(originally appeared in Business Week Online   Dec 18, 2007)

Economic Mysteries Explained!

Or why $3 gas is only a minor inconvenience.
People spend less when they have less money,
so companies must target ads to match a consumer's ability to pay.

Advertising may win hearts and minds, but in hard economic times, it can't pry open wallets. So, rather than fighting the coming economic slowdown, companies will need to learn how to better target ads to match a consumer's ability to pay. Here's how to think about a solution.

Let's start with Algebra I and all those annoying word problems from high school. You know, the ones where a 100-gallon tank of water is draining at 3 gallons per minute while filling at 2 gallons a minute, and you have to figure out how much water remains after 10 minutes?

What matters isn't the answer, but the principle: If you drain a tank faster than it fills, eventually the tank will run dry. Fill more quickly, and eventually it will overflow. Or, as the wise but jaded Mr. Micawber advised in Dickens' David Copperfield:

"Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

How Much Can People Spend?

Unfortunately, consumers rarely know their yearly expenses or disposable incomes ahead of time. But psycho-economic studies show that humans are, nevertheless, intuitively rational economic animals, and they rely unconsciously on judicious approximations to manage their financial lives. The evidence shows that, especially during times of economic uncertainty, most people tend to compare their average rate of spending to their average hourly income. (In venture capital terms, our personal "burn rate.") This is a simple idea, but one with profound consequences for businesses, consumers, and advertisers.

The U.S. median family income is approximately $48,200 a year, according to the Census Bureau. That's $5.50 per hour before taxes, or $4 per hour after taxes—assuming disposable income of approximately $35,000. Which means, day in, day out, an average American family can't spend more than $4 an hour and still keep its head above water.

Now let's break our family's spending into four categories: cheap thrills, affordable purchases, occasional treats, and rare extravagances. Cheap thrills are bought whenever the mood arises; they won't break the bank. Affordable purchases can be acquired now and then; basically they are in equilibrium with hourly income. Occasional treats are exactly that. Just don't overindulge. And extravagant expenses should be avoided at all costs.

Here's how we can expect this behavior to play out (just a bit of plain arithmetic, some double-counting, lots of rounding, and no algebra). But the results are sometimes usefully counterintuitive:

Cheap thrills (less than $1/hour)

• Cable television may run $50 per month, but with three people watching 4 hours a day, it's cheap entertainment at 15¢ an hour.
• A new T-shirt isn't a bad deal. At $25 for the shirt, worn once a week for 15 hours a day, until it wears out in 4 years. This works out to less than a penny an hour. Why not buy two?
• A diamond ring, though a completely unproductive use of capital and frequently purchased when couples have the least disposable income, ends up costing only a penny or two an hour over a 20-year marriage. It's not really a luxury, at least over the long haul—provided you don't get divorced.

Affordable ($1 to $3/hour)

• A cigarette—15¢ each, for a 10-minute nicotine fix—costs about $1 an hour.
• Internet access—$30/month for an hour and a half a day—also about $1 an hour.
• A newspaper—at a dollar for 30 minutes of reading—comes to $2 an hour.
  
• An apartment—$1,500 a month with utilities—ends up costing just $2 an hour. Good thing the median family has $4 an hour to spend, but keeping a roof over your head leaves only $2 an hour for the rest of the day.
  
• Gasoline, if you pay $3/gallon, get 25 mpg, and drive at an average speed of 30 mph, comes to approximately $3.50 an hour ($7 an hour in an SUV).

Treats ($3 to $10/hour)

• Movies cost $4 an hour.
• Cell-phone service—assuming an average customer bill of $60 for 700 minutes of use—works out to $5 an hour.
• Starbucks coffee costs $6 an hour. That's high enough so that a median-income family should always bring coffee from home. And if you have a cigarette and a doughnut with your coffee, it's verging on an extravagance.

Extravagances (greater than $10/hour)

• McDonald's, a $6 meal wolfed down in a half-hour, costs $12 on an hourly basis.
  
• A car—leased for $350 per month, plus insurance and gas, and driven 10,000 miles a year at an average speed of 30 mph (means you spend 300 hours in the car)—costs $18 an hour.
  
• Take a cruise, fly in a plane, or attend a Broadway show. Between $25 and $75 an hour.
  
• Inpatient surgery plus recovery, comes to $250 an hour. Unfortunately, if you don't have health insurance, even life-saving surgery is an "extravagance."

Try a few of these calculations on your own. The math is simple and the results are often illuminating.

How It All Adds Up

What does this mean for advertisers? Well, the Internet now matches radio, TV, and newspapers on a dollar-per-hour basis—which means it's truly a mass-media market with matching economics. Even in a downturn, when Madison Avenue retreats to the tried and true, expect the Internet to absorb its proportion of ad campaigns and to reach similar demographics.

As for sellers: What if you're pitching a product that costs more than a few dollars per hour? Well, don't continue pushing the idea that a $3 cup of coffee is an everyday event—the numbers simply don't work out. Every once in a while, consumers may confuse a treat with an affordable thrill, but, in down economic times, they won't (or simply can't) make that mistake for long. Starbucks (SBUX) is feeling the pain of lower-price coffee competitors. It needs to position Starbucks coffee as a "reward" for working hard, while blunting lower-price competitors through stronger discount and affinity programs.

And that $3-per-gallon tank of gas? Well, the good news is you can drive to work, wear a T-shirt, and read a newspaper, all without breaking the bank. But if you want to save for that annual vacation in June and avoid misery this holiday season, you might want to start packing a lunch from home today.

Greg Blonder is a partner at Morgenthaler Ventures, which has investments in a number of ad-supported companies, including IGA, imeem, NexTag, and Rhythm NewMedia.