5 Fundamental economics concepts that will make you a better designer
By Alen Faljic
Unfortunately, business literacy has been neglected in design education. We come to work unprepared for the realities of the new business world, where design matters. It matters so much that we finally have a say even in the strategic matters.
Design-driven companies such as Apple, Tesla, Airbnb, and Google have shown that design can drive business results. And this opened the doors for all of us. We just need to know how to walk through these doors with some business confidence.
As Trent Huon, ex-Business Design Director at IDEO said in one of our podcast episodes,
“If you haven’t thought about the business then you haven’t designed the idea properly.”
In this guide, we will cover some of the most important and fundamental economics concepts, which govern how the business world works and how business decisions are made. It introduces what you would typically cover in the first semester of an MBA program.
You will learn about:
The good and the bad of growing companies - Economies of Scale
Why is a dollar today worth more than a dollar tomorrow - Time Value of Money
The never-ending dance of markets - The Law of Supply and Demand
You may be asking yourself, why would a designer even need to know these things. To help you understand how these concepts are relevant for a designer's work, there is an explanation of their relevance at the end of each chapter.
While this is a solid introduction to the world of business for designers, there is more for us to learn. You can find more relevant business concepts introduced here or in our Design MBA course.
Now, let's dive into the beautiful world of business and economics.
ECONOMIES OF SCALE
1. The good and the bad of growing companies
Economies of scale might sound complicated but we are all familiar with it from our daily life. We are already instinctively using the concept when cooking. We have probably all experienced that cooking pasta for four people doesn’t take four times as long as cooking pasta for just one person because cooking for more people is more efficient. Now, let's see how this translates into the world of business.
In business, economies of scale describe the advantages of producing bigger quantities. Specifically, we want each additional unit to cost us less than the one before. So, in our pasta example, let’s say that the cost of 1 portion of pasta is 30 minutes and $5. But if we prepare two portions, we would need only 10 additional minutes and $3 worth of ingredients. So, per portion cost is now 20 minutes and $4. In other words, the marginal cost (i.e. cost per additional unit produced) has gone down.
Another example comes from manufacturing. If you have ever tried to create a physical product made from plastics, you know that the mold is very expensive but actually producing a product is much cheaper. For example, we have to pay $10,000 just to create a mold for our product but actually producing it (injecting raw material into a mold) costs only $2 per unit. So, if we produce and sell 1,000 pieces, each product costs us $12. On the other hand, if we can sell 10,000 pieces, the price per product is now only $3 ($10,000/10,000 pieces = 1$/piece + $2/piece). This allows us to lower our price and be more competitive on the market.
Now, you may also understand why every company is trying to get bigger. Economies of scale give you a competitive advantage. Larger companies can produce more efficiently, negotiate better prices, achieve higher profit margins, and hence invest more in future growth.
1.1. Zero marginal cost of production
Economies of scale work particularly well for technology companies with no physical products. For Facebook, adding one more user is virtually free. There is no human labor involved in onboarding a new user and the hosting costs of an additional user are negligible. Similar logic applies to Amazon’s platform. Did you know that more than three-quarters of all products on Amazon are from third-party sellers? This means that Amazon does not need to store their products in its warehouse. So, adding one more third-party seller to Amazon’s website is virtually free. This is called zero marginal cost of production.
That is one of the holy grails of business and a reason why investors love tech companies.
On the other hand, economies of scale don’t work as great for traditional service companies. Of course, you can scale a hairdressing salon and achieve some productivity improvements, but you are still bound by space, time, and your number of employees. That can scale but it’s just not as elegant and easily leveraged as with hardware and software.
1.2. Network effects
A particularly interesting and related phenomenon is called the network effects. It happens when more users and customers lead to a better product or experience. For example, eBay inherently benefits from more sellers who in turn benefit from more buyers. So, both sides promote the service and onboard more users. Other examples are messenger apps like WhatsApp or, in the early days, the landline telephone and fax machines. The more people use it, the more useful it becomes.
Network effects are very important because they enable fast growth and strong competitive advantage. If I was one of the first people to use the telephone, I wanted others to use it so I actively promoted it. Products with network effects are also really hard to disrupt. Imagine entering the social media arena and trying to take users from Facebook. It does not make sense for most people to switch to another platform because all their friends are already on Facebook. So, think twice before challenging a company with strong network effects.
1.3. Diseconomies of scale
At a certain scale, our marginal gains don’t just slow down but actually start going back up. For example, let’s assume that we are organizing a dinner party and that we need to prepare food for 40 people. We immediately realize that we won’t be able to prepare food alone. So, we get three more friends to help us out. But because our kitchen is so small, we get in each other's way and we need to take turns using the oven and stovetop.
All of that results in a longer preparation time than if just one or two people were preparing the dinner. So, that third and fourth friend actually triggered diseconomies of scale. Because of their involvement, the average cost and time of preparing a meal went up. This is a great example of the classic, “too many cooks in the kitchen.”
One reason for diseconomies of scale is organizational. For example, top-heavy companies. Companies with too many managers can face troubles with bureaucracy, resulting in lower productivity and hence higher average cost per unit. Yet another common problem is duplication of effort. If a company's processes are not transparent, employees don’t know that someone else is working on the same problem.
Many design agencies are baited into diseconomies of scale. They could land a super interesting project but don’t have enough designers available. So, they decide to hire two more. A few projects like this and an agency has grown above its normal workload. Now, they have to hire more salespeople to sell more projects, get bigger offices, find a new IT person, etc. And if processes are not set for that size, we may have big communication and organizational problems, resulting in diseconomies of scale.
Therefore, it's crucial for a business to understand its limitations when it comes to economies of scale. They need to be aware of what pushes it over a healthy threshold into the diseconomies scale. The usual suspects are organizational, technical, and supply factors.
1.4. Economies of scope
Let’s go back to our pasta example. Almost every company producing pasta is not focusing just on one type of pasta. They produce spaghetti, penne, lasagne sheets, and maybe even filled pasta like tortellini. Companies do that because producing two related goods reduces the overall marginal cost.
For example, many design agencies today decide to go into the education space. When consultants are not on a project, they can prepare education materials, which are then sold as books or courses. This means that agencies are more efficient with consultants' time. So, they can either offer a book and consulting projects at lower prices to outcompete competitors or they can keep prices as they are and improve their profit margin.
Another example is Elon Musk’s Boring Company, which is a tunnel construction business. The company is reusing the dirt, a waste created in the process of digging tunnels, and turning it into a usable product - a brick. There are almost always ways to utilize economies of scope. It just takes a bit of creativity.
1.5. Ethics of economies of scale and scope
The advantages of economies of scale and scope are so important that most companies and business leaders do almost everything to maximize this benefit. If you combine that with investors' lust for continuous growth, we have a perfect cocktail for questionable growth motives.
Bigger is not always better. Especially if we try to optimize the benefit for the society at large, not just the stockholders. Are more malls better for society? Or is it good to have a healthy number of small independent shops? Is acquiring a company with questionable ethics really a way to benefit from economies of scale? Or is keeping your brand’s story aligned with your mission better for the long term?
Pursuing economies of scale is healthy for a business as long as we can be aware of our organization’s mission and critically ask ourselves: are we trying to get bigger just to get bigger or because it will do good for our customers, suppliers, and all other stakeholders involved in our business model? There is no easy answer. And this is not an easy question to answer. But if we start having these discussions in the board rooms, we’ll take a big first step towards a healthier business ecosystem.
1.6. How are economies of scale relevant for designers?
The concept of economies of scale and scope helps us understand why companies want to grow big. How a product or service is designed is usually the thing that makes or breaks whether a company will be able to achieve positive economies of scale or not. So, it definitely makes sense to keep this in our mind when designing products and product portfolios.
Product design
Are we working on a product or service that could achieve economies of scale? How can our product design remove obstacles to achieving that? Can we build network effects into our design?
Product portfolio
How could we achieve some economies of scope? What related products and services could we offer? What else do our customers want and we could simply produce based on our capabilities? Are our capabilities suitable to serve a different user base? Here we can also think broad and beyond the boundaries of our company (e.g. partnerships).
Entering new markets
When we are designing for new markets, we have to deeply understand the economies of scope, economies of scale, and network effects that are present on that market. This means we have to look at already existing players in the arena and figure out why they are winning so we can adjust our approach and product design accordingly.
To learn more about economies of scale and how to use the keyword “marginal cost” in your next big meeting, check out d.MBA podcast episode #57 The good and the bad of scaling companies
OPPORTUNITY COSTS
2. Hidden costs behind every decision
Let’s say you decided to do an MBA. It is a two-year program at a renowned business school, which costs $150,000 in total without living expenses. So, when we add living expenses due to moving to a more expensive city, total outlay costs (i.e. actual costs) come closer to $200,000. Most people would stop here and conclude that taking an MBA costs $200,000. But in reality, it costs much more.
During these two years, you won’t be working. This means that you are also giving up your income. For example, if you make $75,000 per year, that is another $150,000 in lost income over two years. Using business language, these $150,000 are opportunity costs of taking an MBA. So, a two-year MBA program would cost you $350,000 in total costs compared to working full-time. This means that your MBA would have to accrue more than $350,000 in increased salaries over our entire career for it to be a good investment.
The opportunity costs describe potential benefits that we miss out on because we decided to do something else. For example, working full-time versus taking a full-time MBA program. To calculate opportunity costs, we have to take all expenses and benefits into account and compare alternatives.
Many companies use this concept to inform their investment decisions. For example, should we invest in building a new factory in the USA, Africa or China? We usually approach such questions narrowly. There are three options and we need to choose the best. But actually, we have to consider more options.
A company is not just deciding where to open a factory. By saying yes to building a new factory wherever it may be, we are saying no to many other options. Like investing more heavily in R&D, outsourcing production, buying a fast growing-startup in their industry, etc. Opportunity costs are important because we humans have a hard time seeing things that are not immediately apparent.
2.1. Scarce resources
The concept of opportunity costs is built upon the notion of scarcity and scarce resources. If we could do and have it all, we would not have to make any trade-off decisions. In business, we typically look at time and money as scarce resources, which govern our opportunity costs.
For example, Kodak decided to invest its resources into further developing analog photography so the company did not invest enough resources into a potentially game-changing new technology - digital photography. Kodak’s business model was based on selling film, so they could not understand how they could replace that revenue with a camera that does not need it.
We have to understand that even the biggest companies have limited resources. Even though money is usually not the problem for them, time, focus, and a strategic direction are. If a captain steers a tanker towards the north, it takes a few long minutes and miles to turn it back south. There is momentum behind our decisions.
2.2. Opportunity costs are not strictly monetary
It is important to note that opportunity costs are not just monetary calculations. Usually, we can not just compare a stock with 8% yearly return with a bond that has 2% yearly return.
Let’s have a look at hiring. What makes more sense? Hiring an experienced individual for whom it is harder to fit in the company's culture, or a talented young person who may not know as much but is a good cultural fit. Or should we even outsource this position altogether?
We face non-monetary opportunity costs in our everyday lives. Like saying yes to a Friday night shift and then realizing your favorite band is having a concert in your city. Or taking a cooking class instead of a negotiation workshop.
When we have all the options on the table, we need to look at a wide array of factors that go with each decision. Factors like strategy, emotions, timing, culture, and brand all come into play.
2.3. Sunk costs
While opportunity costs describe benefits that we could have if we choose another option, sunk costs describe costs that can't be recovered. For example, a plane ticket that we bought for our upcoming vacation is a sunk cost.
Sunk costs are extremely important for good decision-making. An especially important concept here is called sunk cost trap. This is a tendency for us to continue with an activity or investment that is not meeting our objectives because we have already invested so much. Good decision-making ignores sunk costs. They are irrelevant. We should only look at the future costs and potential.
Let’s go back to our vacation example. What if after you have already booked your flights, an even better opportunity comes across? Your friends are inviting you to join them on a sailing trip, which is something you've always wanted to do. Should you join them and ignore the plane ticket sunk cost?
Here is another example. Let’s say that your company decided to use a new sales software. So, one of the first things they do before deployment is training staff on how to use this new software, which costs the company $30,000. What if the company finds another software provider that suits them better after the training has already taken place? Should it invest another $30,000 to train staff again or should it keep the already selected software?
2.4. How are opportunity costs relevant for designers?
Designers often complain that no one understands us and listens to our proposals. But we need to understand that decision-makers need to look very broadly when making a decision. We can gain more impact in the company by clearly outlining various options and hence outlining opportunity costs.
Kicking-off design briefs and starting projects
After you have clearly defined the underlying challenge of a project, host a meeting to uncover all possible options. Invite people with various backgrounds and from different departments because that will help you come up with a wide array of routes. Keep asking “What else could be done?” until you have a good list of alternatives that you can explore.
Understand opportunity costs
Once you have a list of alternatives, schedule interviews with experts for each solution. They should help you understand all the advantages and disadvantages of each alternative. Ask them about strategy, timing, culture, brand, financial implications, etc.
Presenting options
When presenting your work, lay out several promising options available. This shows you have thought about different alternatives. Include monetary and non-monetary implications of each decision. In the end, show what you think is the best decision.
To learn more about opportunity costs and how this concept can be used to present design solutions better to get more buy-in from senior stakeholders, check out d.MBA podcast episode #59 Hidden costs behind every decision
TIME VALUE OF MONEY
3. Why is a dollar today worth more than a dollar tomorrow
Imagine that you just won the lottery. Now, lottery officials give you two options. You can either get $1 million right away or you can get $1.8 million in ten years. Which option is better?
The basic rule is that one dollar today is always worth more than one dollar tomorrow. If we have one dollar right now, we can invest in something and let it grow. On the other hand, if we keep it in a bank account or under our mattress, it will be worth less because of inflation.
So, if lottery officials offered us $1 million right now or $1 million in ten years, the choice is easy. We take the money now. But they made our decision a bit harder by offering us $800,000 more in ten years. What to do in this case?
To calculate what makes more sense, we need to look at opportunity costs. If we get $1 million right now, what could we do with it? One option is to invest all of it in stocks. Historical data shows that in the long run, stocks have a yearly return (or growth) of 8%. What many people get wrong is that 8% growth over 10 years is not 80% growth. It is much more because of the exponential growth of compounding interest.
Specifically, 8% compounded (i.e. reinvested) for 10 years results in 216% growth. So, if we took $1 million right now and invested all of it on a stock market, our 1 million would grow to $2,16 million in 10 years. Wow!
Under these assumptions, it does seem that taking $1 million right away makes more sense than taking $1.8 million in ten years because we can make more on the stock market. Of course, when making such decisions, we need to factor in the risk. Obviously, investing money in the stock market is riskier than the guaranteed 1.8 million we would get from the lottery.
3.1. Compounding interest
Albert Einstein famously said that compound interest is the eighth wonder of the world. It is truly remarkable how small compound interest can result in huge returns over a long period of time. For example, if we start investing for retirement when we are 30, we can save exponentially more than if we start investing when we are 40. In the graph below, you can see the difference between these two scenarios even though in both cases, we set aside $200 per month and assumed a 4% yearly growth. Crazy, right?
Compound interest is basically a snowball effect in financial terms. When you take a small amount of money and keep it reinvested over a long period of time, compound interest will do its magic and exponentially increase.
For example, you hear that your company is today generating $10 million per year and growing 50% each year. Doesn’t sound super impressive when you compare it to hyper-growth startups, right? But if this growth continues, our company would generate $75 million in just five years.
When assessing the time value of money, it is important to keep in mind that even small compounding interest can result in huge differences over long time periods.
3.2. How is the time value of money relevant for designers?
While nobody expects us to create complicated financial models, we need to understand the concept of the time value of money. It helps us better understand how decisions are made in our company and how we need to present our work.
Understanding investment decisions
Talk to decision-makers and try to understand what their goal is. What alternative investments and opportunities are they considering? Do they need to beat the stock market (e.g. 8% yearly return)? Do they need to satisfy expectations from VC investors (e.g. 100% yearly growth)? Or, do they just need to pay back the interest loan (e.g. 4% annual interest rate). Once you roughly understand their goals, you won’t just understand their decisions. You will be able to predict them.
Presenting our work
As mentioned in the opportunity costs chapter, it is a good practice to show various options to decision-makers. After understanding the concept of the time value of money, you can support your recommendation also with some financial language like “higher yearly return”. Or, if you have a numbers person in your team, you can also back up options with some projected numbers.
THE LAW OF SUPPLY AND DEMAND
4. The never-ending dance of markets
“I am sorry but we had so much demand for this house that we decided to raise the price by $50,000. Are you still interested?”
Imagine this. You liked the house so you were prepared to pay a certain sum. You even called a bank to check if you can get a loan. But now a seller has decided to raise the price.
This is a typical example of the supply and demand law in action. If there are a lot of buyers at a certain price, sellers can raise their prices. But what happens next? Other homeowners who did not want to sell at a lower price, now start listing their houses, too. This increases the supply to match the demand at a higher price.
We can show the law of supply and demand visually. The horizontal axis shows a quantity of a certain good or service produced and offered on a market. And the vertical axis measures its price. The higher the price, the less demand there is from buyers on the market (point 1). But at such high prices, many producers are willing to offer a good (point 2).
On the other hand, low price means that many people are willing to buy this product or service (point 3). But at this price, only a few suppliers are willing to produce it (point 4).
These two forces work against each other until they balance out in so-called equilibrium (point 5). This is a point where supply and demand achieve a balance. There is just enough supply to satisfy all the demand at that price.
4.1. The invisible hand
You may have heard about the invisible hand before. It is a metaphor that explains how equilibrium is achieved. The self-interest of buyers and sellers work together to achieve a balance on the market, which is also in the interest of society.
For example, if one farmer is selling an apple for $1 and another farmer is selling a similar apple for $2, customers will choose a farmer with the lower price as it is in their self-interest to pay less. So, the more expensive farmer will have to lower prices because it is in her self-interest to sell some apples, too.
This theory was famously introduced by Adam Smith, a well-known Scottish economist who lived in the 18th century and is known as the “The Father of Economics”. At the time, governments were trying to figure out how they should control the market so that enough of a certain good would be produced. For example, how will our country produce enough food for everyone? Smith’s idea was revolutionary because it suggested that the market will find its equilibrium even if a government doesn’t interfere.
Today, we know there are exceptions where governments interfere for the better of society. For example, many governments give big subsidies to farmers so that their food production is financially viable, which keeps the food price at reasonable levels for citizens. In some countries, the health system is defined as a public good and hence financed by all taxpayers. This makes healthcare more affordable for the broad population. Ultimately, governments decide what they see as an imperfect market and where they choose to intervene, which depends on a nation’s history and its value system.
Letting the market balance itself can lead to what is called negative externalities. This is a cost that we suffer because of someone else’s actions. For example, pollution caused by a factory is a negative externality for people living in the area and the environment as a whole. Without governments' involvement, factories will pollute because producing as much as possible and therefore polluting more is in their self-interest because it helps them generate more profit. So, governments all over the world have put various policies in place to fight pollution, which are the negative externalities of manufacturing.
4.2. Shifts in consumer values
When customer values change, we can see big shifts in demand and supply. For example, we have recently seen a big move towards conscious consumerism. People are becoming increasingly aware of the consequences of their buying habits.
For example, we learned that buying fruit and vegetables that have traveled thousands of miles is much more harmful for the environment than consuming locally produced fruit and vegetables. So, the demand for local fruit and vegetables increased even though the price did not go down. Actually, many consumers have become willing to pay more for them.
This is what we call a shift in the demand curve. It occurs when the demand changes due to a non-price factor. For example, changes in taste or values, changes in disposable income, demographics, prices of substitutes, and even future expectations (e.g. think about the Bitcoin price and the fear of missing out when it starts increasing).
Graphically, we show the shift with a parallel demand curve. In our case, the line moved up and to the right, indicating that customers are willing to buy more of the same goods at a higher price. This also leads to a new equilibrium (red point) on a market. Due to an increased demand for local fruit and vegetables, prices also went up a bit, but that also means that more sellers have entered the market and increased the supply.
We can observe the same phenomena on the supply side. In this case, we call it a shift in a supply curve. It happens when there is a change in the number of suppliers, price of raw materials, new technology, and so on. For example, an increase in wood price would make house construction more expensive and hence could lead to a supply shift of wooden houses.
4.3. Veblen goods
The law of supply and demand is one of the most fundamental laws in business but even this law is not universally applicable. We know from experience that certain products sell better when they are more expensive. These goods are so-called Veblen goods.
Things like diamonds, premium cars, jewelry, yachts, etc. They are desirable because they are expensive, and therefore, less accessible. While so-called normal goods become less attractive with a higher price, demand for Veblen goods increases with its price.
It is important to know the difference between normal and Veblen goods because of the implications for product design. When faced with new competitors in the normal goods market, we may need to find ways to offer better value. In the Veblen goods market, we can just amplify the premium features without too much consideration for costs.
4.4. How is the law of supply and demand relevant for designers?
Even though economists call this “the law of supply and demand”, we have very quickly learned that it is actually not a law. It is more of a mental model that we can use to understand how industries, arenas, and even whole countries operate. For us, there is no need to actually calculate anything or draw graphs. We just need to be aware of the fundamental concept as well as demand and supply dynamics in the market in which we design.
So, how does it fit into a designer’s workflow:
Supply empathy
Are there any rumors of new competitors entering our space? This may increase the quantity offered and hence reduce price within a market. Or, do we have reasons to believe that supply will reduce and prices will go up? Now, think about how that would affect a product or service that you are designing. Do you need to make it cheaper and cut some features out? Can you make it more premium? Do you need to completely change it so you play in a different field with different demand and supply dynamics?
Demand empathy
What does our customer research say? Do we expect any non-price factors to affect the demand side? Have values or taste preferences changed so that people will want more or less of a product at the same price? Has the disposable income of our target market changed? Think about how that would affect your product or service. For example, if you observe big changes, that is an opportunity for designers to reimagine products, services, brands, and change expectations of a certain product or service category.
Market research
Having a good understanding of what is already on the market (supply side) is important when designing new products, services, and brands. It will determine how we can price our product or service (and hence what features we can build), how we should position it, and what customers expect from a product or service in this category.
PRINCIPAL-AGENT RELATIONSHIP
5. It takes two to tango
Let’s say that we are selling our house. The first thing we do is hire a real estate agent to help us assess the value of the property. The agent goes through a thorough process and estimates that our house is worth $650,000. That’s more than we expected. Nice.
Since we were so impressed with the agent's work, we also entrusted her to find us a buyer. So, we sign a contract that promises the agent a 5% commission on the home’s sale price. If the agent sells our house at the advertised price, she would get $32,500 and we would get $617,500.
Soon, we start getting prospective buyers who are interested in the property but most of them are offering a sum below our advertised price. We aren’t quite happy with that and tell the agent that we would like to keep going until we find someone who will pay the full price. For us, waiting a bit longer is not a problem.
But let’s look at the incentives of our agent. If we sell a house for $600,000, we are losing much more money than the agent. They lose only $2,500 while we are losing $47,500 ($617,500 - $570,000).
The agent's work will be much more efficient if they sell our house to one of the very first potential buyers. Even if it is for $600,000. Instead of doing 20 tours, she could sell it in a day and start selling another property. And for us, an additional $47,500 is a lot, so we would like the agent to keep going and land a buyer for the advertised price.
This is an example of a principal-agent problem. It describes a conflict in priorities between the owner and the person to whom control has been assigned. In our case, we were the principals as owners of the house and the real estate agent was, well, the agent.
An even more representative example is the relationship between an owner of a business and a company’s executives. For example, if you are a stockholder, (and hence partial owner) in a company, you don’t control what the company’s CEO does. It may be in the stockholders’ interest to get paid dividends each year, which is paid from the profit of the company, but the CEO may decide to invest this profit in expansion.
Examples of a principal-agent problem can be found everywhere. For example, buying fresh fruit online. Have you ever received bananas or another fruit that was very close to its expiration date? As buyers, we want to have the best fruit at the peak of its taste and freshness. But food pickers (agents in this case) want to sell the produce that would soon go bad and result in a direct loss for their company.
A similar example can be found in the manager-worker relationship. Managers may have high expectations of what workers will deliver, but it may be in the worker's interest to deliver an acceptable quality of work and move on to another task instead of doing their very best all the time.
Another good example is when we hire a freelance designer to help us out. It is in our interest to get the best results in the fastest time possible. But if we pay a freelancer per hour, they are essentially incentivized to extend their work and bill us more hours than necessary.
5.1. Solving principal-agent problems
The most important lever for solving these problems are incentives. We need to design a model where the principal’s goals are aligned with the agent's incentives. This means that contracts and culture are set up for win-win.
For example, if we really wanted to sell the house for $650,000 or more we could flip the commission model. What if the agent is incentivized to raise the property’s price, not lower it? We could, for example, award the agent with 5% commission up to $650,000 and 50% commission of every dollar that is above that. So, if an agent sells a house for $670,000, they would receive $42,500 in commission ($32,500 + $10,000).
Or, if company owners want to receive dividends each year, they can put a special dividend clause in the CEO’s contract. If it is set up properly, the CEO will want to pay out dividends to owners because the CEO will also receive them.
Solving the principal-agent problem goes beyond contracts. If it is customer-facing, we can solve it with a different value proposition. For example, there is a pizzeria that promises free pizza if they don’t serve it in under five minutes. After the order is given, waiters put a timer in front of diners, which counts down from five minutes. Needless to say, it rarely happens that you have to wait for your pizza too long in this restaurant. This is a really neat way to build trust and a brand.
A famous example of this is Salesforce. They entered and conquered the world of CRM software by offering a very flexible cancellation policy. In the early 2000s, software companies were operating under the proprietary software model. This meant that a company buying a software signed a long-term contract with a vendor. Companies got locked in and if they did not like the software, there was not much they could do.
On the other hand, Salesforce pioneered cloud technology, which enabled it to offer a cancellation policy that let their customers cancel at any time. This put the power back in customers’ hands as they could leave for another provider and it incentivized Salesforce to do such a good job that their customers felt no need to cancel. Win-win.
Another very common solution to the principal-agent problem are warranties. Without warranties, producers only have the incentive to build a product that would sell. But customers want a product that works well over a long period of time. So, warranties and other similar offers like money-back guarantees are another way to solve this problem.
5.2. How is the principal-agent relationship relevant for designers?
Once you know how to spot a principal-agent problem, you will see them everywhere. The nice thing is that as designers, we can do a lot to align interest in the business ecosystem. This is a great opportunity to exercise our empathy muscle, listen to principals and agents to find out what they really want.
Designing incentives
If we understand what everyone involved in the business model wants, we can help design incentives for each actor. The goal is to align incentives in a way that will work best for all stakeholders for the long term. If you want to learn more about this, check out the design discipline called organizational design.
Designing value propositions
Whenever we are designing products and services, we should look for misaligned incentives. They are a huge opportunity area, where we can find a lot of interesting ideas. Pay special attention to stakeholder’s strong negative feelings and experiences in your research. Sometimes, the reason for that negative emotion is the principal-agent problem.
To learn more about how incentives affect the work of designers and why we are in a unique position to help companies better align incentives, check out d.MBA podcast episode #64 Designing and aligning incentives
Put it all into practice
If you read to this point you’ve made a big step towards understanding how business decisions are made. But there is much more you can do to become a more strategically minded designer and get a seat at the table. Below are a few suggestions and resources from the d.MBA team.
One of the crucial moments in every learning process is taking action. We learn the best when we actually try to use new knowledge. So, my challenge for you is to take one part of this guide and apply it to your process. Pick a concept you found the most interesting and explore it further. Try it and if you hit a wall, you can reach out with your question in the comments below.
Another thing you can do is to share this guide with your colleagues and discuss it together. What we found at the d.MBA is that business confidence grows when discussing business topics out loud with your peers and coworkers. So, share this guide and organize a lunch or a call to discuss it.
If you are ready to take the next step in your career, join us in the next d.MBA intake. It provides an expanded look into business models, business strategy, metrics, and much more. You will have a lot of opportunities to discuss and practice while solving real-world case studies within a cohort of 40 like-minded senior designers from across the globe.
If you’re not there yet but are interested to learn more business concepts, take the free 7-day mini MBA to see if the d.MBA is right for you.