Value Creation and Value Capture – Comprehensive Study Notes (Two- to Multi-Party Value Chains)

I. What is value?

  • Value questions are central but extremely complex; multiple lenses exist (religious, philosophical, economic).
  • Religious perspective (Proverbs 23:4-5) cautions against excessive toil for wealth; wealth can escape and fly away.
  • Philosophical view (Intrinsic vs. Instrumental value): money is good insofar as it leads to other goods; intrinsic value questions are debated (Stanford Encyclopedia of Philosophy, Value Theory, Intrinsic Value).
  • In this course, no universal definition of value is assumed; value is a judgment economizing people make about the importance of goods for life and well-being; value is not an external property but arises within consciousness (Menger, 1871).
  • Acknowledges: different individuals, cultures, and ethical views define value differently; ethical values underpin economic activity; course will introduce moral frameworks while recognizing diversity in values.
  • Emphasizes a particular framework for economic value, noting it may not capture all moral/ethical values.
  • Key takeaway: economic value is a framework for thinking about trade-offs, not a universal moral verdict.

II. What is economic value?

  • II.1 Labor as a source of economic value

    • Adam Smith (Wealth of Nations) popularized the labor theory of value: value is determined by labor required for production.
    • Quote (paraphrased): "Labour is the real measure of the exchangeable value of all commodities; the toil and trouble of acquiring it is what determines value."
    • David Ricardo and Karl Marx also supported labor-based views; Marx argued value could be objectively measured by average hours of labor required.
    • Historical context: Industrial Revolution and productivity gains as machines and specialization emerged; early factories highlighted labor’s role.
    • Luddite movement (early 1800s) protested labor-saving machinery; now broader meaning includes fear of technological progress.
    • Smith’s discussion connected labor with value in simple goods; early production relied on labor with limited machinery.

  • II.2 Economic value as objective (intrinsic)

    • Early thinkers (Petty, Cantillon) proposed objective/value grounded in production inputs (land, labor).
    • Simple production of the era supported objective value: natural value reflected land and labor inputs; Cantillon emphasized land as a determinant.
    • With technological progress and complex production, value ideas evolved beyond simple objective measures.
    • Smith acknowledged more complex production; value then considered as the sum of labor costs, capitalist profit, and land rent for complex goods.
    • Conclusion: objectivity of value diminished as production grew more complex.

  • II.3 Subjective approaches to Economic Value

    • Mill helped shift toward a subjective approach: value depends on usefulness and buyer preferences, not inherent product features.
    • Value is location- and time-dependent; varies by buyer and context; aligns with the concept of marginal utility.
    • Marginal Revolution (Walras, Jevons, and others) introduced mathematical tools to model utility and subjective value.
    • Utility: usefulness to the buyer; can be functional (productive utility) or subjective (brand, aesthetics).
    • Not all utility is directly observable; revealed preferences are inferred from behavior (consumers buy based on willingness to pay).

  • II.4 Economic Value and the “Marginal Revolution”

    • Marginalists defined value via utility and willingness to pay rather than production inputs.
    • Utility varies across individuals, groups, and over time.
    • Marginal value decreases with additional units of consumption (diminishing marginal utility).
    • Mathematical intuition: the marginal value is the slope of the utility function with respect to quantity consumed.
    • Practical implication: price and quantity are driven by marginal utility and marginal costs.

  • II.5 Takeaway about value concepts

    • Modern economics treats value as subjective and measurable via consumers’ willingness to pay, not intrinsic product properties alone.
    • The average economic value of a good is often approximated by the average price buyers are willing to pay.

III. What is a Value Chain?

  • Simple value chain: path of exchange from supplier to firm to buyer; money flows from buyer to firm to supplier (right-to-left), goods flow left-to-right.
  • Use of simple example: QuestroApples.
    • Supplier: Honeypot Hill Orchard (HHO) -> Firm: QuestroApples -> Buyer: end consumer.
    • Visuals: horizontal value chains (goods flow left-right); payments move right-to-left.
  • Use of vertical representation when analyzing value creation/capture to illustrate multi-step processes.
  • Conceptual takeaway: value chains can be extended with more suppliers and buyers to capture more complex interactions.

IV. The Value Stick – a framework for thinking about Value Creation and Value Capture

4.1 Value Creation – the two-party scenario

  • Two components define value creation in the basic case: willingness to pay (WTP) of the buyer and the firm’s cost (C).
  • Value Created in a single step: ext{Value Created} = ext{WTP} - ext{Cost}
  • The buyer’s spending (price) does not itself determine value created; value created depends on WTP and Cost, not on P.
  • WTP: the hypothetical maximum amount a buyer would spend if resources permit; depends on both productive utility and features that appeal to the buyer.
  • WTP can vary across consumers (average WTP is used for firm planning).
  • Cost: approximate as total costs divided by total units sold; includes many cost components depending on the firm and time period.
  • Note: WTP can be influenced by both functional utility and perceived/subjective features (brand, packaging, etc.).

4.2 Value Creation – an example using the two-party scenario (QuestroApples)

  • Example numbers: Cost = $5 per bag; average Buyer WTP = $10 per bag.
  • Value Created = 10 - 5 = 5; QuestroApples creates $5 of value per bag.

4.3 Value Capture in the two-party scenario

  • In a simple two-party value chain (buyer and firm), price determines how value is split between the two.
  • Value Captured by the Firm (Profit): ext{Profit} = P - C
  • Value Captured by the Buyer (Consumer Surplus): ext{Consumer Surplus} = ext{WTP} - P
  • These equations imply:
    • Firm profits rise with higher price relative to cost.
    • Buyer surplus increases when price is well below WTP.
  • Important intuition: value created is driven by WTP and cost; price itself reallocates some of that value between buyer and firm but does not create value.
  • The example emphasizes average price and average cost across the firm’s product portfolio (e.g., BMW with multiple models).

4.4 Value Capture – an example using the two-party scenario (QuestroApples)

  • Updated scenario: firm sells at average price P = $8; WTP = $10; Cost = $5.
  • Value Created remains ext{WTP} - ext{C} = 10 - 5 = 5.
  • Value Captured by the Buyer (Consumer Surplus): ext{CS} = ext{WTP} - P = 10 - 8 = 2.
  • Value Captured by the Firm (Profit): ext{Profit} = P - C = 8 - 5 = 3.
  • Takeaway: prices influence the split of value; higher demand can lift prices and/or volumes, affecting capture; increased competition can reduce prices and shift capture toward buyers.
  • Note: all value in the two-party chain is created by the firm at the one step where the product is sold.

V. How can firms create value?

5.1 Overview

  • Firms create value by either:
    • (1) Increasing average Willingness to Pay (WTP), or
    • (2) Decreasing average costs.
  • These depend on both product characteristics and how the product is delivered or perceived by customers.

5.2 Drivers of Willingness to Pay

  • WTP reflects productive utility and features that appeal to buyers; not mutually exclusive categories but interacting effects.
  • Investments that increase functional utility tend to increase WTP:
    • Example: a detergent that cleans more dishes with the same amount of product.
    • Medical treatments with fewer side effects while maintaining health benefits.
    • Semiconductors with faster calculations.
  • Innovation can raise WTP by introducing new products or improving existing ones (e.g., Adidas soccer cleats with adjustable-length spikes; Bose’s active noise-canceling headphones).
  • Other investments affecting WTP include:
    • Product innovations, process innovations, or technological innovations that enhance features.
    • Accessibility and convenience enhancements (location, distribution, availability).
    • Reputation and perceived quality (e.g., fresh, tasty, chemical-free apples).
    • Subjective product features that appeal to consumers (branding, logos, jingles).
  • Figure 7 (factors affecting WTP) highlights:
    • Functional/productivity factors: utility, reliability, performance, efficiency, etc.
    • Perceptual/appeal factors: brand loyalty, packaging, advertising, visuals, environmental/societal impact, legality, etc.
    • Contextual factors: income, geography, weather, age, gender, expectations, etc.

5.3 Drivers of Cost

  • Average cost is the ratio of total expenditures to total units sold; a simple, approximate method:
    • ext{Average Cost}
      oughly= rac{ ext{Total Costs}}{ ext{Total Units Sold}}
  • Costs depend on many inputs and are allocated over time; fixed costs and scale affect averages.
  • Example considerations for QuestroApples:
    • Costs of obtaining apples, packaging, labor, physical stand, land rent, insurance, etc.
    • The simplification averages across product variety and time period to obtain a single cost figure.

VI. How can firms capture value?

  • Value capture is not identical to value creation; firms may create value without capturing it if WTP increases do not translate into higher prices.
  • Key conditions for value capture:
    • Increases in WTP must be accompanied by higher prices or reductions in costs that allow higher margins.
    • If WTP rises but price does not, the extra value flows to consumers as Consumer Surplus rather than to firms as profit.
    • If higher WTP leads to higher volumes and drives down average costs, capture can improve via margin expansion.
  • Summary: the path from WTP and cost improvements to profit depends on price and competitive dynamics; price changes, competition, and capacity to raise prices influence capture.

VII. Extending the Value Creation and Value Capture Framework to >2 Parties

7.1 Value Creation and Value Capture in an extended value chain

  • Upstream and downstream extensions are possible; add more suppliers or buyers to the chain.
  • General insights when you extend the chain:
    • Total Value Created across the chain equals End Consumer’s WTP minus the average cost of inputs to the first firm in the chain.
    • Value Captured by each firm equals the firm’s selling price minus its own average cost.
    • For the firm at the focal point, its average cost equals the price its supplier charges the firm.
  • In other words, value creation is a chain-wide phenomenon grounded in the initial input price and the final consumer WTP; capture occurs at each step via margins.

7.2 The extended value chain using a now-familiar example

  • Extended example: add Honeypot Hill Orchard (HHO) as supplier to QuestroApples.
  • Given: average input cost to HHO is $4 per bag; firm cost (to buy apples) is $5; end consumer WTP is $10; end consumer price is $8.
  • Calculations:
    • Value Created across the extended chain: ext{Value Created} = ext{WTP} - ext{CS} = 10 - 4 = 6.
    • Value Captured by the Buyer (Consumer Surplus): ext{CS} = ext{WTP} - P = 10 - 8 = 2.
    • Value Captured by the Firm (Profit): ext{Profit} = P - CF = 8 - 5 = 3.
    • Value Captured by the Supplier (Supplier Profit): ext{Supplier Profit} = CF - CS = 5 - 4 = 1.
  • Key takeaway: extending the chain reallocates portions of value toward suppliers, firms, and buyers depending on margins at each link.

7.3 Additional extensions we could pursue (not in scope here)

  • Include even more upstream suppliers and generalize the three-party logic further.
  • Explore rivalry effects: competition can influence prices, WTP, and costs via product and process innovations and supplier pressures.

VIII. Conclusions and Takeaways

  • Value concepts: distinguish value (complex, multi-faceted) from economic value (lab-based or marginal-utility-based frameworks).

  • Historical arc: labor theory of value gave way to objective/intrinsic ideas, then to subjective, marginalist notions emphasizing utility and willingness to pay.

  • Value Creation & Value Capture framework:

    • Value Creation depends on WTP and Cost; price affects only capture, not creation.
    • Value Capture depends on price and cost dynamics; higher WTP can increase capture if price rises or costs fall.

  • Multi-party value chains illustrate how value is created across the chain and how margins accrue to different participants (supplier, firm, buyer).

  • Foundational formulas to remember:

    • ext{Value Created} = ext{WTP} - ext{Cost}
    • ext{Profit (Value Captured by Firm)} = P - C
    • ext{Consumer Surplus (Value Captured by Buyer)} = ext{WTP} - P
    • In extended chains: ext{Total Value Created} = ext{WTP}{ ext{End}} - ext{CS}{ ext{Beginning}} and for intermediaries, ext{Firm Profit} = P - CF,\, ext{Supplier Profit} = CF - CS with the respective symbols defined in context.

  • Important implications: competition, innovation, and distribution strategies shape how value is created and who captures it; ethical and practical considerations must be weighed when applying these concepts to real-world business decisions.

  • Key examples and notions to remember for exams:

    • QuestroApples: simple two-party and extended three-party value chains with explicit numeric illustrations.
    • WTP vs. Price vs. Cost relationships and their impact on consumer surplus and firm profit.
    • Marginal utility and the idea that average value is often proxied by average prices.

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