Business Models

You need to understand the concept of a business model.

A business model specifies how you make money. It answers the question "What customer problem does this business solve, and how does it do so profitably?" You specify a business model with a narrative explaining the idea and numbers explaining why the business will be profitable:

  1. Narrative: Who are the customers? Why will they buy from this company? How does the business make a profit?
  2. Numbers: How does this business get revenue? What are its costs? On what assumptions do its profits depend?

The second part is sometimes referred to as the "numbers test." Typically, businesses create a spreadsheet with revenue and cost assumptions to test whether the business will really make a profit. The spreadsheet specifies the assumptions used in calculating revenues and costs.

Online Dating Site Example

An online dating site addresses the problem of finding a suitable date or a partner. That involves high search costs. People have to go to a lot of parties or bars or nightclubs or church functions to find a good match. Dating sites aim to reduce that search cost in return for a fee. So "why people buy" is because they believe that paying a fee to the dating company is a more effective way to search for a suitable date or partner.

What about the numbers? A dating site might make money by charging people to register on the site. That's a subscription business model. The site's revenue comes from subscribers, and the amount of revenue depends on the number of subscribers and (for monthly subscriptions) the amount of time they stay on the site.

Just because a dating site gets subscription revenue does not mean it will be profitable. Profit=revenue-cost. You have to consider the firm's costs too. Dating sites have high setup costs and - apart from marketing - near-zero variable costs. Their success depends on the network effect and economies of scale. Once they become big enough they tend to become profitable. That's because their setup costs are fixed costs, so as more and more people sign up the company's setup costs per member go down (economies of scale). Marketing costs start off high, but as the dating site grows it becomes more attractive for new joiners (the network effect). Marketing costs ("customer acquisition cost") per new member fall because of repeat buyers (subscribers who sign up month after month) and referrals.

The problem with subscription business models is that people may choose to sign up at sites where there is no subscription fee. That may lead to a "price war" between competing dating sites. Intense competition can mean that the price of subscription tends to zero because the marginal cost of serving one more subscriber is zero (see a firm's costs). Well-established dating sites may be able to compete effectively with new zero-subscription sites if they already have many subscribers (making it attractive for new people to join, even if they have to pay). Further, some customers may be willing to pay for a subscription on the basis that "you get what you pay for" — that is, free sites may have less desirable members.


Magretta (2002) is a great article on business models: Why Business Models Matter by Joan Magretta. Harvard Business Review May 2002, Vol. 80, Issue 5. It's on the Business Source Premier database at the Library.

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License