Value Creation and Value Capture Study Notes

Value Creation and Value Capture

I. What is Value?

  • Key Questions:

    • What is ‘value’?

    • What do humans value?

  • Complexity of Value:

    • Various fields of study provide different lenses on value.

  • Religious Perspectives:

    • Proverbs 23:4-5 discusses the fleeting nature of wealth:

    • "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."

  • Philosophical Perspectives:

    • Central philosophical question: What is of intrinsic value? Contrast with instrumental value.

    • Example: Money is good not as an intrinsic good but for what it leads to (e.g. HD TVs, houses).

    • Stanford Encyclopedia of Philosophy defines intrinsic vs. instrumental value.

  • Carl Menger's Definition (1871):

    • Value is a judgment made about the importance of goods for maintenance of life and well-being, not inherent in goods themselves.

II. What is Economic Value?

II.1 Labor as a Source of Economic Value

  • Historical Context:

    • Economists have questioned economic value since Adam Smith in 1776.

  • Labor Theory of Value (Smith):

    • Value of goods/services determined by labor in their production.

    • Smith's Definition:

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

  • Key Passages from Smith:

    • Value to the person possessing it depends on labor it can command.

    • “The value of any commodity, therefore, to the person who possesses it, is equal to the quantity of labor which it enables him to purchase or command.”

  • Other Supporters of Labor Theory:

    • David Ricardo, Karl Marx

    • Marx argued value measured by average labor hours for production.

  • Industrial Revolution Context:

    • Early factories highlighted productivity gains from labor specialization.

II.2 Economic Value as Objective or Intrinsic

  • Objective Approach to Economic Value:

    • Value determined by inherent features, not subjective preferences.

    • William Petty and Richard Cantillon contributed to these views.

  • Expansion on Labor Value:

    • Smith proposed “adding up” for complex products involving machinery, land usage.

II.3 Subjective Approaches to Economic Value

  • Transition from Classical Economics:

    • In contrast to classical economists, more modern approaches (John Stuart Mill) focus on market demand.

  • Mill’s View:

    • Value determined by demand sufficient to carry existing supply.

II.4 Economic Value and the Marginal Revolution

  • Marginal Utility Theory:

    • Key thinkers: Léon Walras, William Stanley Jevons.

  • Utility Concept:

    • Value defined by usefulness, can vary individually.

    • Marginal Value:

    • Utility generally decreases as consumption increases.

  • Observations of Behavior:

    • Price reflects average economic value consumers are willing to pay.

III. What is a Value Chain?

  • Definition of Value Chain:

    • Sequence of exchange from supplier to firm to buyer.

  • Simple Chain Visualization:

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

  • Example - QuestroApples:

    • Supplying apples from Honeypot Hill Orchard to consumers.

IV. The Value Stick: Framework for Understanding Value Creation and Capture

IV.1 Value Creation – Two-Party Scenario

  • Value Creation Formula:

    • Value Created = Willingness-To-Pay (WTP) – Cost (C)

  • WTP Definition:

    • Hypothetical maximum a buyer would pay, based on utility and appeal of product.

IV.2 Value Creation Example

  • QuestroApples Example:

    • Cost to obtain apples: $5/bag

    • Average WTP: $10/bag

    • Result: Value Created = $10 - $5 = $5

IV.3 Value Capture in the Two-Party Scenario

  • Definition of Value Capture:

    • Price clarifies how much value each party captures.

    • Firm’s Profit Formula:

    • Profit = P - C

    • Consumer Surplus Formula:

    • Consumer Surplus = WTP - P

  • Example Calculation for QuestroApples:

    • Selling price at $8 means:

    • Value Captured by Buyer = $10 - $8 = $2

    • Value Captured by Firm = $8 - $5 = $3

V. How Can Firms Create Value?

V.1 Overview

  • Strategic Avenues for Value Creation:

    • 1. Increase WTP

    • 2. Decrease Average Costs

  • Understanding Drivers:

    • Investments in functional utility can boost WTP.

V.2 Improving WTP

  • Functional Utility Improvements:

    • Increased efficiency, addressing unmet needs.

  • Innovation Examples:

    • Adi Dassler’s adjustable soccer cleats.

  • Subjective Features:

    • Marketing and branding can influence buyer appeal.

V.3 Drivers of Cost

  • Average Cost Definition:

    • Total expenditure divided by total units sold.

  • Cost-Reducing Innovations:

    • Effective operational changes can lower average costs.

VI. How Can Firms Capture Value?

  • Importance of Value Capture for Business Viability:

    • Firms need to ensure that value created translates to profits.

  • Investments and Pricing:

    • Not all increases in WTP will result in higher prices.

VII. Extending the Value Creation and Capture to More than Two Parties

VII.1 Generalizing the Value Chain

  • Complex Value Chains:

    • Consider additional upstream or downstream transactions.

  • Generalization Examples:

    • Extended tailored diagrams illustrating value creation and capture for multiple parties.

VII.2 Example - QuestroApples Extended Chain

  • Inclusion of Honeypot Hill Orchard (HHO):

    • Average cost of inputs to HHO: $4 per bag

    • Value Created = WTP - Supplier Cost

    • Profit Distribution: Firm, Supplier, and Consumer Surplus definitions and calculations.

VIII. Conclusions and Takeaways

  • Key Concepts Introduced:

    • The nature of value and economic value, highlighting evolution from objective to subjective perspectives.

    • Framework for Value Creation and Value Capture, emphasizing complexity as more parties are involved.