The FINANCIAL — You are a budding entrepreneur, with a passion for the hospitality industry.
The FINANCIAL — You are a budding entrepreneur, with a passion for the hospitality industry. You are especially interested in restaurants, and you are considering opening one in the near future.
However, before you start, there are some important questions you need to answer. How are you going to make money, and how are you going to beat the competition? These are questions that every business has to ask, and the answer will ultimately determine the success of your business.
Before you start your business, you want to know what the market looks like. Markets are different for every industry, and for every geography. The composition of the market has a huge impact on how you can price your product. What questions do you need to ask when analyzing a market?
First, how much differentiation is there in the market for the product that you are trying to sell? If you are selling art, it is very easy to distinguish one product from another, while if you are selling copy paper in the bazaar, it is probably hard to convince anyone that your paper is very different from the paper others are selling. The more differentiation there is in the market, the easier it is to charge higher prices: people are not willing to pay a higher price for the same product that they can get cheaper elsewhere. Our restaurant business is probably somewhere in the middle, depending on the type of restaurant. If you are a restaurant selling standard food with standard service, charging higher prices will scare customers away. However, if you have a type of restaurant that is not common in Georgia, for example a Western fast food restaurant, you may be able to get away with charging premium prices.
Second, how much competition is there in the market for your product? If there are a lot of entrepreneurs trying to sell the same product or service, they will drive the price down in their attempts to attract more customers, which will lead to lower profit margins. However, some industries are dominated by a few players, and these markets are called “oligopolies”, or in the case of one big player, a “monopoly”. An example of this is Walmart in the United States. In these cases, the big companies have the power to keep prices high, because there is very little competition, and they control the market.
Third, how much demand is there for your product? Will people want to buy your product? In our restaurant example, think about how big the market is for your food. How often does an average person in your area go to a restaurant, how much do they spend, and what kind of food do they want? This also depends on your pricing: the market for a cheap product is probably a lot bigger than the market for an expensive product. Market demand is probably the single most important factor in determining the success of your business: if nobody wants to buy your product, you will never be successful. Now if you come up with a very revolutionary product, for example Vietnamese cuisine in the high mountains of Georgia, there may not be any demand because people are unfamiliar with the product. In this case you have to create the demand by making people believe that they want and need your product.
Fourth, are there any barriers to entry? Even if it is a highly differentiated market, there is not a lot of competition, and there is enough market demand, there may still be obstacles that keep aspiring entrepreneurs from entering the market. For example, in the case of a restaurant, even though the potential profits are positive, you still need to make a significant capital investment (burners, stoves, fridges, etc.), find a location, and maybe even obtain operating licenses. In some markets these barriers to entry are much higher than in others, and industries with higher barriers to entry usually have higher profits, because of lower competition.Take the case of the oil industry: profits are high, because it is very hard to become an oil driller: you need to invest a lot of money to find oil, a process that can take years.
After you’ve asked yourself these questions, you will be almost ready to start your business. There are just a few more concepts that you need to understand, mostly related to exceptions to the normal rules of a market.
Collusion occurs when different sellers in a market agree on the price of a product together, and decide that they will not lower their prices. This is sometimes also called a cartel, which is technically illegal, but it occurs quite often. Because prices remain artificially high, sellers and producers increase their profits, while consumers suffer. If cartels don’t have price setting power, they sometimes control the price by controlling quantity, which is what OPEC (Organization of the Petroleum Exporting Countries) does: if the price of oil is too low for their liking, they decrease their oil production, pushing prices up.
In some markets however, – the money it costs them to sell or produce that product might be at the same level for a long time because this is the “marginal cost” of the seller: if companies lowered their prices further, they would lose money. This happens in markets with very undifferentiated products, where the competition is purely on price. Examples of this are lending institutions, where most people only look at the interest rate, or taxi rides. The way to compete in this market is to have lower costs, so that you can lower your prices, without making a loss. An example of how this is done are the 3 GEL taxis in Tbilisi: they have lower costs because they run on natural gas instead of gasoline.This can also happen when a big player comes into a new market and has certain cost advantages coming from “economies of scale” which means the average cost of something goes down, when you produce more. When a new player comes into a market and lowers prices significantly, this is often called “dumping the market”.
A more extreme version of this is something called “predatory pricing”, which occurs when a big company charges very low prices, often even making a loss on those products, to drive competitors out of business. Once these competitors are out of business, the predatory pricer is now a monopoly, and can charge monopoly prices, thereby significantly increasing his profits. Imagine there are two airlines flying between Tbilisi and Batumi. One of them is small Fly Adjara, and the other one is the very large airline South Germany Airlines.South Germany Airlines can afford to charge really low prices, because it is still making a profit from other routes. Because of these low prices, Fly Adjara also has to lower its prices, in order to not lose all its customers. Fly Adjara makes a loss, because it has to charge below its cost, and eventually it goes out of business. South Germany Airlines is now a monopolist on the Batumi-Tbilisi route, and can start charging much higher prices, because it is the only carrier that flies between Tbilisi and Batumi.
Understanding the dynamics of the market that you are planning to operate in is crucial before you start your business. This doesn’t happen in an hour or two, and requires thorough research, but it will be time well spent. Too many people start businesses without really knowing who they are up against, and what the market looks like. At the same time, when you are analyzing markets, you might also find other markets that suddenly look much more interesting than the one you were planning to operate in. Do your research before you start. A smart entrepreneur is always prepared.
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