 56 894 nonprofit organisations were
registered in Australia, in categories ranging from arts and culture to science and technology.2 These organisations controlled
more than $176 billion in assets and employed close to 11 million people. In addition, close to 4 million of volunteers
worked for them in unpaid positions.3 Not-for-profits secure funding from private sources, including donations, and from
government sources. They are commonly exempt from federal, state and local taxes.
Although they focus on goals other than generating profits, managers of not-for-profit organisations face many of the same
challenges as executives of profit-seeking businesses. Without funding, they cannot do research, obtain raw materials or
provide services. St. Jude Children’s Research Hospital’s pediatric treatment and research facility in Memphis (Tennessee)
treats nearly 7800 children a year for catastrophic diseases, mainly cancer, immune system problems, and infectious and
genetic disorders. Patients come from all over the world and are accepted without regard to the family’s ability to pay. To
provide top-quality care and to support its research in gene therapy, chemotherapy, bone marrow transplantation and the
psychological effects of illness, among many other critical areas, St. Jude relies on contributions, with some assistance from
federal grants.4
Other not-for-profits mobilise their resources to respond to emergencies. The Australian Red Cross’s Disaster Relief and
Recovery fund is a prime example. Funds from donations go towards staff and volunteer training, support for communities to
prepare for disasters, and to help disaster-affected communities recover from emergencies such as floods, bushfires and other
severe weather conditions.5

The Red Cross mobilised its efforts to respond to disaster on the East Coast after Superstorm Sandy struck
Some not-for-profits sell merchandise or set up profit-generating arms to provide goods and services for which people are
willing and able to pay. University bookshops sell everything from university-branded merchandise to stationery and lollies,
while the Co-op Bookshop sells video games, smart phones, skateboards and computer accessories. Founded in 1912, The
Girl Scouts of the USA are known for their mouth-watering cookies. The organisation has created a biscuit empire valued at
more than US$700 million through sales by local scout troops.6 Handling merchandising programs like these, as well as
launching other fundraising campaigns, requires managers of not-for-profit organisations to develop effective business skills
and experience. Consequently, many of the concepts discussed in this E-Text apply to not-for-profit organisations as well as
to profit-oriented firms.

Concepts and applications check

1. What activity lies at the centre of every business endeavor?
2. What is the primary objective of a not-for-profit organisation?

The private enterprise system

No business operates in a vacuum. All operate within a larger economic system that determines how goods and services are
produced, distributed and consumed in a society. The type of economic system employed in a society also determines
patterns of resource use. Some economic systems, such as communism, feature strict controls on business ownership, profits
and resources to accomplish government goals.

Hit & miss

Live Nation connects superstar artists and fans
Chances are, the last concert you attended may have been produced by Live Nation Entertainment, a Beverly Hills–based
powerhouse. The largest producer of live music concerts worldwide, Live Nation sells millions of tickets each year for
events that range from folk to electronic dance music and that feature entertainers from new artists to music legends. A
few years ago, Live Nation merged with ticket-selling giant Ticketmaster Entertainment to create Live Nation
Entertainment.
Over 250 million fans access various entertainment platforms each year, attending more than 180 000 events in 47
countries. While more than 65 percent of the company’s revenues come from its concert segment, other distinct business
units include venue operations, ticketing services, and artist management and services.
If you’ve ever thought about a career as a concert promoter, consider the ‘accidental trajectory’ of then–university student
Jodi Goodman. After urging a failing jazz club owner in Boston, Massachusetts to allow her to book a few rock music
events, Goodman not only turned the club around, but word soon got out about her knack for managing both artists and
fans. It was not long before other venues sought her talent, and her career took her to San Francisco, California. Jodi
Goodman is now president of Live Nation Entertainment for Northern California. With skill and market expertise,
Goodman continues to bring artists and fans together in one of the top music markets in the country.
Concert revenues continue to rise and the future looks bright. Some of this success can be attributed to the Boston college
kid who read the local music market by bringing some good old rock ‘n’ roll to a jazz club on the brink of closure.

Questions for critical thinking

1. Ticketmaster, now part of Live Nation Entertainment, responded to the threat of the secondary ticket resale market (by
firms like Craigslist and StubHub) by launching its own ticket marketplace. How will Ticketmaster's marketplace
impact secondary market competitors?
 2. Live Nation anticipates double-digit growth in the number of concertgoers worldwide over the next several years.
What factors could contribute to such a healthy increase in attendance?
Sources: Company website, “2013 Annual Report,” http://livenation.com, accessed January 9, 2014; “Live Nation's New Groove: Electronic
Dance Music and Scalped Tickets,” Bloomberg Businessweek, accessed January 9, 2014, www.businessweek.com; Glenn Peoples, “Live Nation
Revenue Hits a Record $2.26 Billion in Third Quarter,” Billboard Biz, accessed January 9, 2014, www.billboard.com; Christine Ryan, “Hot 20:
The Music Woman, Jodi Goodman,” 7x7 Magazine, accessed January 9, 2014, www.7x7.com; Ina Fried, “Live Nation Aims to Unify Ticketmaster,
Ticket Resale Businesses,” All Things Digital, accessed January 9, 2014, http://allthingsd.com.

In Australia, businesses mostly function within the private enterprise system, an economic system that rewards firms for
their ability to identify and serve the needs and demands of customers. The private enterprise system minimises government
interference in economic activity. Businesses that are adept at satisfying customers gain access to necessary factors of
production and earn profits.
Another name for the private enterprise system is capitalism. Adam Smith, often identified as the father of capitalism, first
described the concept in his book, The Wealth of Nations, published in 1776. Smith believed that an economy is best
regulated by the ‘invisible hand’ of competition, the battle among businesses for consumer acceptance. Smith thought that
competition among firms would lead to consumers’ receiving the best possible products and prices because less efficient
producers would gradually be driven from the marketplace.
The invisible hand concept is a basic premise of the private enterprise system. In the United States, competition regulates
much of economic life. To compete successfully, each firm must find a basis for competitive differentiation, the unique
combination of organisational abilities, products and approaches that sets a company apart from competitors in the minds of
customers. Businesses operating in a private enterprise system face a critical task of keeping up with changing marketplace
conditions. Firms that fail to adjust to shifts in consumer preferences or ignore the actions of competitors leave themselves
open to failure. Live Nation Entertainment connects millions of concertgoers with their favourite artists at venues worldwide;
see the Hit & miss feature for keys to the company’s success.
Throughout this book, our discussion focuses on the tools and methods that 21st-century businesses apply to compete and
differentiate their goods and services. We also discuss many of the ways in which market changes will affect business and the
private enterprise system in the years ahead.

Basic rights in the private enterprise system

For capitalism to operate effectively, people living in a private enterprise economy must have certain rights. As shown in
figure 9.1, these include the rights to private property, profits, freedom of choice and competition.

FIGURE 9.1 Basic rights within a private enterprise system

The right to private property is the most basic freedom under the private enterprise system. Every participant has the right
to own, use, buy, sell and bequeath most forms of property, including land, buildings, machinery, equipment, patents on
inventions, individual possessions and intangible properties.
The private enterprise system also guarantees business owners the right to all profits — after taxes — they earn through their
activities. Although a business is not assured of earning a profit, its owner is legally and ethically entitled to any income it
generates in excess of costs.
Freedom of choice means that a private enterprise system relies on the potential for citizens to choose their own employment,
purchases and investments. They can change jobs, negotiate wages, join workers’ unions, and choose among many different
brands of goods and services. A private enterprise economy maximises individual prosperity by providing alternatives. Other
economic systems sometimes limit freedom of choice to accomplish government goals, such as increasing industrial
production of certain items or military strength.
The private enterprise system also permits fair competition by allowing the public to set rules for competitive activity. For
this reason, the US government has passed laws to prohibit ‘cutthroat’ competition — excessively aggressive competitive
practices designed to eliminate competition. It also has established ground rules that outlaw price discrimination, fraud in
financial markets, and deceptive advertising and packaging.7

The entrepreneurship alternative

The entrepreneurial spirit beats at the heart of private enterprise. An entrepreneur is a risk taker in the private enterprise
system. You hear about entrepreneurs all the time — two university students starting a software business in their share house
or a mum who invents a better baby carrier. Many times their success is modest but, once in a while, the risk pays off in huge
profits. Individuals who recognise marketplace opportunities are free to use their capital, time and talents to pursue those
opportunities for profit. The willingness of individuals to start new ventures drives economic growth and keeps pressure on
existing companies to continue to satisfy customers. If no one were willing to take economic risks, the private enterprise
system wouldn’t exist.

 9 Entrepreneurs and opportunities 9.2 Who are the entrepreneurs? 

9.2 WHO ARE THE ENTREPRENEURS?
Learning objective 2
define the various types of entrepreneurs

People and organisations must change often and at a rapidly accelerating pace. Success in highly competitive business
environments, in particular, depends on entrepreneurship. This term is used to describe dynamic, creative, risk-taking
behaviour that results in the creation of new opportunities for individuals and/or organisations. Entrepreneurship can often be
seen in small, medium, large, private, public and government organisations. In other words, it comes in many shapes and
forms.
An entrepreneur creates a new enterprise, opportunity or business venture. In the business context, an entrepreneur starts
new ventures that bring to life new products or services. Entrepreneurs have been responsible for many innovative and useful
products and services in the modern marketplace. Many believe entrepreneurs to be high risk takers but in every successful
venture these risks are calculated risks.
Many different terms are increasingly being used to describe particular types of entrepreneurs. For example, there are
technopreneurs, who are involved in high-technology industries (such as Facebook’s Mark Zuckerberg); social
entrepreneurs, who run social enterprises that are driven by community needs rather than profit;8 and intrapreneurs, who
innovate for change from within large organisations.
Entrepreneurs such as the late Steve Jobs (who co-founded Apple Computers), Sir Richard Branson (who established the
Virgin Group) and all the entrepreneurs who set up small businesses worldwide provide many of the new products, processes
and marketing technologies that allow the global economy to evolve, innovate and prosper. In recent years, the importance of
these entrepreneurs has been recognised through awards, which not only raise the profiles of their businesses locally but also
enhance their profiles worldwide. The value of entrepreneurs is also evident by their inclusion in government think tanks.
Entrepreneurs often participate in programs encouraging other budding entrepreneurs, where they can share success stories
and advice on business plans and networking opportunities, and possibly identify new markets.
Researchers are interested in the characteristics of entrepreneurs. They want to know whether and how entrepreneurs are
different, and what it takes to achieve entrepreneurial success. Before examining the findings, let’s meet some real, high-
profile entrepreneurs. Their stories are rich with ideas for all of us to consider. Although the people and what they have
accomplished differs, they share something in common. These entrepreneurs have all built successful long-term businesses
from good ideas and hard work.9
Entrepreneurial success stories
Phillip Di Bella
Phillip Di Bella believes that ‘Entrepreneurship is all about looking at something and being able to do it better’. After
nine years working in a café, he decided to go out on his own. He sold his house to purchase a site in Brisbane and,
starting with a mere $5000 in capital, he leased a roasting machine and opened a small coffee roasting operation — Di
Bella Coffee. Within ten years, Di Bella Coffee has grown to become Australia’s largest specialty coffee manufacturer,
with an international presence and operations now in Sydney, Melbourne, China, India and New Zealand, as well as an
online store. In the early days, Di Bella literally walked the streets and knocked on doors to get cafés and restaurants to
buy his coffee. Di Bella states that ‘My point of difference was about me being in the people business, not the coffee
business. I wanted to create an experience and to me it’s all about working in partnership with cafés, not just supplying
my product’. That philosophy has clearly worked. A decade later, Di Bella Coffee supplies more than 1200 cafes and
restaurants nationally, and its website has more than 4000 registered online purchasers.

Phillip Di Bella

Carolyn Creswell
In 1992, Carolyn Creswell was an 18-year-old with a part-time job making muesli for a small business that supplied a
handful of cafés and delis in Melbourne. When she was told the business she was working for was going to be sold,
Carolyn negotiated to buy it for a mere $1000. Twenty years later, her company Carman’s Fine Foods exports her muesli,
muesli bars and porridge products to thirty countries around the world. The products are also found in supermarkets and
delis across Australia, and are also available on airlines.

Carolyn Creswell

Steve Chen
Steve Chen was born in Taiwan and raised from the age of eight in the United States. He co-founded the video-sharing
website YouTube in 2005, when he was just 27 years old. Within twelve months, YouTube’s popularity and potential was
such that the fledgling organisation was sold to Google for a staggering $1.65 billion. One of the secrets to YouTube’s
success was that it (spectacularly) met a latent, unfulfilled need. Chen and the other co-founders put the online
community first, allowing them to decide what videos to upload and what was subsequently entertaining them. Users
decide for themselves what they believe is worth watching. YouTube has played a starring role in the online video
revolution, capitalising on the ever increasing broadband network capabilities of most countries around the world.

Steve Chen

Gurbaksh Chahal
Indian-born American entrepreneur Gurbaksh Chahal dropped out of school at the age of 16 and started his first company,
ClickAgents, which focused on performance-based advertising. He sold it for $40 million to ValueClick just 18 months
later. Following this in 2004, Gurbaksh founded his second company, BlueLithium. This company focused on helping
web advertisers with behavioural targeting, and was sold to Yahoo in 2007 for $300 million. Before reaching the age of
30, Gurbaksh had started his third online ad company, RadiumOne, which is focuses on real-time advertising. The
company was recently reported to be valued at more than $500 million.

Gurbaksh Chahal

Mark Bouris
Mark Bouris revolutionised the Australian home loan industry when he launched Wizard in 1996. After starting
operations with just five staff, he developed Wizard into a company worth $500 million in less than ten years. The
company was sold to GE Money for this price in 2006, and is now owned by Aussie Home Loans. Bouris’s background
as the son of a migrant family and as a Sydney property developer made him aware of the need for increasing the general
public’s access to affordable home loans so that they could realise the Australian dream of home ownership. Bouris
realised that borrowers wanted good value and customer service on their terms, rather than those of the banks. He
developed a model based on maximising access for customers through all the possible channels — branches in the
suburbs, telephone service, mobile lenders who can travel to the borrower and, of course, the internet. Price was, and
remains, critical to Australian borrowers so Bouris built relationships with the best mortgage funders in the country and
committed the business to no ongoing fees and charges. Wizard had to keep costs down in order to be profitable in this
market and so it built a model that was low on overheads, big on creativity and smart on pricing. In more recent times,
Bouris became known as the ‘boss’ in the Australian version of the entrepreneur reality television show The Apprentice.
Bouris is now the executive chairman of wealth management company Yellow Brick Road, which intends to ‘keep the big
banks honest’ by increasing competition in the home loan sector.

Mark Bouris

Victoria Ransom
Victoria Ransom is a New Zealand entrepreneur who co-founded the world’s largest social media marketing company,
Wildfire. After studying psychology at university, she started to explore entrepreneurism. Says Ransom, ‘I went into a
graduate business analyst program with Morgan Stanley during the dot com boom and bust, so I got a lot of exposure to
tech entrepreneurs’. Wildfire had its beginnings as a small adventure travel company, later evolving into a social media
marketing company working for high-profile global brands such as Pepsi, Sony, Facebook and Unilever. In 2010 and
2011, she was listed as one of the ‘25 women to watch in tech’, and she has been awarded New Zealand’s ‘Entrepreneur
of the year’ by Ernst and Young. In 2012, Wildfire co-founders Ransom and Alain Chuard sold the company to Google.

Victoria Ransom

Ruslan Kogan
Online technology entrepreneur Ruslan Kogan launched his own brand of discount electronic goods in 2006 from his
parents’ garage. By 2012, he’d made it to eighth position on BRW’s young rich list. The Kogan website offers a range of
consumer electronics, having expanded from an emphasis on LCD televisions to now selling cameras, sound systems,
computers, phones and other household appliances. Kogan has gained a somewhat controversial reputation for his rivalry
with other Australian long-established business leaders and for pushing the boundaries. He once commented of the
Harvey Norman chain ‘I really respect Gerry Harvey as a business man, but entrepreneurs embrace change and evolve
business models’.

Ruslan Kogan
Sources: Kendall Connors, ‘Di Bella Coffee: Passion and Entrepreneurship’, Business Review Australia website, www.business
reviewaustralia.com; Barbara Drury, ‘Invest in Your Skill, Don’t Sell It’, The Age (22 February 2012), www.theage.com.au; Madeleine Heffernan
and Lexi Cottee, ‘Australia’s Top 30 Female Entrepreneurs 2012’, Smart Company (8 March 2012), www.smartcompany.com.au; ‘The Carman’s
Story, So Far …’, Carman’s website, www.carmanskitchen.com.au; Google, ‘Corporate information’, www.google.com/corporate/history.html;
‘Gurbaksh Chahal: Die Hard Entrepreneur’, www.chahal.com; Leena Rao, ‘Social Retargeting Ad Network RadiumOne Raising a $50M Round
at a $500M Valuation’, Tech Crunch (2 March 2012), www.techcrunch.com; Information from Lisa Murray, ‘Wizard Kicks on into the Big
League’, Age (3 November 2004), www.theage.com.au;
AAP, ‘Ex Wizard boss returns to loan market’, Sydney Morning Herald (2009),
http://news.smh.com.au;
Mousumi Kumar Saha, ‘Victoria Ransom: Co-Founder and CEO of Wildfire, World’s Largest Social Media Marketing
Company’, Success Stories (20 August 2012), www.successstories.co.in; Jeanne-Vida Douglas, ‘Beginnings: Victoria Ransom’, BRW (24 August
2011), www.brw.com.au; James Thomson, ‘Kogan Provocateur’, Smart Company (15 June 2012), www.smartcompany.com.au; ‘The List: Young
Rich 20120’, BRW (27 September 2012), www.brw.com.au; Patrick Stafford, ‘Gerry Harvey vs. Ruslan Kogan — Will Frugal Customers Look
for Brand Names or Discounts?’ Smart Company (25 August 2010), www.smartcompany.com.au; Kogan website, www.kogan.com.au.

 9.1 Business and the private enterprise system 9.3 Understanding the profile of an entrepreneur 
9.3 UNDERSTANDING THE PROFILE OF AN
ENTREPRENEUR
Learning objective 3
list the roles and characteristics of entrepreneurs

It is difficult to identify and find entrepreneurs and to determine what they do. Is the artisan, the small business owner–
manager or even the manager of a large corporation an entrepreneur? Are entrepreneurs found in private businesses only, or
can they be in government and not-for-profit organisations as well? This section reviews the two basic schools of thought on
the profile of the entrepreneur: the economists who consider the entrepreneur as an agent who specialises in certain roles, and
the behaviourists who concentrate on the creative and intuitive characteristics of entrepreneurs. Later sections present the
different risks associated with a career as an entrepreneur, and discuss the relevant performance measures to be considered in
entrepreneurship.

The roles of entrepreneurs: an economic perspective

From an economic point of view, entrepreneurship is considered as a function, so entrepreneurs have been all but banished
from the theory of the firm and the market. Microeconomics instead gives pride of place to prices. Guided by the wages and
interest rates they must pay, businesspeople select from different techniques of production (labour-intensive when workers
are cheap, capital-intensive when they are in short supply); however, they do not reinvent or revolutionise them. Guided by
the price their goods are bought for, they decide to increase or decrease production.10 In other words, as Casson noted, ‘The
entrepreneur is what the entrepreneur does’.11 The status of the entrepreneur can then be analysed in terms of a division of
labour that explains this function based on certain roles, such as risk bearer, arbitrageur, innovator and coordinator of scarce
resources.

1: Risk bearer
Cantillon12 described an entrepreneur as a person who pays a certain price for a product to resell it at an uncertain price,
thereby making decisions about obtaining and using resources while assuming the risk of enterprise. According to this view,
merchants, for example, are specialised bearers of risk. Manufacturers can also be bearers of risk in that they purchase the
labour of workers before the product of that labour is sold. Consequently, entrepreneurs should be regarded as calculated risk
takers.
Risk exists when uncertain outcomes can be predicted with some degree of probability. An entrepreneur is prepared to accept
the remaining risk that cannot be transferred through insurance. Knight first developed the distinction between risk, which is
insurable, and uncertainty, which insurers will not touch because they have no way of typing and calibrating it. Knight
argued that an entrepreneur’s new venture is in some aspects unique, and the relative frequencies of past events are not
sufficient to estimate the probabilities of future returns of the venture.13 Uncertainty, which cannot be eliminated or insured
against, is therefore the source of profit:
Profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated
and then only in so far as even a probability calculation in regard to them is impossible and meaningless.14
People must rely on their own judgement when facing uncertainty, because they have no outside information to refer to. It is
on this resource — good judgement — that entrepreneurs earn a profit.15

2: Arbitrageur
For other economists,16 the entrepreneur is the key figure in the market economy. In a continually changing environment,
entrepreneurs move the economy towards equilibrium through speculation and arbitrage. The main function of the
entrepreneur in this context is one of price discovery. The motivation for price discovery is the prospect of a temporary
monopoly gain if the entrepreneur can benefit from being the first to exploit the price differences. Profit is the reward for
recognising a market opportunity and providing the intermediary function. Freedom of entry ensures that the entrepreneur
receives only a normal profit once the costs of discovery are allowed for.

3: Innovator
Schumpeter17 broke with traditional economics because it sought, and still seeks, to optimise resources within a stable
environment. He suggested that dynamic disequilibrium brought on by the innovating entrepreneur, rather than equilibrium
and optimisation, is the norm of a healthy economy. Here, the entrepreneur is an innovator who carries out new
combinations: introducing a new product or technology, discovering a new export market or developing new business
organisations. Schumpeter added that innovations are, as a rule, embodied in new firms.18 Thus the agent of change is the
entrepreneur who, hitting upon the prospective profitability of some unnoticed commercial application, undertakes a new
venture by implementing an innovative idea. Banks — the venture capitalists of Schumpeter’s era — selected the investment
projects to finance.

4: Coordinator of scarce resources

Another economist, Say,19 described the entrepreneur as a coordinator and supervisor of production. The entrepreneur is the
plucky up-start who shifts economic resources out of an area of lower productivity and into an area of higher productivity
and greater yields. Entrepreneurs, however, may not have all the resources (e.g. money, labour, premises, technology)
necessary to launch a business venture. Therefore, a critical role of the entrepreneur involves convincing resource holders to
commit some resource to the new venture and coordinating these scarce resources. To achieve this, the entrepreneur must
have judgement, perseverance and knowledge of the world of business.

The characteristics of entrepreneurs: a behaviourist approach

The second category of researchers who study entrepreneurs are the behaviourists, including psychologists and sociologists.
Early studies in entrepreneurship typically focused on the psychological characteristics and the personality of the individual
as determinants of entrepreneurial behaviour. The most common characteristics are shown in figure 9.2.

Self-confidence Tolerance of ambiguity

Risk-taking propensity Responsiveness to suggestions

Flexibility Dynamic leadership qualities

Independence of mind Initiative

Energy and diligence Resourcefulness

Hard-work ethic Good communication skills

Creativity Perseverance

The need for achievement Profit-orientation

Internal locus of control Perception with foresight

FIGURE 9.2 Characteristics of successful entrepreneurs

Among the almost endless list of entrepreneurial traits suggested, only three have received wide attention in the literature and
show a high level of validity:20 the need for achievement, internal locus of control and a risk-taking propensity.

1: The need for achievement

Of all the psychological measures presumed to be associated with the creation of new ventures, the need for achievement has
the longest history. The need for achievement — a person’s desire either for excellence or to succeed in competitive
situations — is a key personal attribute of successful entrepreneurs.21 Successful entrepreneurs are highly motivated in what
they do. These people are typically self-starters, internally driven to compete against their own self-imposed standards. High
achievers take responsibility for attaining their goals, set moderately difficult goals and desire immediate feedback on how
well they have performed.22

2: Internal locus of control

Locus of control refers to the extent to which people believe they can control events that affect them. People with a high
internal locus of control believe that events result mainly from their own behaviour and actions. Those with a high external
locus of control believe that powerful others, fate or chance mainly determine events. Effective entrepreneurs believe in
themselves, and have a perception that they can control the events in their lives and can, therefore, guide their own destiny.
This attribute is consistent with a high-achievement motivational drive and a need for autonomy.
What seems to underlie the internal locus of control is the concept of ‘self as agent’. This means that individuals’ thoughts
control their actions, and that when they realise this executive function of thinking, they can positively affect their beliefs,
motivation and, to a certain extent, their performance. As a result, the degree to which they choose to be self-determining is a
function of their realisation of the source of agency and personal control.23 In other words, we can say to ourselves, ‘I choose
to direct my thoughts and energies towards accomplishment. I choose not to be daunted by my anxieties or feelings of
inadequacy.’

3: Risk-taking propensity
Although entrepreneurs are not gamblers, they are characterised by a propensity to take calculated risks. In a world of
change, risk and ambiguity, successful entrepreneurs are those who learn to manage the risk, in part by transferring a portion
of the risk to others (investors, bankers, partners, customers, employees and so on). However, risk-taking propensity is
strongly influenced by cognitive heuristics. Entrepreneurs may not think of themselves as being any more likely to take risks
than non-entrepreneurs yet, nonetheless, they are predisposed to categorise business situations more positively.24 Thus,
entrepreneurs may view some situations as opportunities, even though others perceive those same situations as having little
potential.
The characteristics approach eventually reached a dead end, as it could only partially answer the question: ‘What makes
people set-up new ventures?’ The study of the demographic background of entrepreneurs (age, gender, previous
employment) was another attempt to understand these people and uncover a pattern. Demographic studies generally
confirmed that entrepreneurs tend to be better educated; to come from families where the parents owned a business; to start
ventures related to their previous work; and to locate their ventures where they are already living and working. Overall, these
studies provided mixed results.25 This is not surprising — being innovators and idiosyncratic, entrepreneurs tend to defy
stereotyping.

Entrepreneur profile

Matt Barrie, Freelancer.com

As Chief Executive of Freelancer.com, the world’s largest outsourcing marketplace, Matt Barrie empowers
entrepreneurs and connects seven million professionals from around the globe. Freelancer.com is a global marketplace
for online and freelance jobs where businesses connect with independent service providers and freelancers to outsource
their work.
Through the website, employers can hire freelancers to do work in areas such as software, writing, data entry and design
right through to engineering and the sciences, sales and marketing, and accounting and legal services. The average job is
around US$200, making it extremely cost effective for small businesses. Freelancer.com allows small business owners to
get jobs done by outsourcing to entrepreneurs in the developing world.
‘It’s about using technology to connect people who are looking to provide a service with those who need it, at a
reasonable price and in an innovative way’, Barrie says.
Over 4 million projects have been outsourced through Freelancer.com, providing livelihoods for hundreds of thousands of
entrepreneurs in economies where work is desperately needed. Freelancer.com started in 2009 when Barrie bought
GetAFreelancer.com, a Swedish marketplace with 500000 users that was ranked as the 5000th largest website in the
world. Improving the business model and using the cash flow to buy a number of regional marketplaces in the United
Kingdom, Germany, Australia, Hong Kong and the United States, Barrie has grown Freelancer.com into a household
name in the developing world. It now ranks among the top 250 websites globally.
For twelve years Barrie has lectured on entrepreneurship to engineering students and says he became an entrepreneur by
default. ‘I often joke that I’m fundamentally unemployable’, he says. ‘I like to do things differently and question
authority. I figured out that I would have to create a job for myself if I was going to get anywhere’. Barrie’s goal for
Freelancer.com is for it to be the next eBay, but for services. The company achieved 82 per cent compound revenue
growth for the last four years.
Source: Ernst & Young, ‘Matt Barrie’, Exceptional, 2012, p. 12.

 9.2 Who are the entrepreneurs? 9.4 Entrepreneurs and opportunities 

9.4 ENTREPRENEURS AND OPPORTUNITIES
Learning objective 4
explain how entrepreneurial opportunities are formed

We defined opportunities as ‘situations in which new goods, services, raw materials, markets and organising methods can be
introduced through the formation of new means, ends, or means-ends relationships’.26 However, do these entrepreneurial
opportunities happen regardless of the insight of entrepreneurs, as if waiting to be discovered? Or do entrepreneurs create
opportunities by their actions? This section describes two internally consistent theories — discovery theory and creation
theory — to explore how entrepreneurial opportunities occur.27

1: The discovery perspective

The classic view in entrepreneurship argues that opportunities exist because of inefficiencies in the allocation of resources or
competitive imperfections in a market or industry. By combining resources in a novel way, entrepreneurs can form new
means-ends relationships, thereby introducing a previously unseen or unknown good, service or production process in the
marketplace and creating the potential for economic profit.28 This view holds that the inefficiencies that generate
entrepreneurial opportunities are primarily caused by external changes to an industry or market. From the perspective of
those trying to take advantage of them, entrepreneurial opportunities appear as real and objective phenomena — like
misplaced baggage in an airline terminal — just waiting to be discovered.29 The successful entrepreneur, therefore, is the one
who correctly perceives (or discovers) these opportunities.30
The discovery perspective typically follows a causal approach to entrepreneurship as shown in figure 9.3. Once an
opportunity has been discovered, the potential entrepreneur assesses the commercial potential of the idea, leading to the
establishment of goals and a plan to exploit the identified opportunity. The entrepreneur decides whether or not to start a
venture — depending upon the magnitude of the opportunity, the potential entrepreneur’s individual characteristics (e.g. their
ability to attract resources), opportunity costs and prior entrepreneurial experience. Investment and actions such as generating
prototype products and testing market reactions typically follow the business launch. A set of strategic choices is then made
with regard to the business model, partnerships, pricing and product line. After product launch, consumer demand either
takes place or doesn’t, providing the entrepreneurs with feedback on their idea and enabling adjustments.31

FIGURE 9.3 The role of the entrepreneur in the discovery (or causal) perspective

Source: G. Fisher, ‘Effectuation, causation, and bricolage: A behavioral comparison of emerging theories in entrepreneurship
research’, Entrepreneurship Theory & Practice, vol. 36, no. 5, 2012, p. 1024.

2: The creation perspective

Creation theory is the counterpoint to discovery theory for providing an explanation of the actions entrepreneurs take to
generate and exploit opportunities. Counter to the discovery theory, creation theory rejects the idea that opportunities are
objective phenomena formed by market or industry changes. Rather, they are created by the actions, reactions and enactment
of entrepreneurs, who proactively delve into innovative ways of producing new products and services. According to this
model, entrepreneurs do not wait for changes in the market to generate their opportunities. They act first, and then examine
how consumers respond to their actions. In short, opportunities do not exist independently of the actions taken by
entrepreneurs to create them.32
The creation perspective suggests that entrepreneurship is essentially an effectuation process. As shown in figure 9.4, this
process begins with a given set of means and allows goals to emerge contingently over time from the varied actions and
aspirations of entrepreneurs and the people with whom they interact. Entrepreneurs, as they start with a set of means, make
important decisions by focusing on the resources under their control — asking ‘Who am I?’, ‘What do I know?’ and ‘Whom
do I know to uncover opportunities?’33 Their actions consist of things they can do and believe are worth doing. One of the
first things they do is interact with each other. Some of those interactions result in commitments to the new business venture.
However, each stakeholder who comes on board brings to the venture both new means and new goals. Each new
commitment sets in motion two concurrent cycles, one expanding and the other converging.

FIGURE 9.4 The role of the entrepreneur in the creation (or effectuation) perspective

Source: G. Fisher, ‘Effectuation, causation, and bricolage: A behavioral comparison of emerging theories in entrepreneurship
research’, Entrepreneurship Theory & Practice, vol. 36, no. 5, 2012, p. 1025.
Sarasvathy suggests that at each step of the process, entrepreneurs use the following principles to guide their actions:
The bird-in-hand principle. This is a principle of means-driven (as opposed to goal-driven) action. The emphasis here
is on creating something new with existing means rather than discovering new ways to achieve given goals.
The affordable-loss principle. This principle prescribes committing in advance to what one is willing to lose rather
than investing in calculations about expected returns to the project.
The crazy-quilt principle. This principle involves negotiating with any and all stakeholders who are willing to make
actual commitments to the project, without worrying about opportunity costs, or carrying out elaborate competitive
analyses. Furthermore, who comes on board determines the goals of the enterprise. Not vice versa.
The lemonade principle. This principle suggests acknowledging and appropriating contingency by leveraging surprises
rather than trying to avoid them, overcome them, or adapt to them.
The pilot-in-the-plane principle. This principle urges relying on and working with human agency as the prime driver of
opportunity rather than limiting entrepreneurial efforts to exploiting changes in the market such as technological and
socioeconomic trends.34
Key differences between discovery and creation theory
Both discovery theory and creation theory assume that the goal of entrepreneurs is to form and exploit opportunities. Both
theories also recognise that opportunities exist when competitive imperfections are present in a market or industry. However,
as shown in table 9.1, these two theories differ in their analysis of the origin of these competitive imperfections, the role
played by entrepreneurs and information conditions.

TABLE 9.1 Key differences between discovery and creation theory

ASSUMPTION DISCOVERY THEORY CREATION THEORY

FOCUS

Opportunities Opportunities exist, independent of entrepreneurial Opportunities do not exist until entrepreneurs engage in an iterative
actions, just waiting to be discovered and exploited. process of action and reaction to create them.

Entrepreneurs Discovery of new means-ends relationship. Creation of new means-ends relationships. Entrepreneurs may or may
Entrepreneurs actively look for opportunities and they not be different than non-entrepreneurs and may be changed by the
are particularly adept at recognising opportunities opportunity formation process.
(alertness).

Information The possession of information that is appropriate to a Opportunities may be unrelated to currently available information.
conditions particular opportunity leads to opportunity discovery. Extensive new knowledge may have to be created from scratch.

Entrepreneurial Causation: outcome is given. The entrepreneur selects Effectuation: sets of means are given. The entrepreneur selects
process between means to achieve that outcome by starting between possible effects that can be created with those means by
with ends, analysing expected returns, doing starting with means, analysing affordable loss, establishing and
competitive analysis, and controlling the future. leveraging strategic relationships, and leveraging contingencies.

In discovery theory, competitive imperfections are assumed to arise from changes in technology, consumer preferences, or
some other attributes of the context within which an industry or market exists. Technological changes, political and
regulatory changes, and social and demographic changes are examples of the kinds of events that can disrupt the competitive
equilibrium in a market, thereby forming opportunities.35 Discovery theory, therefore, is predominantly about search — that
is, systematically scanning the environment to discover gaps or imperfections in the market. The task of the entrepreneur is
to become ‘alert’ to the existence of these opportunities and to ‘claim’ those that hold the greatest economic potential.
Conversely, in creation theory, entrepreneurial behaviour is not merely a matter of being more alert to static opportunities but
of dynamically creating opportunities and new ventures through actions based on subjective interpretations. Entrepreneurs do
not recognise opportunities first and then act; rather, they act, wait for a response from their actions (usually from the market)
and then they readjust and act again. In this sense, entrepreneurs construct ventures over time, partially through their ability
to influence the social and economic system.36
Entrepreneurs and non-entrepreneurs play very different roles in creation theory. Creation theory suggests that before
entrepreneurs create opportunities, they may or may not be significantly different than those who do not create opportunities.
Alternatively, discovery theory acknowledges that even very small differences between individuals could lead some to form
opportunities while others would ignore the same opportunities. For example, the availability of specific knowledge can play
a critical role in the identification and exploitation of opportunities. Even if two individuals are identical in terms of their
traits, small variations in their local environment may direct one of them to form and exploit an opportunity.37
From the creation theory perspective, future opportunities may be unrelated to currently available information. In fact, this
theory posits that current industry information may indeed hinder the entrepreneur. Extensive new knowledge and
information may have to be created from scratch. Therefore, the information required is often obtained as part of the
opportunity formation process and only becomes available after actions and decisions of entrepreneurs are executed.38

The decision to exploit entrepreneurial opportunities

Although the discovery of an opportunity is a necessary condition for entrepreneurship, there is more to it than that. After
having identified and assessed an opportunity, potential entrepreneurs must decide whether they want to exploit it. Why,
when and how do some people and not others exploit the opportunities they discover? The answer again appears to depend
on the joint characteristics of the individual and the nature of the opportunity.39 Entrepreneurs tend to exploit opportunities
that have a high expected value. Such opportunities are likely to generate a profit large enough to compensate for the
opportunity cost of other alternatives, the time and money invested in the development of the project, and the risk associated
with the project. In particular, exploitation is more common when expected demand is large, industry margins are high, the
technology life cycle is young, and the level of competition in the industry is low.40
Individual differences matter too. Firstly, individuals have different opportunity costs. The opportunity cost principle states
the cost of one good in terms of the next best alternative. For example, suppose a public servant decides to launch a business
venture. The opportunity cost of the entrepreneurial profit is the alternative income that he or she might receive by remaining
a government employee. Since people have different incomes and wages, they are likely to make different decisions about
whether or not to exploit any given opportunity. Secondly, the decision to exploit entrepreneurial opportunities is also
influenced by individual differences in risk perception, optimism, tolerance for ambiguity and need for achievement.41 The
different psychological characteristics of the entrepreneur will be discussed in detail later in this chapter.
Would-be entrepreneurs can use different techniques — including risk-return analysis, real options and affordable loss — to
decide whether or not they should pursue an opportunity.

1: Risk-return analysis
Classic risk-return analysis is often stipulated as the best way to make this decision. The decision criteria used in such
analyses normally encourages prospective entrepreneurs to calculate the net present value (NPV) of future riskadjusted
returns while taking into account their opportunity costs in relation to the job market value.42 For example, Campbell states
that ‘an individual’s decision whether to become an entrepreneur will be based upon a comparison of the expected reward to
entrepreneurship and the reward to the best alternative use of his [or her] time’.43

2: Real options
An alternative approach based on real options has been recently suggested. Real options analysis enables decision makers to
more accurately value investment opportunities in instances where investments can be incurred in stages. The real options
theory concerns classes of investments in real assets that are similar to financial options in structure.44 Just as the purchase of
an option contract conveys the right (but not the obligation) to purchase the underlying asset on which the contract is written,
investment in a real option conveys the opportunity to continue the investment.
In arguing for the value of viewing entrepreneurial investment decisions through a real options lens, McGrath states that ‘if
investments are staged so that expenditures end under poor conditions, losses can be contained’.45 The cost of failure,
therefore, is limited to the cost of creating the real option, less the remaining option value.46 Should conditions prove
favourable, further investments may be made, which is referred to exercising the option.47 Real options reasoning therefore
suggests that the key issue is not avoiding failure but instead managing the cost of failure by limiting exposure to the
downside while preserving access to attractive opportunities and maximising gains.48

3: Affordable loss
A third approach is based on the affordable loss. The idea of affordable loss encourages individuals to pursue an opportunity
based on a loss that is known to be affordable — one that they are willing to bear.49
The estimate of affordable loss does not depend on the opportunity; it varies from entrepreneur to entrepreneur and even
across an entrepreneur’s life stage and circumstances. By allowing estimates of affordable loss to drive their decisions
regarding which opportunities to pursue, individuals reduce their dependence on predictions. According to Sarasvathy, in
order to calculate expected returns,
we have to estimate future sales and possible risks that constitute our cost of capital, and then raise enough money to launch the business venture. To
calculate affordable loss, all we need to know is our current financial condition and a psychological estimate of our commitment in terms of the
worst-case scenario.50

 9.3 Understanding the profile of an entrepreneur 9.5 The risks of a career in entrepreneurship
and relevant performance measures 
9.5 THE RISKS OF A CAREER IN ENTREPRENEURSHIP AND
RELEVANT PERFORMANCE MEASURES
Learning objective 5
define the risks of a career in entrepreneurship and identify relevant performance measures for an entrepreneur

There are four types of risk to be considered before embracing a career in entrepreneurship: (1) financial risks, (2) career
risks, (3) social risks and (4) health risks. All would-be entrepreneurs must ask themselves if they are prepared to live with
these risks, and they should prepare strategies to minimise them.

1: Financial risks
Entrepreneurs usually invest large amounts of their own money to launch a new business venture. They have to commit part
or all of their own savings to the venture, and offer some collateral to raise finance. After start-up, most of the profits are
usually reinvested in the business to expand the activities. Entrepreneurs risk losing all or part of the money invested in their
business if, for example, they go bankrupt.
There are different ways for entrepreneurs to reduce financial risks. In order to set-up the business, one strategy is to borrow
funds from bankers, venture capitalists or partners. Another strategy is to place personal assets in the spouse’s name so that
these assets cannot be seized if the firm goes bankrupt. The legal structure of the business can also help to minimise financial
risks. For example, entrepreneurs who operate a business as a sole proprietorship or as a partnership face unlimited liability,
whereas for a company the liability of the owners is limited to the unpaid value of the shares they hold.

2: Career risks
A question often asked by would-be entrepreneurs is whether they will be able to find a job or go back to their old job if their
venture fails. This is a major concern, especially for well-paid professionals and people close to retirement age. Such people
must ask themselves whether they are prepared to accept a lower paid job, not necessarily in their field of expertise, if they
have to go back to being an employee. One way to minimise career risk is to launch a business on a part-time basis while still
retaining the current job. Should the attempt fail, the person will have a fall-back position and income.

3: Social risks
Starting a new venture uses much of the entrepreneur’s energy and time. Consequently, family and social commitments may
suffer. To minimise subsequent reproaches and disappointments, any decision to set up a new business venture should
involve the family. This might help would-be entrepreneurs to identify potential family problems that can arise from long
working hours, reduced holidays and stress. Discussing the entrepreneurial project also helps to build commitment within a
family. Successful entrepreneurs almost invariably recognise the support of their spouses and/or family in their career.
Another type of social risk is linked to the image of the failed entrepreneur. Some societies have little tolerance for failure. A
typical example is the kia su, or ‘afraid to lose’ attitude that is pervasive in Singaporean culture. This typifies a mentality
where failure is perceived to be a disgrace and to bring shame on the individual and the family.

4: Health risks
Entrepreneurship is a rigorous activity, not only physically but also mentally. In many instances, work and its demands
dominate the lives of entrepreneurs. A clear separation of work and non-work is generally hard to achieve, and a normal
work day can extend to 10 or 12 hours. There is evidence that entrepreneurs experience higher job stress and psychosomatic
health problems than people who are not self-employed.51 Would-be entrepreneurs should make sure that their health can
cope with the demands and challenges of starting and running a business.
The source of many health problems is stress, which stems from the discrepancies between a person’s expectations and their
ability to meet demands. One of the solutions for reducing stress is to create an environment that discourages it — for
example, by having a place where everything can be kept organised.

Relevant performance measures

Entrepreneurship is concerned with the discovery and exploitation of profitable opportunities for private wealth and,
consequently, for social wealth as well. There may be many motives for starting a business, such as acquiring higher social
status or a new lifestyle, but the financial dimension cannot be ignored. After all, a business must generate a profit to stay in
the marketplace, and entrepreneurs must be able to use a simple standard measure — a monetary unit — to assess their
performance. The relevant benchmarks in entrepreneurship are: (1) the absolute level of economic performance that provides
a return for enterprising effort and (2) the social contribution of the individual effort.
Superior performance relative to other enterprises is not a sufficient measure of success in the case of entrepreneurship
because profit must exceed some minimum threshold in order to compensate opportunity seekers for their efforts. Just to
break even, profits must compensate for bypassed alternatives (opportunity cost) and for the cash, effort and time invested in
the venture (liquidity premium), as well as covering a premium for risk and a premium for uncertainty.

1. Opportunity cost. Economists use this term to refer to what is given up when a certain course of action is chosen. For
example, when choosing to set up a business and become self-employed, entrepreneurs must give up a regular salary
and holidays (if they are employees). Opportunity costs are particularly high for well-paid professionals and
executives.
2. Liquidity premium. The entrepreneurial process generally requires substantial investments in order to evaluate and
exploit opportunities. Most would-be entrepreneurs invest their own money in pre-start-up activities, such as building a
prototype, paying a consultant to conduct professional market research, and registering a patent or trademark. In
addition, they spend a considerable amount of their own time and effort in fine-tuning the business concept and
convincing various resource holders (such as venture capitalists, suppliers, clients and potential employees) to take part
in the enterprise.
3. Risk premium. In economics, risk denotes the possibility of a loss. Risk is present when future events occur with
measurable probability. It is measurable because it relates to situations that have many precedents and where, as a
consequence, the odds of success can be calculated. The risk premium depends on the outcome probability of the
business venture. For example, if the odds of success are relatively high because the entrepreneur has developed a
promising product (good trial tests) that can be protected (by a patent or registered trademark) and for which there is a
familiar market, then the risk premium is relatively low.
4. Uncertainty premium. Uncertainty is not measurable, and so cannot be quantified and handled through insurance or
other arrangements. Uncertainty occurs in circumstances that cannot be analysed either on rational grounds, because
they are too irregular, or through empirical observation, because they are unique. Uncertainty is therefore present when
the likelihood of future events is indefinite or incalculable. The uncertainty premium is particularly high if the
entrepreneur has no previous experience of the industry in which the business venture is to be established, and if the
venture is based on radical innovation implying emerging technology.

As depicted in figure 9.5, results that fall below the sum of the four components represent an economic loss for the
entrepreneur, even if the sum is far above the performance of rival firms. Only the surplus above this minimum can be
counted as the entrepreneur’s reward.
FIGURE 9.5 Relevant performance measures for entrepreneurs
Source: Adapted from S. Venkataraman, ‘The distinctive domain of entrepreneurship research’, in J. Katz (ed.), Advances in Entrepreneurship, Firm
Emergence and Growth, vol. 3, Jai Press, Greenwich, Conn., 1997, p. 134.

What would you do?

Dishing up success?
A native Malaysian, you have already completed a diploma at a local polytechnic and an apprenticeship as a chef,
before performing a three-year stint as a food and beverage (F&B) assistant manager in a local five-star hotel. You are
currently finishing your Bachelor of Hospitality Management at a renowned Australian university, having believed that
a university degree abroad was a natural progression in a promising career in hospitality. Upon completion of your
degree, you initially planned to move back to Malaysia and to become an F&B manager or a hotel assistant manager.
Now you are having second thoughts, and may want to launch your own business with a classmate who is also your
girlfriend and the daughter of a rich Australian entrepreneur. You are in the process of writing a business plan to raise
A$150000 from an investor to set up ‘Noodlicious’. The business will provide high quality, fast-served Asian-style meals,
based on a central theme of noodles. The meals will be delivered fresh, faster than other noodle-based products. Adopting
a similar distribution model to mobile coffee companies in Australia (e.g. Cappuccino Xpress, Espresso Mobile Café,
Kiss Cafe), Noodlicious meals will be provided through mobile vending units. To date, you have already invested over
two months of work to develop recipes, and to write a first draft of the business plan. Together with your girlfriend, you
also have invested A$10 000 each to build a mobile vending unit prototype, which has been successfully tested over a
couple of weekends, generating sales of A$700 and a net profit of A$200 per day.
Valued at A$8.2 billion in 2009, the Australian market for ‘fast’ food is large and segmented, with Asian-style foods
representing two of the top three choices in capital cities. However, your research indicates that the market is approaching
saturation, and it is heavily segmented on quality, style, modality and price. Your girlfriend thinks that Noodlicious can
rapidly expand through a franchise system and become the benchmark in the mobile vending noodle business. However,
you know that there are strong competitors in the noodle business, including Wagamama and Noodle Box, and that you
have to work on average 10 hours per day during the first months to launch the business. Is it worth it? You are also
tempted to move back to Malaysia where you could quickly get a stable job through your established network. You would
make at least A$60 000 as a F&B manager and have four weeks’ annual leave.

Questions

1. From a personal perspective, what performance measures should you take into account when assessing this
opportunity?
2. What are the risks involved in launching this business venture?

 9.4 Entrepreneurs and opportunities 9.6 Entrepreneurs in a social context 

9.6 ENTREPRENEURS IN A SOCIAL CONTEXT
Learning objective 6
explain entrepreneurial behaviour in a social context

The social context is crucial to understanding the situations in which entrepreneurial opportunities will emerge and be
pursued.52 Three features of a person’s social context are important to the perception of entrepreneurial opportunities and the
decision to seize them: (1) the stage of life, (2) position in social networks and (3) ethnicity.

1: Stage of life and entrepreneurial behaviour

Most societies have developed stable and widespread expectations about the appropriate times for major life events. Societal
institutions are often organised around these social conventions, such as the age at which schooling should begin, the age at
which marriage is appropriate, the age of retirement and so on. One critical life event is starting a job, which usually occurs
immediately after completing an educational program. If the decision to become an entrepreneur was a common event for
members of society, it would not be surprising to find major regularities in its relation to a stage of life. In reality, however,
that is not the case. Entrepreneurial activity involves a minority of the population, and there is no general theory indicating
the stage of life that is best for launching a business venture.
Entrepreneurs are more effective at building ventures from scratch once they have attained a certain level of maturity and
self-knowledge, but they can achieve this without spending most of their working lives in corporate jobs. Wasserman53
identified two main points in favour of leaping sooner rather than later. First, long stretches in corporate positions often
prevent executives from developing the versatility that new ventures generally require. As an executive they may become
used to delegating, leaving the specialists to deal with HR, IT and financial issues. This is a luxury that start-ups can ill
afford. Second, employees who linger until they reach senior positions maybe age themselves out of what could otherwise be
a satisfying career in start-ups.
Empirical research has shown that those people most likely to pursue entrepreneurial opportunities are men (women’s
participation rate being about half that of men across all countries in the Global Entrepreneurship Monitor) with post-
secondary education, aged between the ages of 25 and 44, and with an established career record. Although not everyone with
these characteristics starts new firms, this set of features is to some extent unique and predictable.

2: Social networks and entrepreneurial behaviour

Humans are social animals, which means that we relate to others; we all have a social network. A person’s self-image
determines what connections are made, and a person’s identity is shaped by his or her network. Every tie is unique. The
networks that entrepreneurs build for themselves and their ventures stand out in a number of respects:
The networks are genuinely personal, intertwining business concerns and social commitments in individual ties. By
way of personal networking, entrepreneurs make their planned venturing career into a way of life. Personal resources
(e.g. information, money, labour) are mobilised to set-up new ventures that are alien to the market.54
The spatial dimension is relevant. For historical, practical and symbolic reasons, many entrepreneurs and their firms
are attached to a place. So, the local and regional socioeconomic environment is both a major determinant and a major
outcome of entrepreneurial activity.55
Although networks are important in both Western and Eastern cultures, they are central to many Eastern cultures and
particularly to the Chinese. The Chinese navigate complex networks of connections (guanxi) that expand throughout their
lives. Everyone is born into a social network of family members. As each person grows up, group memberships involving
education, occupation and residence provide new opportunities for expanding this network.56 The guanxi philosophy has
deep roots. Many South-East Asian firms were established by migrant Chinese or their offspring, who built up networks in
which extended families and clans did business with each other in order to reduce risk. The relative permanence of such
social networks contributes to the importance and enforceability of the Chinese conception of reciprocity (bao).
3: Ethnicity and entrepreneurship
Ethnic and religious affiliations have historically played an important role in entrepreneurship, and there is substantial
information about the extent to which various ethnic groups or new immigrants engage in entrepreneurial behaviour in the
Asia–Pacific region. The main explanation of ethnic entrepreneurship is that it is a response to the lack of opportunities in the
dominant culture. In this situation, entrepreneurship is very often a necessity triggered by a variety of push factors, such as
ethnic discrimination in the host society; lack of recognition of qualifications; poor use of local language; and limited
opportunities. However, entrepreneurship can also be a first choice between different career alternatives, and this might result
from different pull factors, such as the presence in the family of entrepreneurs who act as role models; high social status
given to the entrepreneur in the culture of the immigrant; perception of good entrepreneurial opportunities in the family and
ethnic network; and availability of resources in the ethnic network.

Ethnic Chinese entrepreneurs in South-East Asia

In South-East Asia, there is substantial evidence that entrepreneurship, which is a crucial factor in development, has been
steadily supplied by an ethnic minority — the expatriate Chinese. Historical evidence shows how domestic economies in the
region faltered when ethnic Chinese entrepreneurs were not allowed to operate.57 Usually, both push and pull factors have
influenced ethnic Chinese entrepreneurship. Ethnic Chinese have often been discriminated against, having, for example, been
barred from public service positions and land ownership, and allowed only limited access to tertiary education. As a
consequence, they have often had no alternative but to become self-employed. At the same time, guanxi has provided ethnic
Chinese privileged access to entrepreneurial opportunities and to resources. Initially, ethnic Chinese entrepreneurs fulfilled
an intermediation function, particularly in their role as traders. They filled a gap in the existing market by providing goods
and services that were not available. Today, although many are still engaged in trading and entrepreneurship, considerable
numbers of ethnic Chinese have moved to banking and finance, transport, real estate, property development and hotel and
travel services.

The situation in Australasia

In multicultural Australia and New Zealand, the growth of self-employment among ethnic minorities has been a conspicuous
feature of entrepreneurial activities. In Australia, research has shown that ethnic business creation is positively related to pull
and push motivations.58 That said, first-generation ethnic entrepreneurs were more influenced by push motivation, as
opposed to third-generation ethnic entrepreneurs, who were more influenced by pull motivation. The first-generation ethnic
entrepreneurs placed significantly greater importance on economic necessity and unemployment (which are both push
motivators). The second-generation ethnic entrepreneurs accorded greater meaning to opportunities in Australia for doing
business and making links to the country of origin (these are both pull motivators). The third-generation ethnic entrepreneurs
for the most part entered business due to pull motivators, such as opportunities in Australia; links for doing business in the
country of origin; and ethnic networks. Thus, the current trend reveals that ethnic business operators do not enter business
activity as a last resort but as a positive choice.59

Case study

Rebekah Campbell, Posse

Rebekah Campbell first decided to become an entrepreneur during her childhood. When she was nine, she started
hunting around for lost golf balls from a golf course next to the family holiday house in Kinloch, near Taupo in New
Zealand. One of the two shops in town sold golf balls, so she enquired as to whether they were interested in buying the
golf balls she’d found. After negotiating rates based on the quality of the balls, Rebekah found her venture to be a great
summer earner for her. It did not take long for other children to catch on and the shop owner, overwhelmed by the
number of offers to buy found golf balls, threatened to withdraw from the arrangement. However, Rebekah negotiated
for the exclusive right to sell to the shop and became an ‘agent’ for the other kids — she took a cut on their sales and no
longer had to search for golf balls herself. The discovery of this business model significantly influenced the ventures she
would launch later.
The launch of Posse
In 2000, she moved to Sydney and become an artist manager and launched Scorpio Music, a management company
helping bands produce and market their records. Her first clients were the Evermore brothers from Feilding, New
Zealand. She faced three major obstacles in this business venture. First, it was very expensive to produce a record. It
would typically cost about $100 000 to hire a producer, session musicians and a record studio. Second, given these
costs, her job was to find someone — such as a record label or a rich benefactor — who would invest in the record
production. Third, she had to market the record. This involved producing a video, advertising in magazines, and selling
the records through retail channels. In sum, her job was to contact record labels, sponsors, magazine editors, and
distributors to create some ‘buzz’ and convince them to invest in the band. As her business grew, she signed more
artists, notably: Alex Lloyd, Matt Corby, Amy Meredith and Operator Please.
A large part of the marketing budget was spent on posters and press ads that no one paid attention to. ‘But we stuck with
it because no one had come up with anything better’, says Campbell. In 2008, while promoting a tour for Evermore,
Campbell hit a problem when ticket sales to the band’s Perth gig slumped. She asked the band’s Perth fans if they’d
become promoters of the band, offering to pay commissions for tickets sold. A price was devised for the top five sellers:
they could attend the show by the side of the stage. The success was immediate, and Campbell was soon sending packets
of tickets and posters to 50 kids in Perth. Evermore fans started placing posters in school common rooms and university
foyers and selling tickets to their friends. The show was sold out and the fans all felt that they were now in the music
business.
This marketing coup led Campbell to launch Posse in October 2012 — an online platform that enables bands to
encourage and rewards fans for helping to promote their music, merchandise and tours. Loyal fans used social media to
get their friends to buy tickets to concerts of their favourite bands and received rewards in return. Campbell raised $1.5
million from a syndicate of 21 angel investors and music label EMI.

Going back to the drawing board

By February 2012, Posse had 11 000 users and had facilitated A$2 million in ticket sales. ‘It definitely worked and we
could have continued to grow it into a business’, says Campbell. But there were problems. Posse was integrated with a
number of ticketing websites but ‘if you really wanted to do it properly you had to be integrated with everybody’, she
says. The technical development and negotiation to do that was time-consuming. And it would have been difficult to roll
out globally. ‘We could have done it but we made a decision to take a gamble’, she says.
Through women’s business networking group Heads Over Heels, Campbell met retailers who thought the idea behind
Posse of rewarding loyal customers who made recommendations to their friends could be reworked for use by stores. So,
Campbell and her team redeveloped the Posse platform but very quickly realised that this new direction was a dead end.
‘Retailers flipped out. They loved it’, she says. ‘We signed 40 retailers in four weeks, just with one [sales] person. They
were willing to pay $40 a month’.
However, the problem existed at the other end of the equation. Retailers encouraged their customers to download the
Posse app to pass on vouchers to their friends. In return, they would be rewarded with currency in store. ‘It wasn’t solving
a problem for customers; customers could already refer people to their favourite places’, Campbell says. ‘We made it a
little bit more rewarding [by giving them currency] but it wasn’t enough to get them en masse really excited about it’.

Making a second change of direction

The Posse team embarked on an ‘intense mission’ to ‘solve a real-world problem’ for the customers. After many focus
groups and more than 30 one-on-one interviews that Campbell conducted herself, the team were ready to take a new
direction — to go from retail to social. The latest version of the internet start-up plays into the ‘social search’ trend. In
Posse the social network, users have a virtual street where they can place their favourite five destinations. Stores can
claim their listing on Posse (much the same way as they can on Four Square or Yelp) and reward the customers who
place reviews or include their outlet on their street. Campbell says customers didn’t want currency but were excited to
receive random.pngts.
Friends on Posse can link their streets to create a town that can be explored in a map-like interface. The utility behind
Posse is that users can search locations and categories — for example ‘Bondi’ and ‘restaurant’. Results from friends are
listed first, followed by friends of friends and then ‘most popular’. Campbell believes she is onto a good thing but will
watch the use of Posse and tweak it further where necessary.
Reflecting on her experience as an entrepreneur, Campbell explains that starting a company is hard work and mentally,
physically and emotionally exhausting. However, she advises other entrepreneurs, should they feel unsupported by any
investors, to research new changes of direction [or ‘pivots’ in the industry jargon] and use them as evidence. Too few
people remember that Twitter was originally a podcasting company.
Source: Adapted from J. Gardner, ‘Learning to start again’, BRW, June 28 – July 4, 2012, pp. 42–43; Rebekah Campbell,
www.rebekahcampbell.com.

Questions

1. How did Posse’s opportunity initially emerge? Was this opportunity independent of the perceptions of
Rebekah Campbell, just waiting to be discovered? Or, was it created by her actions? Explain your
reasoning.
2. Some cynical observers might regard changes of direction (or pivots) as marks of failure. Explain why you
agree or disagree with this view. What do you need to consider in order to execute a successful pivot?
3. To what extent did Campbell’s social network play a role in the launch and development of Posse?

 9.5 The risks of a career in entrepreneurship

Summary 
and relevant performance measures
SUMMARY
Learning objective 1: define business and the private enterprise system
Business consists of all profit-seeking activities that provide goods and services necessary to an economic system. Not-
for-profit organisations are businesslike establishments whose primary objective is public service over profits.
The private enterprise system is an economic system that rewards firms for their ability to perceive and serve the needs
and demands of consumers. Competition in the private enterprise system ensures success for firms that satisfy
consumer demands. Citizens in a private enterprise economy enjoy the rights to private property, profits, freedom of
choice and competition. Entrepreneurship drives economic growth.
Learning objective 2: define the various types of entrepreneurs
Entrepreneurship is risk-taking behaviour that results in the creation of new opportunities for individuals and/or
organisations. An entrepreneur is someone who takes strategic risks to pursue opportunities in situations others may
view as problems or threats. There are many examples of entrepreneurs worldwide like Phillip Di Bella, Carolyn
Creswell, Steve Chen, Gurbaksh Chahal, Mark Bouris, Victoria Ransom and Garrett Gee whose experiences can be a
source of learning and inspiration for others. Entrepreneurs tend to be creative people who are very self-confident,
determined, resilient, adaptable and driven to excel; they like to be masters of their own destinies. Entrepreneurship is
rich in diversity, with women and minority-owned business start-ups increasing in numbers.
Learning objective 3: list the roles and characteristics of entrepreneurs
There are two schools of thought on the entrepreneurial perspective in individuals: the economic perspective considers
that the entrepreneur is an agent who specialises in certain roles, such as risk-bearing, arbitrage, innovation and
coordination of scarce resources; the behaviourist approach, on the other hand, has identified three recurrent
entrepreneurial traits — the need for achievement, the internal locus of control, and risk-taking propensity.
Learning objective 4: explain how entrepreneurial opportunities are formed
The entrepreneur and opportunities are the essence of the entrepreneurial process. There exist two dominant
perspectives of the concept of ‘opportunity‘, which view opportunities as either concrete realities or as the execution of
an entrepreneur’s unique vision.
Learning objective 5: define the risks of a career in entrepreneurship and identify relevant performance
measures for an entrepreneur
When considering a career in entrepreneurship, people should also consider the four types of risk (financial risk, career
risk, social risk and health risk) and prepare strategies to avoid or minimise them.
Similarly, would-be entrepreneurs must be careful to have the correct performance measures in mind. Just to break
even, profits must compensate for bypassed alternatives (opportunity cost) and for the cash, effort and time invested in
the venture (liquidity premium), and they must cover a premium for risk and for uncertainty.
Learning objective 6: explain entrepreneurial behaviour in a social context
The social context is crucial to understanding the situations in which entrepreneurial opportunities will emerge and be
pursued. Three features of a person’s social context appear to play a role in relation to the perception of entrepreneurial
opportunities and the decision to seize them: the stage of life, social networks and ethnicity.

Review questions
1. Why is business so important to a country’s economy?
2. In what ways are not-for-profit organisations a substantial part of the economy? What unique challenges do not-for-
profits face?
3. Identify and describe the four basic inputs that make up factors of production. Give an example of each factor of
production that a motor vehicle manufacturer might use.
4. What is a private enterprise system? What four rights are critical to the operation of capitalism? Why would capitalism
function poorly in a society that does not ensure these rights for its citizens?
5. In what ways is entrepreneurship vital to the private enterprise system?
 6. What are the two theories explaining the formation of entrepreneurial opportunities?
7. What techniques can potential entrepreneurs use to decide whether or not they should pursue an opportunity?
8. Which entrepreneurial traits suggested from the behaviourist approach have received wide attention in the literature and
show a high level of validity?
9. What types of risk should be considered before embracing a career in entrepreneurship?
10. To what extent does the social context play a role in entrepreneurship? What are the key features of a person’s social
context to consider?
11. What are the alternative ways of thinking about ethical behaviour discussed in this chapter?
12. What is an ethical dilemma?
13. What are the four stances adopted by organisations in response to demands for social responsibility?

Discussion questions
1. Identify major changes that create opportunities for entrepreneurs.
2. Assuming that opportunities are created rather than discovered, what are the implications for entrepreneurial action?
3. Are entrepreneurs born or made?
4. If a would-be entrepreneur evaluates all the potential risks before starting a business, does it mean that the business
venture will not fail?
5. Social networks are recognised as important elements for entrepreneurs of Chinese ethnicity. Are these networks equally
important for entrepreneurs of other ethnic origins?

 9.6 Entrepreneurs in a social context Endnotes 

ENDNOTES
1. Sara Murphy, ‘Leading Fracking Companies Secure Their Futures’,The Motley Fool, accessed January 27, 2014,
www.fool.com; Wendy Koch, ‘Big Milestone: US Producing More Oil Than It Imports’, USA Today, accessed January 10,
2014, www.usatoday.com; Bryant Urstadt, ‘Here’s the Good News about Fracking’, Bloomberg Businessweek, accessed
January 10, 2014, www.businessweek.com; Anthony Watts, ‘USA Meets Kyoto Protocol Goal—Without Ever Embracing
It’, Watts Up with That, accessed January 10, 2014, http://wattsupwiththat.com; organisation website, ‘Kyoto Protocol’,
www.kyotoprotocol.com, accessed January 10, 2014.
2. Australian Bureau of Statistics (2015). 5256.0 Australian National Accounts: Non-Profit Institutions Satellite Account,
2012–13, http://www.abs.gov.au/AusStats/ABS@.nsf/MF/5256.0, accessed 12 November, 2015.
3. ibid.
4. Organisation website, ‘Quick Facts about St. Jude’, http://www.stjude.org, accessed January 10, 2014.
5. ‘Disaster Relief and Recovery’, Australian Red Cross website, accessed 12 November, 2015,
www.redcross.org.au/disaster-relief-and-recovery.aspx.
6. Issie Lapowsky, ‘The Social Entrepreneurship Spectrum: Nonprofits’, Inc., accessed January 10, 2014, www.inc.com.
7. Joshua Brustein, ‘With CES Antics, Mobile Carriers Make an Eloquent Antitrust Case’, Bloomberg Businessweek, January
8, 2014, www.businessweek.com.
8. ‘What is a Social Entrepreneur?’ Lab for Culture, www.labforculture.org.
9. Let’s Talk Business Network website, www.ltbn.com.
10. ‘Searching for the invisible man’, Economist, 9 March, 2006, www.economist.com.
11. M. Casson, The Entrepreneur: An Economic Theory, 2nd edn, Edward Elgar, Cheltenham, 2005.
12. R. Cantillon, Essai sur la Nature du Commerce en Général (1755), trans. H. Higgs, Macmillan, London, 1931.
13. A. Kuper & J. Kuper (Eds), The Social Science Encylopedia, 2nd edn, Routledge, London, 2003, p. 429.
14. F. Knight, Risk, Uncertainty and Profit, Houghton Mifflin, Boston, 1921.
15. M. Rose, ‘Risk versus uncertainty, or Mr. Slate versus great-aunt Matilda’, Library of Economics and Liberty, 5
November, 2001, www.econlib.org.
16. Mainly the Austrian economists like F.A. Hayek, Individualism and Economic Order, Routledge, London, 1959; I.M.
Kirzner, Competition and Entrepreneurship, Chicago University Press, Chicago, 1973.
17. J.A. Schumpeter, The Theory of Economic Development, Harvard University Press, Cambridge, MA., 1934.
18. Kuper & Kuper, op. cit.
19. J.B. Say, A Treatise on Political Economy (1803), trans. by C.R. Prinsep, Grigg & Elliot, Philadelphia, 1843.
20. W.B. Gartner, ‘A conceptual framework for describing the phenomenon of new venture creation’, Academy of
Management Review, vol. 10, no. 4, 1985, pp. 696–706.
21. D.C. McClelland, The Achieving Society, Free Press, New York, 1967.
22. D. Hellriegal, S.E. Jackson & J.W. Slocum, Managing: A Competency-based Approach, Cengage, 2007, p.189.
23. B.L. McCombs, ‘Motivation and lifelong learning’, Educational Psychologist, vol. 26, no. 2, 1991, pp. 117–27.
24. L.E. Palich & D.R. Bagby, ‘Using cognitive theory to explain entrepreneurial risk-taking: Challenging conventional
wisdom’, Journal of Business Venturing, no. 10, 1995, pp. 425–38.
25. T. Mazzarol, T. Volery, N. Doss & V. Thein, ‘Factors influencing small business startups: A comparison with previous
research’, International Journal of Entrepreneurial Behaviour and Research, vol. 5, no. 5, 1999, pp. 48–63.
26. J. Eckhardt & S. Shane, ‘Opportunities and entrepreneurship’, Journal of Management, vol. 29, no. 3, 2003, pp. 333–49.
27. S.A. Alvarez & J.B. Barney, ‘Discovery and creation: Alternative theories of entrepreneurial action’, Strategic
Entrepreneurship Journal, vol. 1, nos 1–2, 2007.
28. A. Kuuluvainen, Dynamic Capabilities in the International Growth of Small and Medium-sized Firms, PhD thesis, Turku
School of Economics, 2011, p. 57.
29. S.A. Alvarez & J.B. Barney, A Creation Theory of Entrepreneurial Opportunity Formation, Fisher College of Business,
Columbus, OH, 2007.
30. S. Shane, A General Theory of Entrepreneurship: The Individual-Opportunity Nexus, Edward Elgar, Aldershot, 2003.
31. S.K. Shah & M. Tripsas, ‘The accidental entrepreneur: The emergent and collective process of user entrepreneurship’,
Strategic Entrepreneurship Journal, no. 1, 2007, p. 12.
32. Alvarez & Barney, op. cit., pp. 14–15.
33. G. Fisher, ‘Effectuation, causation, and bricolage: A behavioral comparison of emerging theories in entrepreneurship
research’, Entrepreneurship Theory & Practice, vol. 36, no. 5, 2012, p. 1024.
34. S. Sarasvathy, Effectuation: Elements of Entrepreneurial Expertise, Edward Elgar, Cheltenham, 2008, pp. 15–16.
35. Shane, op. cit.
36. T. Baker & Nelson, R., ‘Creating something from nothing: Resource construction through entrepreneurial bricolage’,
Administrative Science Quarterly, no. 50, 2005, pp. 329–66.
37. Alvarez & Barney, op. cit., p. 16.
38. Alvarez & Barney, op. cit.
39. S. Shane & S. Vankataraman, ‘The promise of entrepreneurship as a field of research’, Academy of Management Review,
vol. 25, no. 1, 2000, pp. 217–26.
40. M. Wijdoogen, Learning from Entrepreneurial Failure, VU University Amsterdam, 2008, p. 41.
41. S. Venkataraman, ‘The distinctive domain of entrepreneurship research: An editor’s perspective’, In J. Katz & R.
Brockhaus (Eds.), Advances in Entrepreneurship, Firm Emergence, and Growth, vol. 3, JAI Press, Greenwich, CT, 1997, pp.
119–38.
42. N. Dew, ‘Affordable loss: Behavioral economic aspects of the plunge decision’, Strategic Entrepreneurship Journal, vol.
1, no. 2, 2009, p. 105.
43. C. Campbell, ‘Decision theory model of entrepreneurial acts’, Entrepreneurship Theory and Practice, vol. 17, no. 1,
1992, pp. 21–7.
44. J.P. Doh & J.A. Pearce II, ‘Corporate entrepreneurship and real options in transitional policy environments: Theory
development’, Journal of Management Studies, vol. 4, no. 1, 2004, p. 652.
45. R.G. McGrath, ‘Falling forward: Real option reasoning and entrepreneurial failure’, Academy of Management Review,
vol. 24, no. 1, 1999, pp. 13–30.
46. McGrath, op. cit., p. 13.
47. Wijdoogen, op. cit., p. 56.
48. R.K. Mitchell, Transaction cognition theory and high performance economic results, monograph, International Centre for
Venture Expertise, University of Victoria, 2001, p. 240.
49. Dew, op. cit., p. 117.
50. Sarasvathy, op. cit.
51. M. Jamal, ‘Job stress, satisfaction and mental health: An empirical examination of self-employed and non-self-employed
Canadians’, Journal of Small Business Management, vol. 35, no. 4, 1997, pp. 48–57.
52. P.D. Reynolds, ‘Sociology and entrepreneurship: Concepts and contributions’, Entrepreneurship Theory and Practice,
vol. 16, no. 2, 1991, pp. 47–70.
53. N. Wasserman, ‘Planning a start-up? Seize the day…’, Harvard Business Review, January 2009, p. 27.
54. B. Johannisson, ‘Paradigms and entrepreneurial networks — some methodological challenges’, Entrepreneurship and
Regional Development, vol. 7, no. 3, 1995, pp. 215–31.
55. B. Johannissson, ‘Personal networks in emerging knowledge-based firms: Spatial and functional patterns’,
Entrepreneurship & Regional Development, vol. 10, no. 4, 1998.
56. R. Ma, ‘Social relations (Guanxi): A Chinese approach to interpersonal communication’, China Media Research, vol. 7,
no. 4, 2011, pp. 25–33.
57. A.R. Gambe, Overseas Chinese Entrepreneurship and Capitalist Development in Southeast Asia, LIT Verlag, Hamburg,
1999.
58. M. Chavan & R.K. Agrawal, ‘The changing role in ethnic entrepreneurs in Australia’, International Council for Small
Business, 1999, http://sbaer.uca.edu.
59. ibid.

 Summary 10 Entrepreneurship: definition and evolution 

 CHAPTER 10

Entrepreneurship: definition and evolution

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

10.1 provide a definition of entrepreneurship and state the key elements of entrepreneurship
10.2 explain the process of new venture creation
10.3 explain the role of entrepreneurship in economic growth
10.4 discuss the common features of entrepreneurship in the Asia–Pacific region.

INTRODUCTION
Entrepreneurship takes a variety of forms in both small and large firms, in new firms and established ones, in the formal and
informal economy, in legal and illegal activities, in innovative and more conventional business ventures, and in all regions
and economic sub-sectors. Today it is widely claimed that entrepreneurship is one of the most powerful drivers of growth and
prosperity in the modern global economy. Few factors have as great an impact in creating jobs, producing innovation, or
generally contributing to a dynamic and competitive economy.
The importance of entrepreneurship is perhaps best illustrated in the Asia–Pacific region. The transformation of this region
and the emergence over the past two decades of the newly industrialised economies — such as Hong Kong, Singapore, South
Korea, Malaysia and Thailand — are largely due to entrepreneurial activities. During the same period, the Australian and
New Zealand economies were significantly liberalised, introducing new opportunities for entrepreneurs. These changes
contributed to sustained economic growth.
More recently, entrepreneurship has transformed the economy of two ‘sleeping giants’ in Asia — India and China. India has,
over the past couple of decades, broken away from the Licence Raj and has witnessed a profound entrepreneurial
transformation. Since 1991, when the government started opening up the economy, the country’s mood has changed to one of
business friendly rules and can-do optimism. Communist China’s conversion to entrepreneurship is even more surprising.
Privately owned small and medium-sized enterprises (SMEs) now account for approximately two-thirds of the economy.
More than sixty Chinese companies are traded on the NASDAQ. Since 2002, entrepreneurs can officially become members
of the Chinese Communist Party; and today, the Central Party school offers special courses for entrepreneurs (who are
known as ‘red capitalists’).1
This chapter focuses on defining the notion of entrepreneurship and examines the role of entrepreneurship as a catalyst for
economic growth. The nature of entrepreneurship within the Asia–Pacific region is discussed.

 Endnotes 10.1 Defining entrepreneurship and its key elements 

10.1 DEFINING ENTREPRENEURSHIP AND ITS KEY
ELEMENTS
Learning objective 1
provide a definition of entrepreneurship and state the key elements of entrepreneurship

Entrepreneurship stems from the French word entreprendre meaning ‘to undertake’ or ‘to take in one’s own hands‘. During
the Industrial revolution the term entrepreneur was used to describe the new phenomenon of the individual who had
formulated a venture idea, developed it, assembled resources and created a new business venture.2 The entrepreneur has thus
emerged as a pivotal figure who operates within a market.
Entrepreneurs such as John Rockefeller (who formed Standard Oil), Andrew Carnegie (who advanced the mass production of
steel and lowered its cost), James Watt (who improved on existing ideas and made a workable steam engine), Thomas Edison
(who brought the benefits of electricity through new appliances), and William Jardine and James Matheson (who founded
Jardine Matheson and sent the first private shipments of tea to England) all contributed to the Industrial Revolution.
Entrepreneurs are risk-taking people who react to opportunities, bear uncertainty and serve to bring about a balance between
supply and demand in specific markets. Since the Industrial Revolution, many economists have directed their attention to
entrepreneurship and contributed to the understanding of the concept.

Towards a definition of entrepreneurship

Entrepreneurship remains difficult to define because it is a multi-faceted phenomenon that spans many disciplinary
boundaries. Different studies of entrepreneurship have adopted different theoretical perspectives, units of analyses and
methodologies. For example, topics in entrepreneurship have been researched by psychologists, sociologists, historians,
finance experts and organisation scholars. The focus of research has varied greatly: the entrepreneur, the social network of
the entrepreneur, the new organisation, the new product or service offering, and sometimes the framework conditions of a
whole country have been examined.
Therefore, it is not surprising that there is no agreed definition of entrepreneurship, and uncertainty exists regarding what
constitutes entrepreneurship as a field of study. One of the main obstacles to building a definition of entrepreneurship stems,
perhaps, from the fact that until the late 1990s, most researchers defined the field solely in terms of who the entrepreneur was
and what he or she did. The problem with this approach is that entrepreneurship involves the linking of two conditions: the
presence of lucrative opportunities and the presence of enterprising individuals.3 By defining the field in terms of the
individual alone, early research in entrepreneurship generated incomplete definitions that do not withstand scrutiny.
Consequently, we define entrepreneurship as the process, brought about by individuals, of identifying new entrepreneurial
opportunities and converting them into marketable products or services. Therefore, as suggested by Shane and
Vankataraman,4 the field of entrepreneurship involves the study of sources of opportunities; the processes of discovery,
evaluation and exploitation of opportunities; and the set of individuals who discover, evaluate and exploit those
opportunities.

The key elements of entrepreneurship

Much of the argument over the definition of entrepreneurship revolves around the factors considered necessary for
entrepreneurship to occur. As depicted in figure 10.1, five factors have been commonly cited for entrepreneurship to take
place: an individual (the entrepreneur), a market opportunity, adequate resources, a business organisation and a favourable
environment. These five factors are considered contingencies — something that must be present in the phenomenon but that
can materialise in many different ways.5 The entrepreneur is responsible for bringing these contingencies together to create
new value.
FIGURE 10.1 The key elements of entrepreneurship

Source: ‘strategic Entrepreneurship, Third Edition’ by Philip A. Wickham, Prentice Hall Financial Times, Pearson Education
Limited, England © 2004, p. 134.

1: The entrepreneur
Entrepreneurship requires at least one motivated person. The entrepreneur is the cornerstone of the entrepreneurial process
— the chief conductor who perceives an opportunity, marshals the resources to pursue this opportunity and builds an
organisation that combines the resources necessary to exploit the opportunity. Researchers have hypothesised a number of
factors that influence the way opportunities are recognised and exploited by entrepreneurs. Among these, four have been
identified as especially important: active search of opportunities, entrepreneurial alertness, prior knowledge and social
networks.
Active search of opportunities. Many of the erstwhile studies in entrepreneurship implicitly assumed that recognition
of an opportunity is preceded by a systematic search for available opportunities.6 Similarly, entrepreneurs are more
likely than managers to engage in an active search for opportunities and potentially untapped sources of profit.7 These
findings indicate that actively searching for information is an important factor in the recognition of many opportunities
by entrepreneurs, although such searches must be carefully directed in order to succeed.
Entrepreneurial alertness. Kirzner was the first to use this term to explain the recognition of entrepreneurial
opportunities.8 He defined ‘alertness’ as a propensity to notice and be sensitive to information about objects, incidents
and patterns of behaviour. Individuals with high alertness show a special sensitivity to maker and user problems, unmet
needs and novel combinations of resources. Therefore, alertness emphasises the fact that opportunities can sometimes
be recognised by individuals who are not actively searching for them. But what are the foundations of entrepreneurial
 alertness? It has been suggested that alertness rests mainly on the creativity and high intelligence capacities of
individuals.9 These capacities help entrepreneurs to identify new solutions for the market and customer needs and, at
the same time, to develop creative ways to attract resources.
Prior knowledge. People tend to notice information that is related to information they already know. A wealth of
evidence indicates that information gathered through a rich and varied life (especially through varied work experience)
can be a major plus for entrepreneurs in terms of recognising opportunities. Each person’s prior idiosyncratic
knowledge creates a knowledge corridor that allows him or her to recognise certain opportunities10 but not others.
Therefore, any given opportunity is not obvious to all would-be entrepreneurs.
Social networks. The way people are connected through various social relationships, ranging from casual
acquaintances to close familial bonds, also plays an important role in opportunity recognition, resource acquisition and
the development of an organisation.11 The shape of the social network helps determine a network’s usefulness to its
individuals. Small, tight networks can be less useful to their members than networks with lots of loose connections
(weak ties) to individuals outside the main network. More ‘open’ networks, with many weak ties and social
connections, are more likely to introduce new ideas and opportunities to their members than closed networks with
many redundant ties.12 In other words, a group of friends who do things only with each other already share the same
knowledge and opportunities. A group of individuals with connections to other social networks is likely to have access
to a wider range of information and resources. To achieve individual success, it is better to have connections to a
variety of networks rather than many connections within a single network. With continuous advancements in
information technology, it is expected that online social networks — online virtual communities where users can create
profiles and build networks of people with similar interests or activities — will play a critical role in future personal
and commercial online interactions, and organisation of information and knowledge.13 For example, entrepreneurs can
come across a wider range of opportunities through their online social networks, and they conveniently tap into these
networks to marshal the resources necessary to launch their ventures.
These four factors characterising entrepreneurs have been studied separately and viewed as largely independent aspects of
opportunity recognition and resource acquisition. Recently, however, an integrative framework has been proposed, drawing
on the research in cognitive science — the study of human intelligence that embraces various academic disciplines, such as
psychology, linguistics, neuroscience and economics. This approach suggests that entrepreneurs use cognitive frameworks
they possess to ‘connect the dots’ between changes in technology, demographics, markets, government policies and other
factors. The pattern they then perceive in these events or trends suggests ideas for new products or services — ideas that can
potentially serve as the basis for new ventures.14

2: Opportunity
In broad terms, an opportunity can be defined as a situation in which a new product, service or process can be introduced
and sold at greater than its cost of production. In this situation, new products, services and processes can be introduced
through the formation of new means, ends or means-ends relationships.15
In its most elemental form, what may later be called an opportunity may appear as imprecisely defined market needs [the
‘ends’], or unemployed resources or capacities [the ‘means’].16 Imprecisely defined market needs are the source of market-
pulled opportunities. Prospective customers may or may not be able to articulate their needs, interests and problems. Even if
customers cannot do so, the role of the entrepreneur is to recognise these needs and to develop an offer in which customers
will perceive some value.
Under-utilised or unemployed resources, as well as new technologies or capabilities, may also offer possibilities to create
new value for customers. In this case, entrepreneurs first identify resources that are not optimally used, and then seek a better
use or combination of these in a specific market. This type of opportunity can be called market-pushed opportunities. For
example, the technology for making a material with the combined properties of metal and glass may be developed before
there are any known applications. Similarly, new medical compounds may be created without knowledge of their potential
applications in the field of medicine.17

3: Resources
Having distilled an opportunity, would-be entrepreneurs must be willing and able to marshal resources in order to pursue the
opportunity and transform their idea into an organisation. A resource is any thing or quality that is useful. The resource-based
theory recognises six types of resources: financial, physical, human, technological, social and organisational.
The construction of an initial resource base poses quite a challenge for the entrepreneur. If a venture lacks a reputation and
has no track record, this creates an increased perception of risk on the part of potential resource providers. In most new
ventures, initial resource endowments are incomplete; so entrepreneurs act as though they are trustworthy in order to gain
access to other resources. They may use time-relevant language or symbols (e.g. polished business plans, stories, or stylish
offices) to create an image of success that will encourage providers to commit resources to the venture. In this way, some
resources (social, for example) are leveraged to obtain others (financial, for example). Favourable social capital can be
converted into tangible and intangible benefits, including increased cooperation and trust from others, finance, or assets and
equipment purchased at less expensive prices.18

4: Organisation
Many different types of organisational arrangement exist for the exploitation of entrepreneurial opportunities. Although most
media attention and research in entrepreneurship has focused on new independent start-ups, other possible types of
organisational structure include corporate ventures, franchises, joint ventures and business acquisitions. This indicates that
entrepreneurship can take place in diverse environments, and that there are many ways to become an entrepreneur. The
creation of corporate ventures or start-ups inside a corporation, in order to develop, produce and market a new product or
service, is an illustration of this point. The new entity can be either a new internal division or a new subsidiary in the
established corporation. Joint ventures, licences, franchises and spin-offs (business operations derived as secondary
developments of a larger enterprise, which become separate legal entities) are other examples of possible organisational
arrangements.
Sometimes it is not necessary to build an organisation from scratch to exploit new opportunities and to combine resources.
For example, the acquisition of a business can be an alternative to a start-up if the entrepreneur wants to use an existing
vehicle to ‘hit the ground running’. In this case, the buyer can introduce substantial innovation along the lines of new
products or new processes to give the business a boost. The takeover of a family business by the next generation and the
redeployment of its resources according to a new business model constitutes another example.
Many believe that for a venture to be deemed entrepreneurial it is not sufficient for the owner to launch an organisation; the
venture must also represent innovation. However, everyday evidence shows that starting a business venture does not always
demand much originality or power of invention. The fresh, new firm may be a mere clone of another one in a neighbouring
town. As will be explained in chapter 3, the extent of innovation can vary greatly, and the extension, duplication or synthesis
of existing products, services or processes can also be considered innovation.

5: Environment
The environment plays a critical role in entrepreneurship. Entrepreneurs operate in an environment that can be more or less
rich in opportunities, and where several conditions influence the pursuit of these opportunities. For example, opportunities
can emerge because of market inefficiencies that result from information asymmetry across time and place, or as a result of
political, regulatory, social or demographic changes.
There are two levels of the environment that exert an influence on the emergence of a business venture: the community level
and the broader societal level. At the community level, both the number of organisations in an industry (also called
population density) and the strength of the relationship between these organisations are important to entrepreneurs.
Individuals trying to create business ventures in a population with high density will find more opportunities for acquiring
effective knowledge and creating extensive social networks, but they will also encounter more intensive competition.
At the societal level, at least two aspects shape the environment for organisation: cultural norms and values, and government
activities and policies. Changing norms and values alter entrepreneurial intentions and the willingness of resource providers
to support new ventures. Government actions and political events create new institutional structure for entrepreneurial action,
encouraging some activities and impeding others.19
There is abundant evidence that regulatory and administrative burdens can negatively affect entrepreneurial activity. For
example, excessively stringent product and labour market regulations have implications for firm entry and exit.

Entrepreneur profile
 Olivia Lum, Hyflux

Olivia Lum, founder and CEO of the fast-growing water treatment company Hyflux, has never known her biological
parents. Lum was adopted at birth by an elderly woman she called ‘Grandma’, and grew up in Kampar, a poor
Malaysian mining town. At primary school, the vice principal urged her to leave the confines of Kampar and go to
Singapore, where she would have more opportunities and a greater chance of bettering herself. Ms Lum took his timely
advice and, in 1978, left home with the blessing of her Grandma and just S$10 in her pocket. In the city-state, she won a
place at one of the nation’s top junior colleges. After completing her studies in chemistry, she was hired by the
multinational corporation Glaxo to develop a water treatment system. During her three-year stint at Glaxo, Lum saw the
immense potential of a water treatment business.
So in 1989, Lum started up Hydrochem, the precursor to Hyflux, despite having little in the way of money or
connections. What she did have was passion, energy, enthusiasm and an unwavering conviction that her business idea was
a good one. Armed with strong belief in her abilities, Lum sold her car to start the business. She invested in a scooter so
that she could visit potential customers to show them her company’s water filters and treatment chemicals, and the
company now known as Hyflux was born.
Realising she would only grow the business if she went into manufacturing, in 1993 Lum used some of her company’s
early profit to bring in membrane technology (very fine filters) as a means of treating water. By the mid-1990s, with the
company turning over S$1 million, Lum decided to set up pilot plants in potential clients’ factories. It was a smart move.
Once shown the merits of the technology, which cleaned and filtered water before returning it to fresh water supplies,
companies snapped up Hyflux’s services. Multinational corporations in the electronics, pharmaceutical and textile
industries were among its first big customers. By this time, Hyflux was on a path towards tremendous business success.
Today, Hyflux is one of the world’s most successful suppliers of water desalination equipment, with annual revenue of
over S$450 million and a workforce of more than 2300 people. Lum has won many accolades — including Ernst &
Young World Entrepreneur of the Year. Lum says the secret to her success is simple. ‘We keep focusing on what we’re
good at and what we believe in’, she says.20

 10 Entrepreneurship: definition and evolution 10.2 The process of new venture creation 
10.2 THE PROCESS OF NEW VENTURE CREATION
Learning objective 2
explain the process of new venture creation

Not everyone has the potential to launch a business venture, and not all those with such a capacity will necessarily attempt to
do so. Of those who do attempt it, not all will succeed in creating a new venture. The model of new venture creation
proposed in figure 10.2 explains these observations. Yet, we know that each venture is different, and no single complete
model exists to explain how a venture gets off the ground. Entrepreneurs have different personalities and backgrounds as
well as different goals; all have a different time frame and aspire to launch their ventures in various industries. Thus, the
model presented in figure 10.2 allows for this diversity, rather than specifying a particular path.

FIGURE 10.2 A model of new venture formation

Central to the process of new venture formation is the founding individual. Whether the entrepreneur is perceived as a hard-
headed risk-bearer or a visionary, he or she is perceived to be different in important ways from the nonentrepreneur, such as
the manager, and many believe these differences lie in the psychological traits and background of the entrepreneur. There
have been many attempts to develop a psychological profile of the entrepreneur. The need for achievement, the level of
confidence and a risk-taking propensity are the three psychological traits that have been used in many studies and shown a
high degree of validity in differentiating among types of entrepreneur. Another approach has been to study the background,
experience and aspirations of entrepreneurs.
Entrepreneurs do not operate in a vacuum; they respond to their environments. At the opportunity recognition stage, the
entrepreneur perceives market needs and/or underemployed resources, and recognises a ‘fit’ between particular market needs
and specified resources. A favourable political, economic, social and infrastructure environment facilitates the emergence of
new business ventures. Figure 10.2 shows that the initiation of new ventures requires the combination of the right person in
the right place. The typical would-be entrepreneur is constantly attuned to environmental changes that may suggest an
opportunity.
People may have the propensity to found and develop a business in an environment conducive to entrepreneurship. They may
even have identified a promising opportunity, but the actual decision to launch the venture arises from a clear intention, and
this implies action. In new venture formation, intention is a conscious state of mind that directs attention towards the goal of
establishing the new organisation.21 With the expression of intent (‘I intend trying to start a business’), the hopeful
entrepreneur takes some concrete steps towards evaluating the business opportunity and gathering resources for launching
the venture. Such steps can include the formulation of strategy, the development of a prototype, market research, the
identification of potential partners, and the drafting of a business plan.
Just as the would-be entrepreneur must decide to attempt to establish a business, he or she must finally decide whether to
proceed with or abandon the attempt. The decision may be triggered by a specific event or simply by the accumulated weight
of confirmatory or contradictory information. Although some precipitating events, such as a dismissal, job frustration,
graduation or inheritance, may trigger the launch of the business venture, it is often the passion of the individual, sustained
ultimately by motivation, that pushes the entrepreneur to ‘take the plunge’. If the venture is launched, the triggers have
prevailed over the perceived barriers to start-up. Alternatively, if the person decides to abandon the attempt, then the hurdles
are perceived to be greater than the advantages.22

 10.1 Defining entrepreneurship and its key elements 10.3 The role of entrepreneurship

in economic growth and development 

10.3 THE ROLE OF ENTREPRENEURSHIP IN ECONOMIC
GROWTH AND DEVELOPMENT
Learning objective 3
explain the role of entrepreneurship in economic growth

At a macro level, entrepreneurship is a process of creative destruction. By this, Schumpeter23 referred to the simultaneously
destructive and constructive consequences of innovation. The new destroys the old. Entrepreneurs are central to the process
of creative destruction; they identify opportunities and bring the new technologies and new concepts into active commercial
use. However, a good proportion of creation is non-destructive, and many innovations satisfy new demands rather than
displacing existing products and services. Research showed that roughly 70 per cent of the goods and services consumed in
the 1990s bore little relationship to those consumed a century earlier.24 And even when the creation does involve some
destruction, there are nevertheless some positive aspects to consider for society. For example, the innovations developed by
entrepreneurs often increase productivity and improve general living standards.
In other words, entrepreneurial capitalism produces a bigger pie, and allows more people to exercise their creative talents.
However, it is disruptive nonetheless. It increases the rate at which enterprises are born and die, and forces workers to move
from one job to another. By studying economic history, we can learn valuable lessons about the conditions that allow
entrepreneurs and growth to flourish.

Values, politics and economic institutions

Science and technology can sometimes progress rapidly and then suddenly stop. Consider China’s dazzling supremacy in
science and technology at the start of the fifteenth century. Curiosity, the instinct for exploration and the drive to build had
created in China all the technologies necessary for launching the Industrial Revolution — something that would not occur for
another 400 years. China had the blast furnace and piston bellows for making steel; gunpowder and cannon for military
conquest; the compass and the rudder for exploration; paper and moveable type for printing; the iron plough, the horse collar
and various natural and artificial fertilisers to generate agricultural surpluses; and in mathematics, the decimal system,
negative numbers, and the concept of zero. Such developments placed the Chinese far in advance of the Europeans, although
the latter quickly moved forward thanks to the Industrial Revolution that took place in Britain and Europe in the eighteenth
and nineteenth centuries. The Chinese also rejected and ultimately forgot the technologies that could have otherwise given
them world dominance; this occurred due to a lack of entrepreneurship in China, in turn caused by three broad, overlapping
factors: values, politics and economic institutions.25

1: Values
Entrepreneurship is a process of economic change. It follows that a readiness for change, or at least the willingness to live
with it, is essential if a society is to get richer (except by conquest). This, in part, accounts for China’s falling behind.
Chinese civilisation came under the domination of a bureaucratic elite, the mandarins. They provided continuity and stability
to Chinese life, but were also a conservative influence on innovation, resisting the introduction of new techniques unless they
provided a clear benefit to the bureaucracy.26 Consequently, the mandarins often opposed change; and at the close of the
fifteenth century they ended long-standing sea-trade ventures, choking off commerce and shipbuilding.27
Acquisitiveness is another value that sustains growth. As change agents in a society, entrepreneurs have a regard for the
material, and they are willing to exploit nature for human benefit. However, naked greed is no use. Growth is based on
sustainable development; it requires investment, and investment is deferred gratification. The enlightened self-interest
praised by economist Adam Smith combines the desire for wealth with prudence and patience.28

2: Politics
Values are a powerful entrepreneurial catalyst at the individual level. At a macro level, politics provides a framework for
entrepreneurship. Economic institutions are the tools used by entrepreneurs to capitalise on opportunities and convert those
opportunities into marketable products or services.
Once again, China provides a good example of the influence of politics over entrepreneurship. The Ming dynasty (1368–
1644) was one of the most stable Chinese dynasties but also one of the most autocratic. The sprawling bureaucracy needed
by the highly centralised government was continued by the subsequent Qing dynasty, which lasted until the imperial
institution was abolished in 1911. What was chiefly lacking in China for the further development of capitalism was not
mechanical skill, scientific aptitude or sufficient accumulation of wealth, but scope for individual enterprise. There was no
individual freedom, no security for private enterprise, no legal foundation for rights other than those of the state, and no
guarantee against arbitrary extortion by officials or intervention by the state.
If too much order (as in China) impedes entrepreneurship, conversely too much chaos is just as bad. Consider Russia in the
75 years before the Russian Revolution of 1917. Creativity flourished in the chaos of the dying empire. Great authors such as
Tolstoy, Dostoevsky, Chekhov, Turgenev and Gogol emerged during this period. Likewise, in the world of music, many
Russian artists of that period are still played in concert halls. In science, Russia was a leader and produced several Nobel
laureates. However, without some degree of order it was impossible for the Russians to use that creativity to develop a
successful economy. Chaos led to more chaos and ultimately to the Russian Revolution. Order was reimposed and creativity
died.29 Successful societies create and manage a tension between order and chaos without letting either of them get out of
hand. New ideas are easily frustrated if societies are not receptive to the chaos that comes from change, yet societies have to
maintain an appropriate degree of order to take advantage of creative breakthroughs.

3: Economic institutions
Economic institutions are part of the framework conditions influencing entrepreneurship. In the West, where the state was,
and is, a central institution, the economic sphere came to be separated from political control under a variety of pressures.
This led to a spawning of other institutions, such as property rights, stock exchanges, banks, courts, laws of contract and so
on.30 With time, these allow a flourishing of many different types of economic enterprise that are different in size, ownership
and organisation. Here was yet another form of pluralism that existed in Europe, but not in China or in Japan before the
Industrial Revolution — just as governments competed, so did the entrepreneurs and the different forms of organisation.

The relationship between entrepreneurship and economic growth

It is the quality of entrepreneurs’ performances that determines whether capital grows rapidly or slowly, and whether this
growth involves innovation and change, that is, the development of new products and new production techniques.
Differences in growth rates between countries and between different periods in any one country can therefore be traced back
largely to the quality of entrepreneurship. Fundamentally, economic growth occurs not because of broad improvements in
technology, productivity and available resources, but because entrepreneurs (a) improve their technology, organisation and
processes, (b) become more productive and innovative and (c) force other firms out of business. As this ongoing creative
destruction occurs, new and better jobs than the lost ones are created, the overall level of productivity rises, and economic
wellbeing increases.
One indicator of creative destruction is the business dynamics taking place within the national economy.31 This is the extent
to which firms enter an industry, grow, decline and exit an industry. Despite the recognition that business dynamics are a
necessary feature of economic growth, it is often hard for public opinion and government to accept the destructive dimension
of entrepreneurship. It is illusory to think that society can benefit from the growth and progress generated by entrepreneurial
activities (new products and services, job and wealth creation) without incurring enterprise restructuring and bankruptcies
and their inevitable consequences (removal of products from the marketplace, staff retrenchments, losses by investors).
The level of entrepreneurial activity is a function of the degree to which people recognise the opportunities available and
their capacity (motivation and skills) to exploit them. Entrepreneurial activity is, in turn, shaped by a variety of factors
(referred to as entrepreneurial framework conditions) that help to foster start-ups. Such factors include the availability of
start-up financing, education and training in entrepreneurship, ‘incubator’ facilities, government policies, and programs
targeting the development of entrepreneurship.
At a broader level, there is a relationship between national conditions, such as legal institutions, general infrastructure, labour
and financial markets, and the performance of established firms. History shows that the process of innovation and
entrepreneurship consists of an accumulation of numerous institutional, resource and proprietary events involving many
factors from the public and private sectors.32 Finally, social values, politics and institutions shape the macro context within
which entrepreneurial processes occur. It is important to recognise, however, that although government agencies and
educational institutions can create conditions in which entrepreneurship can prosper, it is ultimately up to individuals and
firms to take up the challenge of launching new activities.

Measuring entrepreneurial activity

Given the fact that there are many different institutional ways of exploiting opportunities, measuring entrepreneurial activity
in the economy is a difficult task. Substantial attention has been given recently to fast-growing new firms in expanding
industry sectors, and this has provided anecdotal evidence that some countries are more entrepreneurial than others. The
Global Entrepreneurship Monitor (GEM)33 is an international research consortium that aims to go beyond such
impressionistic evidence and to systematically assess two things: (1) the level of start-up activity, or the prevalence of
embryonic firms and (2) the prevalence of those that have survived the start-up phase.
First, start-up activity is measured by the proportion of the adult population in each country currently engaged in the process
of creating a business. Second, the prevalence of new firms is measured by the proportion of adults in each country involved
in operating a business that is less than 42 months old when the survey is completed. For both measures, the research focus is
on entrepreneurial activity in which the individuals involved have a direct, but not necessarily full, ownership interest in the
business. Combining these measures provides an excellent index of the total level of entrepreneurial activity.

How entrepreneurial are the people of different countries?

The overall level of entrepreneurial activity for a selection of countries participating in the GEM project is presented in
figure 10.3. The vertical bars represent the precision of each estimate based on the size of the sample in each country at the
95 per cent confidence interval. The range in prevalence rates shows a tenfold difference, from a low of 3.8 per cent in
Hungary to 14.4 per cent in Brazil. When countries are grouped according to a global region, it appears that entrepreneurial
efforts are not uniformly distributed around the world. Without question, entrepreneurial activity is quite low and uniform
across most developed European countries. Anglo-Saxon countries have a relatively high level of activity compared with
European countries. Latin America has among the highest and most uniform levels of activity. The situation in Asia is
contrasted: while Japan and Singapore have a low rate of entrepreneurial activity, Hong Kong SAR, China and India are the
most entrepreneurial countries in the region.
FIGURE 10.3 Total entrepreneurial activity by country and region (mean 2006–2012)

Source: GEM Consortium www.gemconsortium.org.

The GEM study uncovered a dynamic dimension to entrepreneurial activity. Respondents were asked to indicate whether
they were starting and growing their business to take advantage of a unique market opportunity (opportunity
entrepreneurship) or because it was the best option available (necessity entrepreneurship). In the case of necessity
entrepreneurship, people launch a business venture not so much to pursue a unique opportunity but because they have no
other way of making a living. Cross-national comparisons indicate that from 3 per cent of adults in Japan to over 16 per cent
in New Zealand are engaged as opportunity entrepreneurs. The level of necessity entrepreneurs had an even greater variation,
from virtually none in Europe to 5 per cent or more in India and China. The analysis indicated that developing countries
generally have a higher prevalence rate for necessity entrepreneurship.
People are finding it easier in this information age to establish a new business; conversely, incumbents are finding it more
difficult to defend their territory. Back in 1960, the composition of the Fortune 500 was so stable that it took 20 years for a
third of the constituent companies to change. Now, it only takes four years.34 There are many reasons for this. First, the
information revolution has helped to lower transaction costs (the information, negotiation and control costs involved in every
economy transaction) and to unbundle existing companies. Second, the economic growth is being driven by industries, such
as computing and telecommunications, where innovation is particularly important. Third, advanced economies are
characterised by a shift from manufacturing to services. Service firms are usually smaller than manufacturing firms, and
there are fewer barriers to entry.

 10.2 The process of new venture creation 10.4 Common features of entrepreneurship
in the Asia–Pacific region 
10.4 COMMON FEATURES OF ENTREPRENEURSHIP IN THE
ASIA–PACIFIC REGION
Learning objective 4
discuss the common features of entrepreneurship in the Asia–Pacific region

Entrepreneurship styles, habits and environments vary significantly across the Asia–Pacific region. At first glance, there
appears to be little in common in setting up a business in Australia, Malaysia or Hong Kong. Despite the differences, there
are some key features in Asia–Pacific entrepreneurship that distinguish it from European and American entrepreneurship.
For example, a common characteristic is the key role played by the state in the development of entrepreneurship. Another
common denominator is the presence of ethnic entrepreneurs. For instance, Chinese people living outside the current
administration of the People’s Republic of China have been at the heart of the region’s economic boom.
Most ethnic Chinese who left the mainland (known as huaqiao) did so with little wealth and could not rely on the
governments of other South-East Asian countries for assistance. Often battling prejudice and discrimination, these families
created their own businesses and, in the process, developed much of the modern private sector throughout South-East Asia.
Wary of their new local governments, the ethnic Chinese discovered that a common background provided a basis for mutual
trust and, therefore, presented an opportunity for business and trade throughout the Asia–Pacific region. Language, culture
and ethnicity served as common ground, but family provided the most reliable and secure assurances in an area where formal
business agreements were difficult to enforce. Today, companies owned by ethnic Chinese families in Singapore, Malaysia,
Thailand, Indonesia and the Philippines make up about 70 per cent of the private business sector in those countries and are
rising influences in Vietnam, Australia and New Zealand.35
Ethnic Indians constitute another sizeable segment of the immigrants of diverse nationalities in the Asia–Pacific region. In
terms of sheer numbers, they are the third largest group, behind the British and the Chinese. Over 15 million people of Indian
origin have settled in 70 countries. They are significant minorities in Malaysia, Singapore and Sri Lanka, and have made
important contributions to the development of entrepreneurship across the Asia–Pacific region. For example, one of the main
reasons behind the emergence of Silicon Valley as the world hub of high-tech industries has been the presence of ethnic
Indian entrepreneurs. In addition, the pyramid structures of Asian firms, and the active role of the state are further common
features of entrepreneurship in the Asia–Pacific region.

Sociocultural features of ethnic Chinese

Redding36 suggested that the impact of Chinese culture has worked through the two main determinants of social structures,
which in turn affect the workings of organisations. These are (1) the rules that govern the stabilisation and legitimisation of
authority, that is, the vertical dimension of order and (2) the rules that govern the stabilisation of cooperation, that is, the
horizontal dimension of order.
The norms for vertical relationships are taught via Confucian concepts. The Confucian ethical system regulating social
behaviour has three principal ideas: benevolence (ren), righteousness or justice (yi) and propriety or courtesy (li). Regulation
is certainly the appropriate term. Confucianism is a secular system developed at a time of chaos to allow harmony to coexist
with rigid hierarchy. This worked by providing a set of principles for action, most of which surround the role of the father as
the pivot of the social system.
As a result, the style of leadership adopted commonly has a paternalistic flavour, and the adoption of such a style by the
business owner sets the tone for other managers to echo it with their subordinates. This style can also bring with it nepotism
and autocracy, as social interaction in the Confucian system is very much a tradition. Organisation charts and job descriptions
are replaced by social deference. People come into the organisation pre-programmed to understand hierarchy instinctively.
Similar considerations apply to the rules for horizontal order, particularly in the development and handling of relationships.
This begins with a clear distinction between in-group members or insiders (zijiren) and out-group members or outsiders
(wairen). Chinese people typically maintain expressive ties with close family members, mixed ties with friends and other kin,
and instrumental ties with strangers or out-group members with whom there is no lasting relationship.37 Social interaction
expectations, norms and behaviours differ among these three kinds of ties.
Western and Eastern entrepreneurs and firms have a different approach to relationships. To most Western firms, relationships
are secondary — a company tends to decide which business or projects it is interested in and then cultivates the necessary
connections. Asian companies believe that relationships come first and that investment opportunities flow from them. This
philosophy finds its root in the historic uncertainty and separateness felt by expatriate Chinese. Many local firms in the Asia–
Pacific region were established by Chinese migrants and their offspring in not-so-friendly environments, away from their
country of origin, in countries with rules-based, yet, weak systems. Consequently, expatriate Chinese tended to rely mainly
on relationships with extended families and clans to build up the business and reduce risk. The interlocking relationships
soon extended to local officials keen to benefit from Chinese entrepreneurial skills. This web of connections, or guanxi, is
still paramount with most ethnic Chinese groups in the Asia–Pacific region.

Ethnic Indians
Although expatriate Indians are often described as a fractionalised community from diverse Indian regions, castes and
religions, they nevertheless have unity in their diversity. The vast majority adhere to some form of the caste system, and
Hindu mythology pervades their culture. India has also instituted an exceptional education system that has trained a ready
core of highly skilled and highly educated professionals and entrepreneurs who are familiar with the English language and
Western ways. As a result, most of the recent migrants to Australia, New Zealand, Singapore and the United States are
capable of quickly stepping into middle- and upper-level jobs.
Like their less educated counterparts, most high-tech Indian immigrants rely on ethnic strategies to enhance entrepreneurial
opportunities. Seeing themselves as outsiders to the mainstream technology community, foreign-born engineers and scientists
in Silicon Valley have created social and professional networks to mobilise the information, know-how, skill and capital to
start technology firms. Combining elements of traditional immigrant culture with distinctly high-tech practices, these
organisations simultaneously create ethnic identities within the region and aid professional networking and information
exchange.
India has begun to reverse its brain drain, as many Indian-born scientists, professionals and entrepreneurs are returning to
their mother country. Officials in India say they had seen a sharp increase in the arrival of people of Indian descent recently
— including at least 100 000 in the last year alone.38 Such people have helped to fill some of the skills gap created by the
country’s recent boom. India’s entrepreneurial tradition stretches a long way back; for example, the Marwari baniyas
merchant community extended their trade networks to many regions of India and even to neighboring countries, building
their wealth by bargaining hard with those outside their circle. However, the new generation of entrepreneurs usually launch
a business based on merit and professionalism rather than kinship ties.39

The pyramid structures of Asian family firms

Another common feature of entrepreneurship in the Asia–Pacific region relates to the type of ownership and structure of the
enterprises. Most of the businesses across the region are family-owned, although the proportion of family businesses is lower
in Australia and New Zealand compared with Asia. For example, the family, as an institution, dominates India — be it in
culture, religion, politics or business. Estimates indicate that 95 per cent of all registered Indian firms are family-owned
businesses, and that they generate 75 per cent of the GDP and 57 per cent employment in the country.40 In Hong Kong, 15
families control corporate assets worth 84 per cent of GDP.41
Although all countries in the region basically have the same legal structures under which businesses operate, most Asian
companies have a distinctive feature. Control of firms is enhanced through ‘pyramids’ — complex and opaque structures of
private holding companies, layer upon layer of subsidiaries, and cross-holdings — where voting rights exceed formal profit
rights. Most of these pyramids have been established by overseas Chinese entrepreneurs, and their purpose is to draw outside
capital into the family group and retain control over the use of this capital within the family.
The pyramid scheme functions like this: let’s say a family holds a 51 per cent controlling stake in a company at the pyramid’s
apex. Similar stakes are then held in the second and third tiers of companies. Thus, control of the entire pyramid from top to
bottom is maintained, even though the family’s financial commitment decreases proportionally from tier to tier. In this case,
the second tier is only 26 per cent (51 per cent of 51 per cent), whereas the third tier stakes are only about 13 per cent.42
This discrepancy between the family’s control (voting rights) and ownership (profit rights) creates an opportunity and,
indeed, an incentive to expropriate minority shareholders in second and third tier companies. How? One way is for the
controlling family to make these companies pay miserly dividends. Better still, the family could make a second tier company
sell an asset to third tier company at an artificially low price, or make second tier company buy an asset from a third tier
company at an inflated price.

The role of the state

Over the past decades the state has played a ubiquitous role in entrepreneurship in virtually all Asia–Pacific countries.
Encouraging entrepreneurship has been increasingly recognised by governments across the region as an effective means of
creating jobs, increasing productivity and competitiveness, alleviating poverty and achieving societal goals. It is, therefore,
not surprising that the state has been a strong promoter of entrepreneurship to the extent that it has even become an
entrepreneur itself — hence the term ‘state entrepreneurship’.

Promotion of entrepreneurship and SMEs

Every country in the region has engaged in some sort of promotion of entrepreneurship and of SMEs. Singapore was among
the first to promote entrepreneurship, developing a comprehensive policy to deal with related matters, and creating an
environment conducive to entrepreneurial activities — thus earning the country a high ranking in the Work Bank league
tables for ease of doing business. Along with its big investments in digital media, bioengineering and clean technology, the
government has set up a public venture-capital fund, created huge incubators and used financial incentives to lure foreign
scientists.43
A comprehensive network of small business agencies has also been set up by the various states in Australia. Likewise,
Malaysia has taken a dynamic approach to the promotion of entrepreneurship by creating a ministry totally dedicated to
entrepreneurial issues. The Ministry of Entrepreneur Development was set up in 1995 to assume full responsibility for all the
functions of the Ministry of Public Enterprise, which was abolished.

State entrepreneurship
Governments have traditionally played an important role in a few ‘sensitive’ sectors in all Asia–Pacific countries. Those
sectors include telecommunications, media, real estate, natural resources and banking. Even in countries labelled ‘free
market economies’, such as Australia and Singapore, the government still owns companies in those sectors, although the
telecommunications sector has recently been deregulated and government icons, such as Telstra in Australia and SingTel in
Singapore, have been partially privatised.
Singapore is certainly the champion of state entrepreneurship. In the 1960s and 1970s, the government initiated many
enterprises in key sectors, including manufacturing, shipping, air transport, international trade and long-term finance. The
main vehicle for state entrepreneurship in Singapore is government- linked companies (GLCs). These enterprises are formed
under holding companies, which in turn depend on a ministry.44 Examples of GLCs are Sambawang (infrastructure, marine
engineering, information technology and leisure activities), Development Bank of Singapore (banking), Neptune Orient
Lines (shipping) and Singapore Airlines (air transport). Consequently, public servants have often played the role of
entrepreneurs in Singapore.
Similarly, the Malaysian government controls companies in various industries, including printing (e.g. Percetakan Nasional
Malaysia Berhad, or PNMB), banking (e.g. Bumiputra-Commerce Bank, Danamodal Nasional Berhad), oil and gas (e.g.
Petronas), air transport (Malaysia Airlines) and conglomerates, such as UDA Holdings Berhad with activities in property
development, hospitality and retail. The picture was much the same in Indonesia until 1999, when the Wahid government,
under International Monetary Fund pressure, was forced to privatise and dismantle state monopolies.
In China, the state-owned enterprises left over from the state planning era still represent about one third of the economy.
Although these enterprises are now under severe scrutiny over their performance, almost all of them benefit from protective
barriers in their home market. Such an example would be the world’s biggest mobile operator China Mobile as its
competition has been limited by ministerial decree to a handful of domestic companies. The government regulates other
areas of strategic interest, such as steel, energy and finance, in a similar fashion.45

Emerging trends
The new millennium brought profound changes that have affected entrepreneurship in the Asia–Pacific region. The main
force behind those changes lies in the rise and supremacy of the free-market economy as a framework for entrepreneurship.
This trend has its roots in the collapse of the communist system; trade liberalisation led by the World Trade Organization;
and the Asian financial crisis (1997–98).

Liberalisation and globalisation

All countries in the Asia–Pacific region embarked on some program of deregulation and privatisation in the 1990s. Some
countries moved towards deregulation on their own initiative, such as New Zealand, Australia, Singapore and Vietnam.
Others, such as Thailand and Indonesia, were more or less forced to follow after the Asian financial crisis. Many laws
restricting entrepreneurial endeavours, particularly for ethnic Chinese and foreign nationals, have been scrapped or watered
down. Furthermore, several state-owned companies were totally or partially privatised in the 1990s. This change has created
new opportunities for would-be entrepreneurs, and considerably improved the environment for entrepreneurship.
At the same time, economic openness and regional trade have led to the emergence of production networks in which
entrepreneurs and SMEs from the region seize on outsourcing and subcontracting opportunities to provide flexible, value-
added products and services. The proliferation of internet businesses provides new opportunities, too. Thanks to
technological advances in business management and practices, many SMEs in Singapore, Hong Kong and China are
expanding their business operations from homes and other flexible arrangements. Such flexibility in doing business is
enabled through myriad business opportunities possible through the borderless cyberspace environment.46

Adoption of Western ideas

Western ideas have spread quickly into South-East Asia through different channels, such as films, television, advertising,
internet and education systems. For example, many of the ethnic Chinese entrepreneurs who built huge conglomerates are
preparing to hand over those companies to members of the next generation, who have often been educated in American,
British or Australian universities where they learned Western ways of doing business. Buzan and Segal47 suggested that we
are moving into a ‘Westernistic age’ marked by the fusion of Western and other cultures. The power of the West has been,
and still is, based on forms of social, economic and political organisation that allow individuals to make more of their human
potential than had been previously possible. Some parts of Western ideology still encounter strong resistance in South-East
Asia, notably democracy, civil society and human rights. But, as Japan, Korea, Singapore and Taiwan demonstrate,
‘Westernisation’ does not mean becoming identical to the West or losing one’s own culture.
Convergence, in other words, has limits; although it appears to be quite widespread in matters of routines and practices, such
as factory layouts, accounting practices, and technical standards, there is a realm of beliefs, attitudes and meanings where
convergence is difficult to find. Differences, therefore, remain salient between the countries in the region, at both cultural and
institutional levels.

Adoption of rules-based systems

South-East Asian economies have traditionally been based on relationships. Business transactions were made on the strength
of personal agreements rather than on contracts. Transactions in the Chinese guanxi system are still mainly private. They are
neither verifiable nor enforceable in the public sphere. After the 1997–98 financial crisis, Asia’s governments made a big
effort to clean up their financial and regulatory regimes. Stronger rules-based systems were introduced, with stricter insider-
trading and contract laws and more rigorous competition policies. Consequently, the usefulness of guanxi in gathering
information and providing finance and personal favours has begun to decline. As Asia’s markets become more rules-based,
its entrepreneurs are increasingly prepared to deal with contracts outside the traditional network.
Other recent changes relate to the corporate governance and human resource practices of medium and large companies in
South-East Asia. We can observe an increased disclosure in public accounts, the search for an image of good management,
and the employment of ‘outsiders’ in key positions to deal with Western sources of capital and technology.

Emergence of an entrepreneurial society

The rise of the entrepreneur, which has been gathering speed over the past two decades in the Asia–Pacific region, can be felt
both at the economic and broader societal levels. Masses of new entrepreneurs are storming onto the world market, as a
result of the opening up of China and India. About 65 per cent of China’s economy is now dominated by SMEs serving local
markets or engaged in global supply networks of the ‘workshop of the world’. With this surge of entrepreneurial capitalism,
the ideology of family status by seeking private wealth is reemerging. The masses of Asian entrepreneurs not only adapt
Western ideas into their local markets but also transcend these ideas with their own technological advances. These effects are
now being experienced by the entire world.
Entrepreneurship in Australia, for many, has become synonymous with decency, fairness and honesty in business. Big
companies are, in contrast, seen as ‘the bad guys’ by consumers who now embrace entrepreneurs and the brands they
endorse. The perception of entrepreneurship among consumers has become so positive that consumers now regard an
entrepreneurial attitude, personality and inventiveness as three of the foremost qualities they look for in a brand.48
The rapid growth of entrepreneurialism in countries such as China and India is felt at the societal level, reflected in
attitudinal changes spilling over not only into mainstream business but also politics and civil society. Often outstripping their
respective countries’ abilities to keep up with their laws to regulate them, entrepreneurs continue to create their own rules
and invent new ways of doing things ahead of social norms and customs.49

 10.3 The role of entrepreneurship in economic

Summary 
growth and development
SUMMARY
Learning objective 1: provide a definition of entrepreneurship and state the key elements of entrepreneurship
Entrepreneurship is the process of people identifying new opportunities and converting them into marketable products
or services. Therefore, the field of entrepreneurship involves the study of (1) sources of opportunities; (2) the processes
of discovery, evaluation and exploitation of opportunities; and (3) the set of individuals who discover, evaluate and
exploit those opportunities. Five factors have been commonly cited for entrepreneurship to take place: an individual
(the entrepreneur), a market opportunity, adequate resources, a business organisation and a favourable environment.
These five factors are considered contingencies — something that must be present in the phenomenon of
entrepreneurship but that can materialise in many different ways. The entrepreneur is responsible for bringing these
contingencies together to create new value.
Learning objective 2: explain the process of new venture creation
Central to the process of venture formation is the founding individual. Each individual entrepreneur is different,
leading to difference venture models. The need for achievement, the level of confidence and a risk-taking propensity
are identified as the three psychological traits representative of entrepreneurs.
Learning objective 3: explain the role of entrepreneurship in economic growth
At a macro level, entrepreneurship has been referred to as a process of creative destruction and a catalyst for economic
growth. Entrepreneurs identify opportunities and bring the new technologies and concepts into active commercial use.
In doing so, they create new business ventures, jobs and wealth, but they also force out of the marketplace the
enterprises which failed to innovate. However, measuring entrepreneurial activity in the economy is a difficult task
because there are many different institutional forms for exploiting opportunities. The Global Entrepreneurship
Monitor, an international research consortium, showed that the level of entrepreneurial activity differed significantly
between countries. This difference reflects major variations in the degree to which the opportunities are perceived to
exist, rather than differences in opportunities themselves.
Learning objective 4: discuss the common features of entrepreneurship in the Asia–Pacific region
While studying entrepreneurship styles, habits and environments across the Asia–Pacific region, we can identify three
common features: (1) the key role played by the state in the promotion and development of entrepreneurship; (2) the
pyramid structures of Asian firms, which are mainly family-owned; and (3) the presence of ethnic Chinese and ethnic
Indian entrepreneurs who have been at the heart of the region’s economic boom.
Following the spread of the free market and the development of trade, the region has undergone major changes.
Among these, the movement for liberalisation and globalisation, the adoption of Western ideas, the emergence of rules-
based systems, and the increased pressure for disclosure are likely to have profound effects on entrepreneurship and
small businesses. These trends have led to the rise of the entrepreneurial society, which recognises and celebrates the
vital economic and societal roles played by entrepreneurs.

Review questions
1. What are the key elements of entrepreneurship?
2. What are the critical stages in the process of new venture formation?
3. What are the central factors necessary for entrepreneurship to thrive in a country?
4. What are the common features of entrepreneurship in the Asia–Pacific region?
5. What are the emerging trends affecting entrepreneurship in the Asia–Pacific region?

Discussion questions
1. Why is it often said that entrepreneurship is a complex phenomenon? Identify different dimensions of or approaches to
this phenomenon.
2. It is often said that entrepreneurship consists of ‘economic experiments’. Would you agree with this statement? Why?
3. What are the main benefits of entrepreneurship?
 4. At what level (national or regional) can policy makers encourage entrepreneurship? Explain your reasoning.
5. Can entrepreneurship be taught and learned?

Suggested reading
Baron, R.A., Entrepreneurship: An Evidence-based Guide, Edward Elgar, Cheltenham, 2012.
Khanna, T., Billions of Entrepreneurs: How China and India are Reshaping their Futures and Yours, Harvard Business
School Press, Boston, 2007.
Ries, E., The Lean Startup: How Today’s Entrepreneurs Use Continuous Innovation to Create Radically Successful
Businesses, Crown Publishing, New York, 2011.

 10.4 Common features of entrepreneurship in

Endnotes 
the Asia–Pacific region
ENDNOTES
1. ‘The more the merrier, Special report on entrepreneurship’, The Economist, 14 March 2009, p. 11.
2. R. Cantillon, Essay on the Nature of Commerce (1755), trans. H. Higgs, Macmillan, London, 1931.
3. S. Vankataraman, ‘The distinctive domain of entrepreneurship research’, in J. Katz, (ed.), Advances in Entrepreneurship,
Firm Emergence and Growth, JAI Press, Greenwich, Conn., 1997, pp. 119–38.
4. S. Shane & S. Vankataraman, ‘The promise of entrepreneurship as a field of research’, Academy of Management Review,
vol. 25, no. 1, 2000, pp. 217–26.
5. P. Wickham, Strategic Entrepreneurship, Prentice Hall, Harlow, 2004.
6. S. Shane, A General Theory of Entrepreneurship: The Individual-Opportunity Nexus, Edward Elgar, Aldershot, 2003.
7. B. Gilad, S. Kaish & J. Ronen, ‘The entrepreneurial way with information’, in S. Maital, (ed.), Applied Behavioural
Economics, vol. II, Wheatsheaf Books, Brighton, 1989, pp. 480–503.
8. I. Kirzner, Competition and Entrepreneurship, University of Chicago Press, Chicago, 1973.
9. S. Shane, see note 7.
10. S. Shane, ‘Prior knowledge and the discovery of entrepreneurial opportunities’, Organization Science, vol. 11, no. 4, pp.
448–69.
11. R.P. Singh, G. Hills, R. Hybels & G. Lumpkin, ‘Opportunity recognition through social networks of entrepreneurs’,
Frontiers of Entrepreneurship Research, Babson College, Wellesley, 1999, pp. 228–41.
12. M. Granovetter, ‘The strength of weak ties’, American Journal of Sociology, vol. 78, no. 6, 1973, pp. 1360–80.
13. M. Kasavana, K. Nusair & K. Teodosic, ‘Online social networking: Redefining the human web’, Journal of Hospitality
and Tourism Technology, vol. 1 no. 1, 2010, pp. 68–82.
14. R. Baron, ‘Opportunity recognition as pattern recognition: how entrepreneurs “connect the dots” to identify new business
opportunities’, Academy of Management Perspectives, February 2006, pp. 104–19.
15. J. Eckhardt & S. Shane, Opportunities and entrepreneurship, Journal of Management, vol. 29, no. 3, 2003, pp. 333–49.
16. I. Kirzner, ‘Entrepreneurial discovery and the competitive market process: an Austrian approach’, Journal of Economic
Literature, vol. 35, 1997, pp. 60–85.
17. A. Ardichvili, R. Cardozo & S. Ray, ‘A theory of entrepreneurial opportunity identification and development’, Journal of
Business Venturing, vol. 18, no. 1, 2003, pp. 105–23.
18. C. Brush, P. Greene & M. Hart, ‘From initial idea to unique advantage: the entrepreneurial challenge of constructing a
resource base’, The Academy of Management Executive, vol. 15, no. 1, February 2001, pp. 64–78.
19. H. Aldrich & M. Martinez, ‘Many are called, but few are chosen: an evolutionary perspective for the study of
entrepreneurship’, Entrepreneurship Theory & Practice, vol. 25, no. 4, 2001, pp. 41–56.
20. Ernst & Young, ‘Wonder woman’, Exceptional, 2012, pp. 26–9.
21. B.J. Bird, Entrepreneurial Behavior, Scott, Foresman & Co., Glenview, Ill., 1989.
22. T. Volery, N. Doss, T. Mazzarol & V. Thein, ‘Triggers and barriers affecting entrepreneurial intentionality: the case of
Western Australian nascent entrepreneurs’, Journal of Enterprising Culture, vol. 5, no. 3, 1997, pp. 273–91.
23. J.A. Schumpeter, The Theory of Economic Development, Harvard University Press, Cambridge, Mass., 1934.
24. ‘The entrepreneurial society, Special report on entrepreneurship’, The Economist, 14 March 2009, p. 18.
25. L.C. Thurow, Building Wealth: The New Rules for Individuals, Companies and Nations, HarperCollins, New York, 1999.
26. R. Marsh, The Mandarins: The Circulation of Elites in China, 1600–1900, Free Press, Glencoe, Ill., 1961.
27. Thurow, op. cit.
28. ibid.
29. L. Thurow, Building Wealth, Harper Business, New York, 2000.
30. W.E. Williamson, The Economic Institutions of Capitalism, Free Press, New York, 1985.
31. Z.J. Acs, B. Carlsson & C. Karlsson (eds), ‘The linkages among entrepreneurship, SMEs and the macroeconomy’, in
Entrepreneurship, Small and Medium-Sized Enterprises and the Macroeconomy, Cambridge University Press, Cambridge,
Mass., 1999, p. 16.
32. A. Van de Ven, ‘The development of an infrastructure for entrepreneurship’, Journal of Business Venturing, vol. 8, no. 4,
1993, pp. 211–30.
33. More information on the Global Entrepreneurship Monitor is available at www.gemconsortium.org.
34. ‘Global heroes — Special report on entrepreneurship’, The Economist, 14 March 2009, p. 6
35. M. Weidenbaum & S. Hughes, The Bamboo Network: How Expatriate Chinese Entrepreneurs are Creating a New
Economic Superpower in Asia, Free Press, New York, 1996.
36. G.S. Redding, The Spirit of Chinese Capitalism, de Gruyter, New York, 1990.
37. W.K. Gabrenya & K.K. Hwang, ‘Chinese social interaction: harmony and hierarchy on the good hearth’, in M.H. Bond
(eds), The Handbook of Chinese Psychology, Oxford University Press, Hong Kong, 1996, pp. 309–21.
38. K. Semple, ‘Reverse brain drain: For many immigrants’ children, American dream lies in India, China’, The Times of
India, 17 April 2012.
39. ‘Entrepreneurship in India’, The Economist, www.economist.com, 18 December 2008.
40. S. Gurumurthy, ‘Why family businesses undergo changes’, www.moneycontrol.com.
41. S. Claessens, S. Djankov & L. Lang, ‘The separation of ownership and control in East Asian corporations’, Journal of
Financial Economics, no. 58, 2000, pp. 81–112.
42. ‘Pharoah capitalism’, The Economist, 14 February 2009, p. 81.
43. Finfacts Ireland, ‘Lands of opportunity: Israel, Denmark and Singapore — and what about Ireland?’, www.finfacts.ie, 16
March, 2009.
44. S. Choo, ‘Developing an entrepreneurial culture in Singapore: Dream or reality’, Asian Affairs, vol. 36, no. 3, November
2005, pp. 361–73.
45. ‘Time to change the act’, The Economist, 21 February, 2009.
46. H. Lim & F. Kimura, ‘The internationalization of small and medium enterprises in regional and global value chains’,
ADBI Working Paper Series, no. 230, Asian Development Bank Institute, 2010.
47. B. Buzans & G. Segal, Anticipating the Future, Simon & Schuster, New York, 2000.
48. Grey Group, Eye on Australia 2005, Grey Group, Melbourne.
49. Khanna, T., Billions of Entrepreneurs: How China and India are reshaping their Futures and yours, Harvard Business
School Press, Boston, 2007.

 Summary 11 Starting an enterprise:

the entrepreneurship alternatives 

 CHAPTER 11

Starting an enterprise: the entrepreneurship alternatives

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

11.1 explain the three major issues to consider before going into business
11.2 compare three different types of market entry: start-up, purchase and franchise
11.3 use the ‘6 step’ process to organise your strategy for going into business
11.4 explain the decisions to go global and discuss developing a strategy for international business.

INTRODUCTION
Entering into the business world as the owner–manager of a firm is a complicated, time-consuming activity. It is a decision
that should not be taken lightly, and involves a careful weighing up of both the advantages and disadvantages of going into
business.
Several different options are available to people intending to go into business. Although starting a new firm is often the most
popular choice, it is not always the most appropriate one. Sometimes it may be more beneficial to purchase an existing
enterprise, with its own established production processes and customer base. Another avenue to consider is that of
franchising, where a person buys the right to use a pre-existing operating and selling system. In this chapter, each of these
options is considered in detail, and different methods of calculating purchase prices and costs are examined. Also, the steps
involved in deciding on a business start-up, a purchase or a franchise are explained. This knowledge can help prospective
entrepreneurs and small business owners to make a more informed and accurate decision about the most appropriate way for
them to go into business.

 Endnotes 11.1 Issues to consider before going into

business and comparisons of market entry option 

11.1 ISSUES TO CONSIDER BEFORE GOING INTO BUSINESS
Learning objective 1
explain the three major issues to consider before going into business

Before examining each of the various business options available, it is best to understand the framework in which new, small
entrepreneurial ventures begin. As discussed in the previous chapters, any business venture is driven by three forces: the
entrepreneur or small business owner; the resources that he or she has; and the nature of the business opportunity itself (see
figure 11.1). Each of these has a major bearing on the methods and strategy used when going into business.1

FIGURE 11.1 Three issues to consider before going into business

Source: W.D. Bygrave, ‘The entrepreneurial process’, in The Portable MBA in Entrepreneurship, 2nd edn, John Wiley & Sons, New York, 1997, p.
11.

1: The entrepreneur/small business owner: personal goals and abilities

Personal self-awareness is important for a successful business venture. Effective owners or entrepreneurs have a thorough
and honest understanding of their own personal strengths and weaknesses and a clear idea of their own (as opposed to their
prospective business’s) goals before they commit themselves to the business.
The amount of prior knowledge and enthusiasm they have for the industry sector they wish to work in is important. Most
business owners find that their chances of success are greater if they are involved in an industry in which they already have
some experience and in which they enjoy working.
Business owners should also have a clear idea about why they are going into business and what they hope to achieve. Such
personal goals may include:
a certain level of personal income each year (‘to make $X per year’)
a specified (percentage) return on investment for funds invested in the project
personal freedom (‘being my own boss’)
providing job opportunities for other family members
making the business grow into a larger enterprise within a certain time period.
The prospective business owner’s personal risk profile also needs to be considered. No business is ever guaranteed. There
will always be uncertainty about whether a firm will succeed. Going into business inevitably involves risking a certain
amount of one’s own money, credibility, time and enthusiasm. Just how much risk a person is willing to take is an important
determinant in assessing business options.
Individual business owners, like other members of the community, can usually be classified into one of at least three different
categories of risk-related behaviour. Risk-averse people are usually unwilling to bet much, if anything, on their new venture.
For these people, business operations with a proven track record (such as a franchise or well-established existing business)
are a preferred option. Moderate risk takers will usually be willing to invest up to, but not beyond, a predetermined amount
of resources. They will usually choose to buy an established firm or a new business that has been soundly researched and
whose viability is reasonably self-evident. High risk takers, who often put up most of their own personal resources, are
usually people who start up new businesses, especially in ‘cutting-edge’ and capital-intensive markets, where the chances of
failure are much higher, although the potential return on investment is also more lucrative.

2: Resource availability
Access to resources can be a key determinant of the business option chosen. Business ventures require the
owner/entrepreneur to have or obtain numerous resources.
The most obvious of these resources is finance. Prospective small business owners or entrepreneurs who do not have a great
deal of money will be limited in their choices, and they will usually opt for a new business in a field where both entry costs
(the price involved in starting the firm) and exit costs (the price involved in liquidating the enterprise if it does not prove to
be viable) are low. For example, service-sector businesses generally have low entry and exit costs, whereas the reverse is true
for manufacturing and retail firms.
Almost as important is a supply of personnel for the venture. A committed team of employees can allow a business project to
be much larger in scale and ambition than a solo venture; on the other hand, difficulties in employing appropriately trained
staff can cripple otherwise viable projects.
Another important resource is time. Some business ideas can take a long time to reach fruition, and this may not always
coincide with the desires of the entrepreneur. Some people are prepared to spend a lengthy period of time getting their idea
right, whereas others may have a more pressing need or desire to realise an immediate financial return on their investments.
Starting a new business may prove to be a useful option in the former case, but not in the latter.

3: The opportunity
Different business opportunities also impose implicit constraints on the type of business chosen. If a person wants to run a
McDonald’s store, for example, then there is only one option: enter into a franchise arrangement with the parent company.
Alternatively, if an entrepreneur has a unique product idea that has not been previously tested in the market, then a start-up
operation is probably most appropriate, since it will allow the owner–manager to structure the venture in a way that best suits
their unique circumstances. In some circumstances, the opportunity to become a business proprietor can emerge when the
ownership of an existing family-based business is transferred between family members.

 11 Starting an enterprise:
11.2 Three forms of market entry 
the entrepreneurship alternatives
11.2 THREE FORMS OF MARKET ENTRY
Learning objective 2
compare three different types of market entry: start-up, purchase and franchise

Comparison of business options

There is rarely a clear best choice among the three different types of business avenue. Each of the three forms of market
entry (start-up, purchase or franchise) has its own respective advantages and disadvantages as discussed in the following
pages.

TABLE 11.1 Differences between businesses

FACTOR START-UP PURCHASE FRANCHISE

Market/customer base Unknown Unknown Predetermined

Advertising and pricing strategy Unknown Defined Predetermined

Future growth possibilities Unlimited Unlimited Restricted

Staffing flexibility High Low Moderate

Flexibility in managerial decision making High Moderate Low

Risk of failure High Moderate Low

Level of initial financial outlay At owner’s discretion Substantial Substantial

Subsequent financial commitments Nil Nil Yes (ongoing levies and royalties)

Goodwill costs No Yes Yes

Ability to raise external funds Poor Moderate Moderate

There is rarely, if ever, a best option that will suit the needs of all entrepreneurs or small business owners. Determining the
most suitable mechanism for an entrepreneur or small business owner will usually involve careful consideration of personal
goals and financial and other resources, and a clear understanding of the nature of the business opportunity that the
prospective owner or entrepreneur wishes to exploit.

1: A new business start-up

Once personal goals have been set, available resources determined and the business opportunities examined, the choice of
business option can be made. The first option that usually springs to mind for most budding small business owners or
entrepreneurs is starting their own business operation as a totally new venture.

The advantages of starting a new business

Sometimes intending business operators find that they have to start their own enterprise simply because there is no existing
business available for purchase. Alternatively, they may find that the only firms available for sale on the open market are too
expensive, or the asking price is, in some other way, considered unreasonable. However, starting a new business venture does
provide a number of opportunities that other forms of business management do not offer; these are outlined as follows.

Ability to determine business direction

Ideally, a new business start-up allows the owner of the venture to exert near-total control over the enterprise. The products
to be sold, the target customer base, the organisational culture of the enterprise, and the financial strategy of the business can
all be determined by the entrepreneur, since he or she will be personally responsible for building each of these elements. In
contrast, the purchase of an existing business usually means that the new owner has to assume responsibility for many
unfamiliar operating procedures that may take some time to change, if they can be altered at all.

Flexibility
Because a new business is a ‘blank slate’ at its inception, it can be moulded and shaped to fit the needs of both the owner and
the market. In contrast, an existing business has established systems, strongly held organisational procedures, and defined
ways of operating, all of which preclude rapid change. From this perspective, a new business is seen to be more flexible and
to have a greater capacity to innovate than its established counterpart. In addition, the start-up business owner is able to build
up the project slowly over time, and get it right as it progresses.

Cost minimisation
Properly handled, many new small businesses (especially micro-enterprises) can start trading with a lower cost base than
established businesses, since they do not have the ongoing costs of their established competitors or any of the inefficiencies
that may have built up over time. While a new business can sometimes be successfully commenced with lower fixed costs,
purchasing an existing business may result in the new owner paying for several additional unwanted items, such as the
purchase of goodwill, existing assets or stock on hand, regardless of whether the new owner wishes to use them or not.

Lifestyle goals
A new business allows the owner to develop a particular desired lifestyle. For example, many people seek self-employment
because they no longer wish to have a ‘boss’ to whom they are answerable. For others, a new business may bring with it the
opportunity to work more convenient hours, to spend more time with friends and members of their family, to work from
home, to build an asset they can pass on to their children, or to avoid a stressful environment in their current workplace.

What would you do?

Food for thought

You are a business broker who advertises and sells businesses. This morning a mother and son arrived at your office.
Alex is 25, has a communications degree, and has been working for the last three years as the personal assistant to the
chief executive of a large public corporation. Alex plans to put all his savings into buying a business for himself. His
mother, Elaina, is 48 and has just inherited a sizeable amount from her husband, who died two months ago. Elaina
worked for a few years in a television studio, but has spent most of her life as a stay-at-home mother. The two want to
go into business together and have come to ask about two fast-food shops you have advertised for sale.
One is a well-established stand-alone enterprise that’s been selling hamburgers, fries and salads for the last seven years,
but the owner wants to retire. The existing staff plan to stay on, and the price includes all fixtures, fittings and trading
stock. The premises are rented on a secure long-term lease.
The other is a take-away noodle franchise controlled and run by a large US firm that also owns the premises where the
business is located. The price covers not only all fixtures and trading stock but also a franchise entry fee. The new
franchisee will be able to sign a five-year agreement with the franchisor.
The two shops operate across the road from each other in a middle-class suburb where they have been fierce rivals since
the franchise opened five years ago.
The entry price for both businesses is the same. Although the price is high, your clients have just enough funds to cover it
and associated legal fees. However, the commission you will receive for selling the franchise business is much larger.
Your clients are keen to buy, but they are unsure which business is the best for them, so they have come to you for your
expert professional opinion. Under both the code of ethics of your profession and the law of the land, you are required to
 give your clients a balanced assessment of each course of action and your recommendation as to what they should do.

Questions

1. What advice will you give your clients?

2. Are there any other options that they should consider if they want to go into business?

The disadvantages of starting a new business

Despite the benefits outlined previously, starting a new business can also be very risky. There are several limitations and
drawbacks that can potentially destroy or weaken the viability of a new business venture.

Raising capital
Because a new business does not have any established financial history or resources to draw on, financing the business
venture can be difficult. Many financial institutions are reluctant to extend credit to unknown and unproven enterprises, and
the business owners may find that they have to provide much (if not all) of the initial capital themselves. If the intending
business owner does not have the necessary access to finance, the business may quickly fail from a lack of sufficient start-up
funds or working capital.

Lack of an established customer base

By definition, the formation of a new business means that the entity does not yet have any customers of its own. Although
the owner may be in a position to attract customers through personal networks and previous industry experience, there are
rarely enough to immediately create a viable business. Instead, the business owner will need to invest a considerable amount
of time, energy and money in researching and marketing to a defined target market base.

Cash flow shortages

Lack of capital and a shortage of customers may mean that the business’s cash flow will be under severe stress during the
early days of its existence. This cash flow shortage is common in new businesses, and may exist for a few months or even
several years. When cash flow is tight, a sudden unexpected change in the business environment (such as an interest rate
increase, a currency devaluation or additional unplanned expenses) may mean that the business can no longer pay its bills on
time.

Learning curve expenses

Because a new enterprise is one in which nobody has previously done the work required, there will be a considerable number
of one-off events where the owner will have to invest time, effort and money to get the business working effectively
(frequently referred to as a learning curve). For example, the operator of a new business must develop a name and brand,
decide on suitable premises, recruit and train staff, devise an initial marketing campaign, and make the firm known in the
marketplace. Much of this will not result in the direct generation of customer sales, but it is still necessary. However, because
this is a new activity, it is likely to take far longer than would be the case in an established business.

Costs of a start-up venture

Regardless of the type of business venture being explored, some costs are common to all new enterprises. Any starting
business will need to meet the following costs:
licences and permits required to register and operate the business
working capital
information technology and telecommunications equipment
operating plant and equipment
staff recruitment expenses
insurance
raw materials (or trading stock)
rental of premises (unless working from the owner’s home)
stationery, office supplies and equipment.
These are just the most basic of all expenses, but they will still typically run to several thousand dollars for even the simplest
and most budget-conscious enterprise.

Home-based start-ups
One option to reduce costs for many small-scale commencement enterprises is to work from home. Home-based business
owners are able to save time and money through reduced travelling costs, no rental fees for premises, and the use of personal
household facilities to double as work tools (such as personal computers). However, there are some practical administrative
and legal decisions that small business owners should bear in mind before opting to work from home. They need to ensure
that their financial recordkeeping is in order, so that work and personal expenses can be accurately separated and accounted
for when preparing financial returns. They also have to bear in mind that local government laws may limit the size and type
of firm that can be based at home, the operating hours of the business, customer parking, and the extent to which signage and
other advertising can be displayed outside the home. There are also personal security and insurance issues to consider. It may
be risky to invite strangers into the home, and a domestic insurance policy usually does not cover losses suffered as a result
of operating a business within the house. Finally, it is also important to remember the limitations imposed by a home-based
business. Although a residential location may be a cost-effective place in which to start, in the medium to long term it is
usually suitable only for business owners who have limited growth goals, or who wish to remain self-employed.
Entrepreneurs who seek to expand in the marketplace, increase their range of product and service offerings, or employ staff
to work with them will inevitably find that they need to either outsource such activities or move into commercial premises
where greater economies of scale can be instituted.

2: Purchasing an existing business

Sometimes commercial goals and ambitions are best fulfilled by the acquisition of a firm that is already operating — also
referred to as a going concern.
The main advantage of purchasing an existing business is that it allows a proprietor to begin trading immediately, since an
established business operation, cash flow, staff, product range and customer base already exist. It is also easier to arrange
finance for the venture, and the established track record of the firm allows the prospective owner to make a more objective
evaluation of likely future performance than would be the case if starting a new enterprise. In many respects, the advantages
of buying an existing firm are the mirror opposite of the disadvantages of starting a new firm, as mentioned previously.
Potential businesses can be found in a variety of ways. They may be advertised for sale by a business broker (an agent who
specialises in listing and selling businesses, and who may often focus on one or two particular industries); listed by the
current owner in a newspaper or online advertisement; sold through accountancy firms; or, in the case of very troubled
businesses, disposed of via insolvency or bankruptcy trustees. Another option is to cold canvass existing owners to see if
they are willing to sell.
Although accurate market research and an honest appraisal of business opportunities are critical to the launch of a brand-new
firm, the issues involved in the purchase of a going trading concern are more complex. In addition to such market analysis,
the prospective purchaser must also be able to correctly calculate a purchase price, and know the appropriate issues to
investigate before making an offer.

Establishing a purchase price

How much is a business worth? As more than one economist has noted, an item is worth whatever someone is prepared to
pay for it. Such a refrain may be of little consolation to a buyer who is trying to negotiate a complex deal and who needs to
have some realistic understanding of what constitutes a ‘fair’ price.2
The methods for establishing a reasonable purchase price tend to fluctuate, and can be prone to trends and fads among
advisers as to what is the ‘best’ method. The definition of what constitutes a best price also depends on whether one is a
purchaser (to whom a lower price is preferable) or a vendor (to whom the highest possible selling price is critical). Finally,
different industries also tend to favour different valuation methods, which can make the task even more complicated.
Generally speaking, there are several different ways in which the price of an existing business can be set. Purchase prices can
be broken down into three broad categories — market-based valuations, asset-based valuations and earnings-based
valuations.3

1: Market-based valuations
In an efficient and open marketplace, the price of a business should be easily determined by reference to previous sales. If a
similar business has been sold in the past, then that price can be seen as an accurate reflection of what the current business is
worth. According to this school of thought, the open marketplace is the best judge of a firm’s worth.
There are two main types of market-based valuation:
The going market rate method. As its name suggests, this is simply the ‘current market’ price for a particular type of
firm. It is usually established by reference to recent selling prices for other firms of a similar size and industry type.
For example, if a small IT firm in a particular city was recently sold for $350000, then the next such firm put up for
sale will be priced at about the same amount.

Selling price = Selling price of similar firms

Although such a technique may not fully reflect a firm’s own particular strengths or weaknesses, it is a useful starting point
in working out a final price. Current market rates can often be determined by studying similar businesses advertised for sale
online, in newspapers or via a business broker.
Revenue multiplier method. A slightly more sophisticated approach is to adopt one of a number of ‘rules of thumb’
(informal guidelines) on pricing. The most common of these is the use of a revenue multiplier. This technique is often
used in the purchase of professional practices, such as businesses run by doctors, dentists and accountants. In most
such industries, there is a common ‘industry multiple’ that is used to estimate the most likely purchase price of the
practice. The selling price is established by multiplying the annual turnover of the business by this multiple.

Selling price = Turnover × Standard industry multiple

For example, an accountancy practice may use an established industry multiple of 0.7 or 1.0. If the annual turnover of the
firm is $225000, and the multiple applied is 0.7, then the asking price would be $157500.
Whether one uses the going market rate or the revenue multiplier method, such approaches avoid the need to undertake
detailed calculations or complex financial analysis. The techniques are simple and easy to understand, especially for
entrepreneurs and small business owners who are not familiar with valuation methodologies. However, such methods have a
number of serious weaknesses. The price reached is largely dependent on broader sales trends, and may not fully recognise
the special circumstances of the individual business being considered. If prices in the market as a whole become overinflated,
then the purchaser will pay more for the business than it would otherwise be worth. Moreover, these methods do not take into
account the future earnings potential of the business or the value of the assets in hand. Finally, it can often be difficult to
collect accurate information about market prices, since few small businesses are sold by public tender or share floats, or in
other public forums.

2: Asset-based valuations
An alternative to relying on market forces is to set a price after examining the assets and liabilities of the business. This
involves examining present and historical data about the business, which is usually found among the financial records
(‘books’) in the balance sheet.
Book value. In this process, the asking price is set by first calculating the worth of all the firm’s assets. These may be
tangible items (such as stock on hand, equipment, property, vehicles, furniture and fittings) and intangible commodities
 (such as intellectual property rights and goodwill). The liabilities of the business are then subtracted to produce a final
value.

Selling price = Tangible assets + Intangible assets − Liabilities

Adjusted book (net asset) value. In practice, the simple book value method is really only the starting point in price
calculations. Relying on the books of accounts means that only historical information is referred to, rather than
contemporary information. For example, a building may be shown on the balance sheet at the price paid for it several
years ago (less depreciation), but it may actually be worth much more today because of a general increase in property
asset prices. To overcome this, valuers often adjust the initial book value in a number of ways. The assets may be
revalued to reflect their current worth, as may the liabilities. This is a somewhat subjective measure, which can vary
from one valuer to another.
Similarly, the question of determining exactly what constitutes goodwill is extremely problematic. At its simplest,
goodwill is the extra value a purchaser is prepared to pay because of the firm’s unique position. This may be something
as simple as a track record of consistent net profits, or it may be something less easily measured but just as important
to its success, such as a highly favourable location, a well-known brand name, a good reputation in the local
community or a loyal customer base. In many cases, one or two years net profits may be used as a proxy measure for
the sum of a firm’s goodwill.

3: Earnings-based (cash flow) valuations

In contrast to the historical or present-day focus of book valuations, some purchasers are more concerned about the potential
of the business they want to buy. From this perspective, future earning power and the ability to produce cash income (which
can, in turn, be used to provide working capital, grow the business, reduce debt and reward the owner) are most important.
Return on investment. The capitalised value method — commonly referred to as the return on investment (ROI)
technique — is one of the most widely accepted and used valuation tools.4 It is based on the assumption that the risk
and return of a business should be reflected in its selling price. It works on a formula that includes the estimated future
profit:

For example, the selling price of a business making $100000 with an ROI of 50 per cent will be

Different industries have different levels of risk, and therefore differing ROI. As in all investment decisions, a higher
level of risk is often associated with a higher level of return. In other words, if investors in a business are prepared to
be exposed to a high chance that the business will fail and their money will be lost, then they are entitled to a higher
ROI. However, because they are riskier enterprises, the selling price of such firms is likely to be low. Future income
cannot be guaranteed to the purchaser.

4: Choosing between valuation methods

In reality, the above valuation methods rarely provide a complete guide to a final purchase price. Indeed, the techniques
discussed above are only some of the more common ones used. There is a wide variety of methods that can be used, and
many different ways they are calculated and names they are known by.
For these reasons, the approaches described are perhaps best treated as guidelines that can be used to establish a negotiating
stance. In theory, if used effectively, the various methods should all produce broadly similar valuations.5 However, this is
rarely the case in practice.
Most entrepreneurs and small business owners tend to place greater reliance on some methods than on others. The arguments
that ‘cash is king’ and that a solid predictable stream of income is central to future success lead some people to favour cash
flow (earnings) valuations. However, due to the relative complexity of such calculations and the difficulty of predicting
future earnings, some purchasers prefer to use an asset-based method. This has the advantage of being easier to calculate and
understand. Market-based prices are the easiest of all for small business owners to use but, since few small firms are publicly
traded, information on the purchase price of other similar businesses is usually difficult to obtain.6

Questions to ask
Researching information about an existing business for sale usually requires at least as much, if not more, effort than starting
up a firm. For example, the purchase will often entail assuming responsibility for debts or liabilities incurred by the previous
managers. These may include unpaid tax bills, accrued staff leave entitlements, legal actions outstanding against the firm, or
creditors whose accounts are due. It is important to note that in many jurisdictions, such liabilities continue to rest with the
business itself, regardless of the change of ownership. These liabilities may not be apparent unless a thorough examination of
the business’s accounts and records is made before purchase. Less obvious, but still significant, are other potential liabilities
such as undesirable or poorly trained staff, products with a poor reputation in the marketplace, or a large base of unsatisfied
previous customers — all this comprises ill-will. In addition to current or potential liabilities, there is always the risk that a
dishonest or negligent vendor has misled the purchaser.
Overcoming this requires the purchaser and advisers to conduct a due diligence study. Due diligence is the detailed scrutiny
of a business in order to obtain all the information needed to comprehensively evaluate it and determine whether it is a
worthwhile investment. Such an investigation is best performed by a team assembled by the prospective purchaser, and
should include accountants, legal advisers, a business broker and specialist consultants. Common questions that should be
asked include:
Why is the vendor selling?
Will existing staff remain if the business is sold?
What current liabilities does the business have?
Are there any outstanding taxation debts?
Is there any outstanding litigation against the firm?
Can all licences and permits to operate be transferred to the new owner?
Will all intellectual property and intangible assets be transferred to the new owner?
How accurate and honest are the financial accounts that have been provided?
What is the level of accrued staff leave that will have to be paid?
What is the likely future state of the industry — is demand increasing or decreasing?
Is the lease on the premises secure? Is it transferable to a new business purchaser? How long does the existing lease
run?
Will suppliers continue to provide stock, and at the same price, as they have previously?
What is the condition of the physical assets? Will any need to be replaced in the near future?
Will customers remain loyal to this business once the current proprietor has departed?

Other issues
When negotiating the purchase of a business, it makes good sense to include a restraint of trade clause in the final contract
of sale. This prohibits the vendor from establishing a rival business within a reasonable distance of the premises. Although
such clauses are often limited by the courts, they do prevent the vendor from selling a firm and then using the proceeds to
become a competitor.
In addition to the purchase price, buyers should also be aware that they will face ancillary costs. These can include the
accountant’s fees, for reviewing the books of the business; legal fees, for the contract of sale; valuation costs; government
taxes, such as stamp duty, on the sale transfer and contract registration; and bank fees, when loans are established to pay for
the business.

3: Entering a franchise system

Franchising has become an increasingly popular form of business system over the last 30 years.7 Although franchising has
been in existence for well over a century, it is still relatively new in many industries. It provides another avenue through
which people can begin their own business, and many franchises now exist in such diverse fields as petrol retailing, motor
vehicle distribution, real estate sales, personal services, professional practices, fast food and retail sales.
At its simplest, a franchise is an arrangement whereby the originator of a business product or operating system (commonly
referred to as the franchisor) gives a prospective small business owner (the franchisee) the right to sell these goods and/or
to use the business operations system on the franchisor’s behalf. Franchising has continued to grow throughout the Asia–
Pacific region in recent years. In 2012, there were over 1200 franchise systems operating in Australia, with a total of about
73000 franchised outlets. These franchises generated $131 billion in turnover and employed more than 400000 people. Most
franchise systems in Australia are relatively small: the typical franchisor has about 22 franchisees.8 The number of franchise
systems in Australia has generally continued to trend upwards over time. In 2002, for example, there were only about 700
systems.9 In 2012, there were some 485 franchise systems operating in New Zealand, with approximately 22000 franchisees.
Nationally, the franchising sector employs more than 100000 people, generates more than NZ$20 billion in annual turnover,
and accounts for almost 5 per cent of all SMEs in the country.10 Likewise, Singapore has approximately 420 franchise
systems and Malaysia has about 630 systems, while there are over 100 systems operating in Hong Kong. In contrast, India
has an estimated 800 franchises while there are more than 3500 operating in China.11
There are two basic types of franchise. A product franchise gives a small business operator the right to sell a particular
commodity or set of goods. In this arrangement, the franchisee is used as a distribution mechanism for a good or service, and
has a large measure of independence as to how the business will be set up and operated. The franchisor’s role is limited to
ensuring that sufficient stock is made available and that the franchisee is selling the product at a satisfactory price and
providing customers with suitable after-sales service and support. One of the first such franchises was one created to
distribute and sell sewing machines; today, many other individual products (including clothing, vehicles and household
goods) are sold via this system.
In contrast, a business system franchise is a more detailed agreement between the two parties. In this arrangement, the
franchisor not only supplies the product but also gives comprehensive guidelines on how the business is to be run. The
franchisee is expected to follow a predetermined set of rules about all aspects of managing and operating the business. This
will usually include pricing; production processes; marketing; staff recruitment, remuneration, training and evaluation;
product offerings and promotional methods; recordkeeping; operating hours; use of different suppliers; store layout and
fittings and so on. A well-known example of a business system franchise is that operated by fast-food giant McDonald’s. The
store proprietors (franchisees) are usually expected to follow a comprehensive set of instruction manuals and operating
systems written by the franchisor, and they are usually given detailed training in these before starting their own restaurant.
The main benefit of the system franchise is that all aspects of organising and operating the business have already been
investigated, pre-tested and successfully implemented by the franchisor, and the viability of the franchise has also usually
been assessed in advance. There is little, if any, extra management work or market research that the franchisee has to do,
apart from going through the actual process of setting up and then overseeing the particular store. In many ways, this type of
franchise represents a compromise between the previous two business options: although franchisees are still technically
starting a new firm, they are also buying in a large body of existing knowledge.

Advantages and disadvantages of franchising

There are many benefits to be gained from entering a franchise arrangement, particularly if it is a business system format.
The new business owner is spared the task of developing an operating system, which usually represents a large amount of
time and energy in most new small firms. There is less ‘learning by mistakes’, which can often cause many businesses to
falter and fail. As a result, there is a commonly-held view that most franchises have a lower failure rate than new
independent small businesses. However, there is only limited empirical evidence to support this argument; in many cases,
independent start-ups may in fact have better survival rates.12
Customers are usually attracted by the presence of an established product or brand name, which is backed up by the
franchisor’s ongoing marketing efforts. Most franchisors provide continuing training for franchisees, as well as market
research into emerging trends and purchasing behaviour. The cost of raw materials and supplies is often lower, as the
franchisor can use the combined power of many franchisees to negotiate discounts. All these advantages mean that raising
capital can also be easier, since financial institutions are often more willing to lend money to buy a franchise than they are to
start a new, unknown enterprise.
However, access to these systems does not come cheaply. The purchase price for entering into a business system franchise is
often quite high, and may be beyond the reach of many small-scale entrepreneurs. In addition to this initial outlay,
franchisees are sometimes expected to pay a proportion of their profits to the franchisor, and may also be required to pay a
separate marketing levy.
There are other limitations and drawbacks. Many franchises are sold on a geographical basis. Franchisees are often restricted
to serving a set market, and may not expand beyond a predetermined boundary. The opportunities for individual store owners
to innovate and change the pre-set rules are limited, since the core appeal of many franchises is their uniformity. If the parent
company (franchisor) fails or is poorly run, then the dependent franchisees may also be at risk of collapsing. In some
countries (such as Australia, China and Malaysia) there are franchise-specific laws that must also be complied with, while in
others (such as New Zealand, Hong Kong, India and Singapore) there are none.
It is also important to bear in mind that a franchise is essentially a contractual arrangement, and therefore has a limited
lifespan. At the end of a set period (which is typically from five to seven years), the franchisee will have to negotiate a new
contract with the parent franchisor; renewal of the contract is not always guaranteed.
Franchises can be an attractive option to many intending small business owners, especially those who are risk-averse or who
have only limited experience in managing their own enterprise. However, franchises are often not suitable for entrepreneurial
personalities who have their own ideas about what products to offer and how to manage a firm, and who wish to aggressively
increase their market share. More information about franchises can be obtained from the sources listed in table 11.2.

TABLE 11.2 Major franchise organisations in the Asia–Pacifc

COUNTRY ENTITY

Australia Franchise Council of Australia, www.franchise.org.au

New Zealand Franchise Association of New Zealand, www.franchiseassociation.org.nz

Hong Kong Hong Kong Franchise Association, www.franchise.org.hk

Malaysia Malaysian Franchise Association, www.mfa.org.my

Singapore Franchising and Licensing Association (Singapore), www.flasingapore.org

China China Chain Store & Franchise Association, www.chinaretail.org

India Franchising Association of India, www.fai.co.in

General Asia–Pacific Franchise Confederation, http://franchise-apfc.org

 11.1 Issues to consider before going

11.3 Procedural steps when

into business and comparisons of market entry option starting a business venture 
11.3 PROCEDURAL STEPS WHEN STARTING A BUSINESS
VENTURE
Learning objective 3
use the '6 step' process to organise your strategy for going into business

With so many issues to examine, a common dilemma for the nascent entrepreneur is: what priority should I give to the
various factors involved in evaluating my business commencement options? Once the decision to start a new business has
been made, there are a number of steps which, if followed in a logical manner, provide a useful framework for evaluating and
then acting on the intended project (see figure 11.2). They are designed to be conducted in a sequential ‘lock-step’ manner
(i.e. each stage must be largely completed before moving on to the next). In this way, if the idea appears unviable at any
stage, it can be aborted before too many resources have been committed to the project.

FIGURE 11.2 The process of going into business

1. Undertake market research

Before beginning, it is necessary to know whether there really is a demand for the proposed service or product and whether
there is room for another business in the market. This stage involves the collection of critical strategic information, such as
data on competitors, general industry trends, the intended target customer base, products, pricing, and production/delivery
processes. Such information must be collected in an impartial and accurate manner.

2. Check the statutory requirements

There are many laws that cover small business, and it is the responsibility of all owner–managers to comply with the relevant
legislation. This can include rules regarding business names, permission to operate in a particular location, health and safety
laws, taxation rules and export permits. In many nations there are several different jurisdictions that apply the laws, from
national governments to state or provincial governments and local councils. Failure to obtain the necessary approvals will
mean that the business cannot trade, so securing such permits is an important early step in the process.
It is also necessary at this stage to obtain an indication of the likely legal structure of the business. This can be as a sole
trader, where the owner retains all rights and liabilities; a partnership, where profits and responsibilities are shared; a
company, which is a more complex legal structure that owns the business and takes responsibility for it.; or a trust, where
assets are held by an independent party for designated beneficiaries.

3. Access suitable core resources

Any business venture requires a suitable business address and facilities before it begins operating. For a home-based
business, this may be a relatively simple issue; it may involve, for example, ensuring that there are enough desks and chairs
and adequate space, or that the local authority will allow the business to operate from a residential location. In contrast, if
commercial facilities are required, more attention to detail is needed. The intending owner must ensure that the premises are
in a good location, suited to the needs of the business, and that a satisfactory lease contract has been negotiated.
The decision to proceed with a new venture also rests on access to suitable equipment and tools. For example, a mobile
carpentry service that cannot obtain work tools and an appropriate vehicle is unlikely to succeed, as is a restaurant that does
not have sufficient refrigeration or cooking facilities.
An important but often overlooked aspect of any proposed business start-up is the availability of suitable insurance.
Although some insurance policies (such as workers compensation and third-party motor vehicle insurance) are compulsory in
many countries and easily obtainable, other policies may be discretionary but very important. For example, an abseiling
business that cannot obtain sufficient insurance to cover possible injury claims by clients may need to reconsider its plans,
since failure to obtain such coverage could cause the business to fail if faced with a large negligence claim.

4. Critically evaluate options: buy, start-up or franchise?

The collection of the preliminary information outlined above should now allow the intending business operator to make a
more knowledgeable and honest assessment of the chances of success. At this point, it is also preferable to compare the
benefits and disadvantages of the start-up venture model with those of buying an existing business or entering into a
franchise. Ideally, this analysis should be done in conjunction with an accountant or other qualified business adviser.

5. Work out financial projections

The intending business owner will need to know each of the following financial considerations before going into business:
the amount of money needed to be raised (for working capital, equipment purchases, advertising, wages, insurance,
leases, vehicles and/or other items)
the amount of money that will need to be borrowed (if the owner’s funds are not sufficient) through a loan from a
financial institution or other source; if funding is not available, then the project may not be viable
the projected cash flow for the next year
the projected profit and loss for the whole year (which will show whether the business is viable in the long term).
If purchasing an existing firm, the prospective owner will also need to see a balance sheet.

6. Prepare a business plan

If the decision is made to proceed, the prospective business owner should now develop a more detailed plan for the business,
covering as many different aspects of operations, marketing and finance as possible. This provides a blueprint for action and
a timeline for implementation, and also helps in the raising of any necessary capital.

 11.2 Three forms of market entry 11.4 Going global and developing
a strategy for international business 
11.4 GOING GLOBAL AND DEVELOPING A STRATEGY FOR
INTERNATIONAL BUSINESS
Learning objective 4
explain the decisions to go global and discuss developing a strategy for international business

Although expanding into overseas markets can increase profits and marketing opportunities, it also introduces new
complexities to a firm’s business operations. Before deciding to go global, a company faces a number of key decisions,
beginning with the following:
determining which foreign market(s) to enter
analysing the expenditures required to enter a new market
deciding the best way to organise the overseas operations.
These issues vary in importance, depending on the level of involvement a company chooses. Education and employee
training in the host country would be much more important for an electronics manufacturer building an Asian factory than
for a firm that is simply planning to export Australian-made products.
The choice of which markets to enter usually follows extensive research focusing on local demand for the firm’s products,
availability of needed resources and ability of the local workforce to produce quality merchandise. Other factors include
existing and potential competition, tariff rates, currency stability and investment barriers. A variety of government and other
sources are available to facilitate this research process.

Levels of involvement
After a firm has completed its research and decided to do business overseas, it can choose one or more strategies:

1. exporting or importing
2. entering into contractual agreements such as franchising, licensing and subcontracting deals
3. direct investment in the foreign market through acquisitions, joint ventures or establishment of an overseas division.

Although the company’s risk increases with the level of its involvement, so does its overall control of all aspects of
producing and selling its goods or services.

1: Importers and exporters

When a firm brings in goods produced abroad to sell domestically, it is an importer. Conversely, companies are exporters
when they produce — or purchase — goods at home and sell them in overseas markets. An importing or exporting strategy
provides the most basic level of international involvement, with the least risk and control.
Exports are frequently handled by special intermediaries called export trading companies. These firms search out
competitively priced local merchandise and then resell it abroad at prices high enough to cover expenses and earn profits.
When a retail chain such as Dallas-based Pier 1 Imports wants to purchase West African products for its store shelves, it may
contact an export trading company operating in a country such as Ghana. The local firm is responsible for monitoring quality,
packaging the order for transatlantic shipment, arranging transportation, and arranging for completion of customs paperwork
and other steps required to move the product from Ghana to the United States.
Firms engage in exporting of two types: indirect and direct. A company engages in indirect exporting when it manufactures a
product, such as an electronic component, that becomes part of another product sold in foreign markets. The second method,
direct exporting, occurs when a company seeks to sell its products in markets outside its own country. Often the first step for
companies entering foreign markets, direct exporting is the most common form of international business. Firms that succeed
at this may then move to other strategies.
In addition to reaching foreign markets by dealing with export trading companies, exporters may choose two other
alternatives: export management companies and offset agreements. Rather than simply relying on an export trading company
to assist in foreign markets, an exporting firm may turn to an export management company for advice and expertise. These
international specialists help the exporter complete paperwork, make contacts with local buyers and comply with local laws
governing labeling, product safety and performance testing. At the same time, the exporting firm retains much more control
than would be possible with an export trading company.
An offset agreement matches a small business with a major international firm. It basically makes the small firm a
subcontractor to the larger one. Such an entry strategy helps a new exporter by allowing it to share in the larger company’s
international expertise. The small firm also benefits in such important areas as international transaction documents and
financing, while the larger company benefits from the local expertise and capabilities of its smaller partner.

Countertrade
A sizable share of international trade involves payments made in the form of local products, not currency. This system of
international bartering agreements is called countertrade.
A common reason for resorting to international barter is inadequate access to needed foreign currency. To complete an
international sales agreement, the seller may agree to accept part or all of the purchase cost in merchandise rather than
currency. Because the seller may decide to locate a buyer for the bartered goods before completing the transaction, a number
of international buyers and sellers frequently join together in a single agreement.
Countertrade may often be a firm’s only opportunity to enter a particular market. Many developing countries simply cannot
obtain enough credit or financial assistance to afford the imports that their people want. Countries with heavy debt burdens
also resort to countertrade. Russian buyers, whose currency is often less acceptable to foreign traders than the stronger
currencies of countries such as the United States, Great Britain, Japan and European countries, may resort to trading local
products ranging from crude oil to diamonds to vodka as payments for purchases from foreign companies unwilling to accept
Russian rubles. Still, other countries such as China may restrict imports. Under such circumstances, countertrade may be the
only practical way to win government approval to import needed products.

2: Contractual agreements
Once a company, large or small, gains some experience in international sales, it may decide to enter into contractual
agreements with local parties. These arrangements can include franchising, foreign licensing and subcontracting.

Franchising
Franchising can work well for companies seeking to expand into international markets, too. A franchise, as described earlier
in the chapter, is a contractual agreement in which a wholesaler or retailer (the franchisee) gains the right to sell the
franchisor’s products under that company’s brand name if it agrees to the related operating requirements. The franchisee can
also receive training, marketing, management and business services from the franchisor. While these arrangements are
common among leading fast-food brands such as Grill’d, McDonald’s and KFC, other kinds of service providers like NRMA
also often look to franchising as an international marketplace option.
Domino’s Pizza has expanded to more than 10 000 stores in more than 70 international markets around the world. Its largest
international market is in Mexico, but wherever it operates, the company fine-tunes its menus to meet local tastes with such
specialties as its Junkanoo Feast pizza in the Bahamas, which includes pepperoni, barbeque chicken and banana peppers;
squid in Japan; and chorizo in Mexico.13

Foreign licensing
In a foreign licensing agreement, one firm allows another to produce or sell its product, or use its trademark, patent or
manufacturing processes, in a specific geographical area. In return, the firm gets a royalty or other compensation.
Licensing can be advantageous for a small manufacturer eager to launch a well-known product overseas. Not only does it get
a proven product from another market, but little or no investment is required to begin operating. The arrangement can also
allow entry into a market otherwise closed to imports due to government restrictions. Sometimes a licensing agreement can
ensure product freshness by allowing manufacturing to take place in the local market. Morinaga, a Japanese food
manufacturer, holds licenses to produce Lipton teas, Kraft cheeses and Sunkist fruit drinks and desserts in Japan.14

Subcontracting
The third type of contractual agreement, subcontracting, involves hiring local companies to produce, distribute, or sell
goods or services. This move allows a foreign firm to take advantage of the subcontractor’s expertise in local culture,
contacts and regulations. Subcontracting works equally well for mail-order companies, which can farm out order fulfilment
and customer service functions to local businesses. Manufacturers practise subcontracting to save money on import duties
and labour costs, and businesses go this route to market products best sold by locals in a given country. Some firms, such as
Maryland-based Pacific Bridge Medical, help medical manufacturers find reliable subcontractors and parts suppliers in Asia.
A key disadvantage of subcontracting is that companies cannot always control their subcontractors’ business practices.
Several major companies have been embarrassed by reports that their subcontractors used child labour to manufacture
clothing.

3: Offshoring
While it is not generally considered a way of initiating business internationally, offshoring, or the relocation of business
processes to a lower cost location overseas, has become a widespread practice. Despite increasing labour costs, China is still
the top destination for production offshoring and India and the Philippines for services offshoring. Many business leaders
argue, in favour of offshoring, that global firms must keep their costs as low as possible to remain competitive. But the
apparent link between jobs sent overseas and jobs lost at home has made the practice controversial.
Offshoring shows no signs of slowing down, but it is changing, particularly for manufacturers. Mexico, India and Vietnam
are now the countries with the lowest manufacturing costs. Not surprisingly, maintaining flexibility by offshoring to a few
different low-cost locations may be Australian firms’ lowest risk strategy for the future. The rising cost of Chinese labour has
created a wave of change. Mexican workers now cost about the same as Chinese workers, and many countries, like Vietnam,
have seen gains due to the country’s lower wages. India and the Philippines remain top outsourcing destinations.15

International direct investment

Investing directly in production and marketing operations in a foreign country is the ultimate level of global involvement.
Over time, a firm may become successful at conducting business in other countries through exporting and contractual
agreements. Its managers may then decide to establish manufacturing facilities in those countries, open branch offices or buy
ownership interests in local companies. Apple is involved in the trend of reshoring, or bringing jobs back to the United
States, mainly from China. See the “Hit & miss” feature for more.
In an acquisition, a company purchases another existing firm in the host country. An acquisition permits a largely domestic
business operation to gain an international presence very quickly. Facebook acquired online photo, video and social media
site Instagram for US$1 billion in cash and stock. This acquisition allows Facebook users to share photos, and it eliminates
Instagram as a Facebook competitor.16
Joint ventures allow companies to share risks, costs, profits and management responsibilities with one or more host country
nationals. By setting up an overseas division, a company can conduct a significant amount of its business overseas. This
strategy differs from that of a multinational company in that a firm with overseas divisions remains primarily a domestic
organisation with international operations. BMW and Toyota signed a technology-related joint venture to join forces for
future products and technology development, which includes developing a platform for a mid-size sports vehicle.17

Hit & miss

Apple brings manufacturing work back home
As recently as a decade ago, you could purchase an Apple product made in the US. Apple, along with numerous other
companies, took pride in their ‘Made in USA’ status. But in recent years, Apple and other companies chose a lower cost
labour structure in overseas countries. But that strategy seems to be slowly changing, with a small but gradual boomerang
back to the United States — mainly from China. It’s called reshoring, and Apple is part of the trend to bring
manufacturing back to the US.
Recently, the company created 2000 engineering, manufacturing and construction jobs in a facility in Arizona, where
components for its products will be produced. In addition, Apple is producing its newly redesigned Mac Pro computer in
Austin, Texas. The benefits of this move back home include quicker response to production problems and increased
quality control.
 Significant wage increases in China over the past decade and concerns over protecting intellectual property overseas are
two reasons that helped prompt the move. In addition, geographically close-knit design and production teams leave less
room for error in the manufacturing process.
For Apple, bringing jobs home is certainly a positive way to help the US economy. With reshoring — and reuniting
design and production in one country — Apple will need to change the slogan on some of its products back to ‘Made in
the USA’.

Questions for critical thinking

1. Are there certain types of products, companies or industries in which reshoring makes the most sense?
2. Is your decision to purchase a product ever influenced by where it was produced? If so, explain.

Sources: Clare Goldsberry, ‘As “Made in USA” Gains in Popularity, Companies Reshore Manufacturing’, Plastics Today, accessed January 6,
2014, www.plasticstoday.com; Juliette Garside, ‘Apple Creates 2000 Jobs Shifting Production Back to US’, The Guardian, accessed January 6,
2014, www.theguardian.com; Joel Johnson, ‘“Made in America,” or How Re-Shoring Can Transform the Global Procurement Landscape’, Spend
Matters, accessed January 6, 2014, http://spendmatters.com.

From multinational corporation to global business

A multinational corporation (MNC) is an organisation with significant foreign operations. As table 11.3 shows, firms
headquartered in the United States and China make up 4 of the top 10 world’s largest multinationals. Other locations include
Brazil, China, the Netherlands and the United Kingdom. Note that the two top industries are banking and oil and gas.

TABLE 11.3 The world’s top 10 leading companies, based on a combined ranking for sales, profits, assets and
market value.

RANK COMPANY INDUSTRY COUNTRY OF ORIGIN

 1 ICBC Banking China

 2 China Construction Bank Banking China

 3 JPMorgan Chase Banking United States

 4 General Electric Conglomerate United States

 5 Exxon Mobil Oil & Gas United States

 6 HSBC Holdings Banking United Kingdom

 7 Royal Dutch Shell Oil & Gas Netherlands

 8 Agriculture Bank of China Banking China

 9 Berkshire Hathaway Conglomerate United States

10 PetroChina Oil & Gas China

Source: ‘The world’s biggest companies’, Forbes, accessed February 8, 2014, www.forbes.com.
Many US multinationals, including Nike and Walmart, have expanded their overseas operations because they believe that
domestic markets are mature and foreign markets offer greater sales and profit potential. Other MNCs are making substantial
investments in developing countries in part because these countries provide low-cost labour compared with the United States
and Western Europe. In addition, many MNCs are locating high-tech facilities in countries with large numbers of technical
school graduates.

Developing a strategy for international business

In developing a framework in which to conduct international business, managers must first evaluate their corporate
objectives, organisational strengths and weaknesses, and strategies for product development and marketing. They can choose
to combine these elements in either a global strategy or a multidomestic strategy.

Global business strategies

In a global business (or standardisation) strategy, a firm sells the same product in essentially the same manner throughout
the world. Many companies simply modify their domestic business strategies by translating promotional brochures and
product-use instructions into the languages of the host nations.
A global marketing perspective can be appropriate for some goods and services and certain market segments that are
common to many nations. The approach works for products with nearly universal appeal, for luxury items such as jewelry,
and for commodities like chemicals and metals. Alcoa, for instance, is the world's biggest producer of aluminum for markets
that include aerospace, automotive, building and construction, consumer electronics, packaging, and commercial
transportation. Because in many applications aluminum's strength and light weight mean there are no good substitutes for it,
the company forecasts a long-term increase in global demand, especially in China, India, Russia, the Middle East, and Latin
America. It also views itself as committed to a global strategy that incorporates the highest ethical and sustainability
practices. Recently, Alcoa was awarded the top spot for its use of basic resources by the annual Covalence Ethical Rankings,
a prestigious international survey that ranks the ethical performance of multinational companies.18 Regardless of global
business strategies, companies need to be aware of cultural and business customs in the countries in which they do business
and of whether certain behaviors are accepted, as the feature Solving an ethical controversy discusses below.

Solving an ethical controversy

Bribery or the cost of doing business?
Roughly translated, guanxi is the Chinese word for relationships and involves making business connections with local
companies and officials. Some say guanxi is a local custom and a generally accepted business practice in China, while
others say it is a form of bribery to extort money from companies anxious to do business there.
Should foreign companies practice guanxi when doing business in China?
PRO
CON
1. Building mutually beneficial relationships with
1. The concept of guanxi is another word for doing whatever
connected networks of local businesses and
it takes (no matter the cost) to make headway in the
government officials provides foreign companies
Chinese business marketplace.
with strategic advantages.
2. Although they are doing business in a foreign land, U.S.
2. The concept of guanxi is a local custom, and
companies must abide by the Foreign Corrupt Practices
companies and officials expect foreign companies to
Act, federal legislation that prohibits the exchange of
seek their advice and expertise to navigate the
money for obtaining or retaining business.
complicated business environment in China.

Summary
Competing in world markets includes understanding local customs and business practices of the countries in which a
company plans to operate. At the same time, however, companies must base their business strategy on solid business and
ethical foundations. Regardless of the legal implications in the United States, business officials must know how to operate
financially and ethically in any business situation.
Sources: Aruna Viswanatha, ‘U.S. Corporations Beg Clarity on Anti-Bribery Law’, accessed January 6, 2014, http://www.reuters.com; ‘Avon
Bribery Scandal in China, Not Really a Big Deal’, China Lawyer in Shanghai (blog), accessed January 6, 2014; Kelly Baldwin, ‘Guanxi: The
Ethics of Chinese Business Relationships’, accessed January 6, 2014, http://myportfolio.usc.edu; David Wolf, ‘Business Ethics and Culture
Clashes in China’, accessed January 6, 2014, http://siliconhutong.com.
Multidomestic business strategies
Under a multidomestic business (or adaptation) strategy, the firm treats each national market in a different way. It
develops products and marketing strategies that appeal to the customs, tastes, and buying habits of particular national
markets. Companies that neglect the global nature of the internet can unwittingly cause problems for potential customers by
failing to adapt their strategy. At first, European consumers were hesitant to adopt online ordering of products ranging from
books to railroad tickets. But in recent years, internet use in Western Europe has grown dramatically. Companies as diverse
as the European divisions of Amazon.com; Egg PLC of London, an online financial services company; and the French
national railroad have seen the numbers of visitors to their websites climb, along with internet revenues.

 11.3 Procedural steps when starting a business venture Summary 

SUMMARY
Learning objective 1: explain the three major issues to consider before going into business
Going into business requires budding small business owners and entrepreneurs to understand the three factors that
influence all business ventures: (1) the personal goals, desires, experience and abilities of the owner or entrepreneur;
(2) the financial, human and other resources that can be used in the enterprise; and (3) the nature of the business
opportunity itself.
Learning objective 2: compare three different types of market entry: start-up, purchase and franchise
There is rarely a clear best choice among the three different types of business avenue; when making a decision, it’s
important to take into account several factors. These factors include: market/customer base, advertising and pricing
strategy, future growth possibilities, risk of failure, goodwill costs, among others.
There are three very different ways of getting into business: starting a new business, buying an existing operation or
entering into a franchise arrangement. Starting a new business involves the wholesale development of a complete
business idea, which must cover not only all the issues involved in starting up, but also the task of managing the
business on a day-to-day basis once it begins trading. A new business provides maximum flexibility, but also heightens
the risk of business failure.
Buying an established enterprise can lower the risk of business failure. It will also provide the owner with an
immediate source of cash flow and customers. But this is a more expensive option, and great care must be taken when
determining what constitutes a reasonable purchase price. There are three main ways of setting a price: market-based
valuations, asset-based valuations and earnings-based (cash flow) valuations.
Franchises may take the form of either product or business system arrangements. The latter is more comprehensive,
and usually has a lower failure rate, but it severely limits the freedom and flexibility of the business owner and can be
expensive to enter into.
Learning objective 3: use the ‘6 step’ process to organise your strategy for going into business
There are six steps involved in the process of evaluating business options. These start with undertaking market
research; understanding the legal requirements pertaining to the proposed business venture; and obtaining all necessary
resources required for the business venture. After these first three steps, the intending business owner must critically
evaluate which business avenue is the best option. Once this decision has been made, some preliminary financial
projections can be made, and then a business plan prepared.
Learning objective 4: explain the decisions to go global and discuss developing a strategy for international
business
Exporting and importing, the first level of involvement in international business, involves the lowest degree of both
risk and control. Companies may rely on export trading or management companies to help distribute their products.
Contractual agreements, such as franchising, foreign licensing and subcontracting, offer additional options.
Franchising and licensing are especially appropriate for services. Companies may also choose local subcontractors to
produce goods for local sales. International direct investment in production and marketing facilities provides the
highest degree of control but also the greatest risk. Firms make direct investments by acquiring foreign companies or
facilities, forming joint ventures with local firms and setting up their own overseas divisions.
A company that adopts a global strategy develops a single, standardised product and marketing strategy for
implementation throughout the world. The firm sells the same product in essentially the same manner in all countries
in which it operates. Under a multidomestic (or adaptation) strategy, the firm develops a different treatment for each
foreign market. It develops products and marketing strategies that appeal to the customs, tastes and buying habits of
particular nations.

Review questions
1. What are the top five due diligence questions the adviser should ask Alan and his son to consider?
2. Do you think Alan and his son should sign up to the franchise? Why?
3. On the information provided, do you think Alan should lend his son the money? Explain your answer.
 4. Compare the options of starting a new independent business in this area against buying the proposed franchise. What are
the advantages and disadvantage of each business commencement option?
5. What are the advantages and disadvantages of being the first franchisee to invest in a new franchise?
6. Identify several potential barriers to communication when a company attempts to conduct business in another country.
How might these be overcome?
7. Identify and describe briefly the three dimensions of the legal environment for global business.
8. What are the major nontariff restrictions affecting international business? Describe the difference between tariff and
nontariff restrictions.
9. How has the EU helped trade among European businesses?
10. What are the key choices a company must make before reaching the final decision to go global?

 11.4 Going global and developing a strategy

Endnotes 
for international business
ENDNOTES
1. J.A. Timmons & S. Spinelli, New Venture Creation: Entrepreneurship for the 21st Century, McGraw-Hill, Boston, MA,
2004.
2. Small Business Development Corporation, Western Australia, A Guide to Buying a Small Business, SBDC, Perth, 1998.
3. S. Holmes, P. Hutchinson, D. Forsaith, B. Gibson & R. McMahon, Small Enterprise Finance, John Wiley & Sons,
Brisbane, 2003, p. 315.
4. Small Business Development Corporation, see note 2.
5. D. Waldron & G.M. Hubbard, ‘Valuation methods and estimates in relation to investing versus consulting’,
Entrepreneurship Theory and Practice, no. 16 (Fall), 1991, pp. 43–52.
6. R. McMahon, S. Holmes, P.J. Hutchinson & D.M. Forsaith, Small Enterprise Financial Management: Theory and
Practice, Harcourt Brace, Sydney, 1993.
7. S. Weaven & L. Frazer, ‘Current status of franchising in Australia’, Small Enterprise Research, vol. 13, no. 2, 2005, pp.
31–45.
8. L. Frazer, S. Weaven & K. Bodey (2012), Franchising Australia 2012, Asia–Pacific Centre for Franchising Excellence,
Griffith University, Brisbane, p. 9.
9. ibid.
10. S. Flint-Hartle, L. Frazer & S. Weaven (2012), Franchising New Zealand 2012, Asia–Pacific Centre for Franchising
Excellence, Griffith University / Massey University, Brisbane, p. 2.
11. P.F. Zeidman (ed.), Franchise In 33 Jurisdictions Worldwide, various editions, 2010, 2011, Law Business Research,
London; Hong Kong General Chamber of Commerce (n.d.), Franchising in Hong Kong www.franchise.org.hk; World
Franchise Council – country profiles, www.worldfranchisecouncil.org; Registrar of Franchises, Malaysia, 2012, pers. comm.,
November.
12. J. Stanworth, D. Purdy, S. Price & N. Zafiris, ‘Franchise versus conventional small business failure rates in the US and
UK: More similarities than differences’, International Small Business Journal, vol. 16, no. 3 (April), 1998, pp. 56–69; T.
Bates, ‘A comparison of franchise and independent small business survival rates’, Small Business Economics, vol. 7, no. 5,
1995, pp. 377–88.
13. Company website, ‘Domino’s Pizza Bahamas’, www.amlfoods.com, accessed January 6, 2014.
14. Company website, www.morinagamilk.co.jp, accessed January 6, 2014.
15. Matt Phillips, ‘China’s Labor Costs Are Now as High as Mexico’s’, Quartz, accessed January 6, 2014, http://qz.com;
‘2013 Top 100 Outsourcing Destinations Rankings’, Tholons, accessed January 6, 2014, www.tholons.com.
16. Shayndi Race and Spencer E. Ante, ‘Insta-Rich: $1 Billion for Instagram’, The Wall Street Journal, accessed January 6,
2014, http://online.wsj.com.
17. Chris Tutor, ‘BMW, Toyota Outline New Tech Joint Venture, New Sports Car,’ Auto Blog, accessed January 6, 2014,
www.autoblog.com.
18. Company website, ‘Alcoa Best in Class in Covalence Ethical Reputation Ranking,’ press release, www.alcoa.com,
accessed January 6, 2014.

 Summary