Perhaps the most important question confronting anyone thinking about creating a start-up, or marketing any product for that matter, is determining the size of the potential market.

There isn't an easy answer for this because, frankly, a "market" is not a thing, but an idea. You can't see a market, but you only have an idea that it exists. So, if you can't see something, but you want to measure it, how do you do this?

Well, there are actually several ways to approach this problem, and we'll consider one of these here and other methods in future tutorials.

IS SIZE THE PRIMARY OR SECONDARY DEMAND?

Regardless of the approach, the first thing to consider is whether you want to determine the size of "primary demand" or "secondary demand".

Primary demand is the size of the market for a product category - like "virtual hard drives". Secondary demand is the size of the market for a particular brand - like xdrive.com or idrive.com. As you might imagine, secondary demand is more naturally associated with market share. You can read more about primary and secondary demand in our tutorial on firstmovers.

Since most companies we've dealt with tend to be interested in the demand for new technologies or services, our focus will be on primary demand - or the size of the market for a product category.

DECOMPOSE AND BUILDUP

The first thing to note about almost all methods for estimating market size is that they are based on decomposing the larger "market size" problem into smaller problems, and building the results of these smaller problems into the market size. The best way to see this approach is in the familiar method of estimating market size as follows:

Market size = number of buyers in the market x
quantity purchased by an average buyer in the market per year x
price of an average unit

Notice how the total problem is broken down into its constituent elements (i.e., the number of buyers, the quantity per buyer, etc.) and aggregated up (through multiplication) to get the final result.

This is a common technique used by many companies, with the major differences being how they break the problem down and how they build in back up.

For example, an Internet service provider may think of the number of buyers at the level of a household - since a household buys the Internet service, not an individual. In contrast, an application service provider (ASP) selling to corporations would likely focus on the employees in the customer corporation who will use the service, not the corporation itself.

CHAIN RATIO METHOD

The art of breaking down a problem and building it up is also at the heart of the "chain ratio method". Similar to what we just described, but more focused on the size of the market in terms of number of customers, rather the dollars. Think of this method as trying to determine the "number of buyers in the market" in the simple equation above.

The chain ratio method can be used by either first breaking down the problem into smaller problems and then building up, or estimating (really almost guessing) the size of the total market and then doing some fine tuning. We'll focus here on latter approach of fine tuning a general broad estimate of the market by looking at the infamous cat problem.

THE CAT PROBLEM

Let's look at the question consulting firms like to ask potential employees to determine how they think. The question is: How many cats are there in the U.S.?

Here's how you answer this question. Notice how we'll approach this by fine tuning a broad estimate of the total market.