Value Creation and Value Capture

Value Creation and Value Capture

I. What is value?

  • Importance of understanding "value" and "what do humans value?"

    • Complexity arises from interdisciplinary perspectives.

    • Various fields, including psychology, economics, philosophy, and religion, offer different interpretations.

    • Example religious perspective:

    • "Do not toil to acquire wealth; be wise enough to desist. When you set your eyes on it, it is gone, for it will surely sprout wings and fly away like an eagle."

      • Proverbs 23:4-5

    • Philosophical perspective: Intrinsic vs. instrumental value

    • Stanford Encyclopedia of Philosophy, "Value Theory," Section 2.1 states,

      • "Of course, the central question philosophers have been interested in, is that of what is of intrinsic value, which is taken to contrast with instrumental value…"

    • Money is typically viewed as not intrinsically good; it is valued for what it can lead to, such as:

      • HD TVs

      • Houses in desirable school districts

      • Vanilla lattes

  • Current definition of value:

    • "Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing people make about the importance of the goods at their disposal for the maintenance of their lives and well-being."

    • Carl Menger, 1871

  • Acknowledgment of diverse cultural traditions defining value:

    • Moral and ethical values vary across time, place, and person (e.g., truth, justice).

    • These values are foundational to economic and business activities.

  • Introduction of frameworks exploring morality and ethics in business.

  • Emphasis on that economic value may not reflect the entirety of moral and ethical values.

II. What is economic value?

II.1 Labor as a source of economic value

  • Economists' inquiry into the nature of economic value:

    • Adam Smith's contributions (1723-1790).

    • His seminal work, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), presents labor theory of value.

    • Labor is a measure of exchangeable value:

      • "Labour is the real measure of the exchangeable value of all commodities…"

      • Wealth of Nations, Chapter 4

  • Other economists supporting labor theory:

    • David Ricardo (1772-1823): Introduced comparative advantage.

    • Karl Marx (1818-1883): Furthered labor theory; suggested value can be objectively measured by average human labor hours needed.

  • Observations about the Industrial Revolution:

    • Smith noted early productivity gains were due to machinery and specialization of labor.

    • Changes during the Industrial Revolution highlighted shifts in value dynamics.

  • Luddite movement as opposition to job-replacing technology:

    • Originated from textile workers protesting machinery.

    • The term "Luddite" now applies to anyone opposed to technological advancements.

II.2 Economic value as objective (or intrinsic)

  • Labor theory as one of the approaches to understand economic value as objective:

    • Other proponents include William Petty (1623-1687) and Richard Cantillon (1680-1734).

  • Increasing complexity from technological advancements changed perspectives on economic value.

    • Smith noted that value for complex products should be understood via a process of "adding up" including:

    • Labor costs

    • Profit of the capitalist

    • Land rent

  • Shift toward a recognition that economic value may not be purely objective.

II.3 Subjective approaches to Economic Value

  • Transition from classical economics (Smith, Ricardo, Marx) to modern economics:

    • Emerging subjective valuation of economic goods:

    • John Stuart Mill (1806-1983): Value determined by the market demand and subjective perception.

    • Marginal Revolution introduced mathematical approaches:

    • Utilized calculus to develop theories around utility and value.

    • Value is based on individual perception rather than inherent characteristics.

  • Subjective valuation illustrated through potential buyers' willingness to pay (WTP).

  • Understanding of marginal value in consumption:

    • Satisfaction decreases with additional consumption of a good (diminishing marginal utility).

II.4 Economic Value and the “Marginal Revolution”

  • Léon Walras and William Stanley Jevons contributed to the understanding of utility:

    • Value derived from usefulness to consumers, which varies across individuals and time.

  • Abstract and formal theories built using mathematical tools.

  • Utility reflects consumers' preferences and is essential in determining economic value.

  • Consumer observable behaviors can infer value and preferences rather than self-reported data.

III. What is a Value Chain?

  • Introduction to the concept of a value chain:

    • Path of exchange from supplier to firm to buyer.

    • Simplified illustrations of value chains show flows:

    • Goods/services flow from left to right (supplier to firm to buyer).

    • Payments flow from right to left (buyer to firm to supplier).

  • Example: QuestroApples.

    • QuestroApples sources apples from Honeypot Hill Orchard (HHO) and sells them to consumers.

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

4.1 Value Creation – the two-party scenario

  • Value creation defined through:

    • Buyer’s willingness to pay (WTP).

    • Firm’s costs.

  • Value created formula:

    • Value \, Created = WTP - Cost

    • Depicts differential between what consumers will pay and what firms spend to discover value.

  • Nuanced definition of WTP reflects utility of product/services and product appeal.

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

  • Example calculation with QuestroApples:

    • Cost of apples = $5/bag, WTP = $10/bag.

    • Value Created = Value \, Created = 10 - 5 = 5

    • Thus, $5 of value created.

4.3 Value Capture in the two-party scenario

  • Understanding value capture through price.

  • Formulae for value capture:

    • Firm Profit: Value \, Captured \, by \, Firm = P - C

    • Consumer Surplus: Value \, Captured \, by \, Buyer = WTP - P

  • Highlights:

    • Value captured is influenced by firm costs and buyer’s willingness to pay.

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

  • Value Calculations for QuestroApples:

    • Selling price = $8/bag,

    • WTP = $10, Cost = $5.

  • Computed values:

    • Value Created = $5

    • Consumer Surplus = $2 (WTP - P: $10 - $8)

    • Firm Profit = $3 (P - C: $8 - $5).

V. How can firms create value?

5.1 Overview

  • Methods for firms to create value involve:

    • Increasing WTP

    • Decreasing average costs.

5.2 Drivers of Willingness to Pay

  • WTP influenced by:

    • Product’s utility and appealing features.

    • Innovations impacting utility increase WTP (example: Adidas cleats).

    • Subjective features (branding, aesthetics) also play a role in increased WTP.

  • Factors impacting WTP:

    • Income, geography, branding, advertising, consumer expectations, social impact.

5.3 Drivers of Cost

  • Average Cost conceptualization:

    • Total costs divided by total units sold yield average costs.

    • Elements of average costs include:

    • Production, labor, supply chain, rent, and insurance.

  • Cost innovations can help firms produce more efficiently, thus reducing average costs while maintaining quality.

VI. How can firms capture value?

  • Differentiating creation from capture of value:

    • Not all firms' WTP increases lead to profit without a corresponding price increase.

    • Cost decreases, while sustaining WTP increases, are essential for capturing added value.

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

7.1 Value Creation and Value Capture in an extended value chain

  • Analysis expands to recognize multiple parties.

  • Generalized value chain illustration reflects:

    • Total Value Created = End Consumer WTP - Average cost of inputs to the firm.

    • Value Captured computed for each firm using standard formulas.

7.2. The extended value chain using a now-familiar example

  • Applying QuestroApples context:

    • If HHO's cost is $4, appropriate computations yield:

    • Value Created = $6, Consumer Surplus = $2, Firm Profit = $3, Supplier Profit = $1.

7.3. Additional extensions we do not pursue here

  • Future exploration involves extending with more suppliers or examining competition effects on prices and WTP.

VIII. Conclusions and Takeaways

  • Overview of critical concepts:

    • Conceptual definition and nature of value.

    • Distinction between economic value and subjective perceptions.

    • Value Creation and Capture framework and its application in various contexts.

References

  • Marx, Karl (1867/2006) Das Kapital. New York, NY: Atlantic Monthly Press.

  • Menger, Carl (1871/2007) Principles of Economics. Auburn, AL: Ludwig von Mises Institute.

  • Mill, John Stuart (1838/2012) The Principles of Political Economy. Cambridge, UK: Cambridge University Press.

  • Routledge Blog (2022) "Nature: Can we put a value on it?”

  • Smith, Adam. (1776/2010) An Inquiry into the Nature and Causes of the Wealth of Nations. Hampshire, UK: Harriman House Limited.

  • Stanford Encyclopedia of Philosophy, “Value Theory,” Section 2.1 “Intrinsic Value.”

  • Stobierski, Tim (2020) “Willingness To Pay: What It Is & How To Calculate,” Harvard Business School Online – Business Insights.