The Economics of Value

David Maister has a post on "Value Pricing" from Friday, October 13, 2006, which is quite interesting, and generated many comments (some from VeraSage Senior Fellow Ed Kless). Since it discusses the origin of value, I thought it important to clarify the economics behind this, since there are so many fallacies regarding the true causes of value and prices.

First, I'd like to thank David for mentioning my book, Professional's Guide to Value Pricing as being the "best source" on the topic.

David makes the following argument regarding value:

However, I think many people who analyze this situation get it completely wrong. They want to call it value pricing because they think that if they create more value for the client, they should be paid more.

Wrong! We like in a capitalist, free exchange society. In such an economy price is not set by what things cost to make, nor the scale of the benefits delivered to the client.Instead, prices are set by scarcity—the relative supply and demand for the service provided. Water has more inherent benefit than diamonds, but diamonds cost more because of an artificially managed supply and demand imbalance.

If you save your client a million dollars through your tax advice (for example), that doesn't mean you deserve a high percent of those savings—IF MANY OTHER TAX ADVISORS WOULD ALSO HAVE ACHIEVED THAT BENEFIT.

The Diamond-Water Paradox

David is restating a conundrum that confounded the great economist Adam Smith [1723-1790], one of the greatest economic and social thinkers in the history of ideas, known as the "diamond-water paradox."Smith explained in Chapter 4 of Book I of Wealth of Nations:

"Nothing is more useful than water: but it will purchase scarce anything. . . . A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it."

None of us would be able to live beyond a couple of weeks without water, yet its price is relatively cheap compared to the frivolous diamond, which certainly no one needs in order to stay alive. This conundrum led to some incredible discoveries, advancing our understanding of value. As the Danish physicist Niels Bohr once observed: "How wonderful that we've met with a paradox. Now we have hope of making some progress."

Most people confronted with this paradox—including Smith—would resolve it by replying the supply of diamonds is sparse compared to water, and hence they command a higher price. This is an intuitive, and very reasonable, solution. After all, water is approximately 71 percent of the earth's surface, while diamonds are found in only a limited number of places in the world, and the supply is even further restricted by diamond cartels, such as De Beers, which of course did not exist in Smith's day.

Yet the scarcity theory lacks explanatory power. If it was true, I, as the author of a book you may someday read, could sign your copy in pink crayon, attesting to the fact that only one copy exists of this book with my autograph in pink crayon. It is like a Picasso, one of a kind—in other words, scarce. How much is it worth? My autograph does not enhance the value of the book by one cent.

Just because something is scarce does not make it valuable. Think about it: if scarcity determined value, then those drawings on your refrigerator from your children and grandchildren should be incredibly valuable, because they are, indeed, rare.

The Marginalist Revolution

Three economists, from three different countries, developed the theory of marginalism and posited the subjective theory of value: William Stanley Jevons [1835-1882], from Great Britain, Leon Walras [1834-1910] from France, and Carl Menger [1840-1921] from Austria.

What made this new theory so revolutionary? As Menger explains in his book Principles of Economics, written in 1873 when he was 33 years old:

Value is . . . nothing inherent in goods, no property of them. Value is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of men. . . . [T]he value of goods . . . is entirely subjective in nature.

The value of goods arises from their relationship to our needs, and is not inherent in the goods themselves. . . . Objectification of the value of goods, which is entirely subjective in nature, has nevertheless contributed very greatly to confusion about the basic principles of our science. . . . The importance that goods have for us and which we call value is merely imputed.

Value is like beauty—it is in the eye of the beholder. Menger further developed this theory with his law of imputation, wherein he labeled final consumer goods "lower order" and the necessary producer goods "higher order" (sometimes called producer goods, or capital goods). He then demonstrated that the demand for the higher-order good—land, equipment, and other necessary input—"is derived from that of the corresponding goods of lower order."

Menger illustrated this concept with the example of tobacco. Suppose, for some reason, that tobacco is no longer desired by people and the demand for it disappears. Existing tobacco products' price would fall to zero, even though it was produced at a considerable cost. But what would happen to all of the necessary factors of production—land, tobacco plants, tools, machinery, and so forth—the higher-order goods? They, too, would drop in price significantly, since the demand for these products is derived from the consumer's demand for tobacco. Some of these goods might have a value, but only in alternative uses, not in the production of tobacco.

When we changed from a horse and carriage economy to the automobile, all sorts of goods of a higher order lost their value—hay production dropped, blacksmiths lost jobs, among others who supplied the old industry.

The popularity of the Atkin's diet will cause many workers in the companies that make pasta, doughnuts, chocolate, beer, and other high-carbohydrate products to lose their jobs. The reason labor unions cannot "save jobs" is because they cannot control what customers value, and it is what customers value that gives them the jobs in the first place. The Channel Tunnel between London and Paris cost billions to build, but the return on investment calculations and sunk costs do not matter to today's customers. They are only concerned with the relative price of taking the "Chunnel," flying, or taking the ferry.

Why Are Diamonds More Expensive than Water?

The value of anything depends on the margin—the edge, the addition (or subtraction) to value. The margin is what happens next. The most difficult decisions we confront are marginal decisions. For instance, few of us waste any time deciding whether or not we have to work; the question is should we work more or fewer hours?

If you were to pile straws onto the back of a camel, eventually the camel's back would break. It might seem reasonable to blame all the straws, but if straws could talk (and think) they would blame the marginal straw—that is, the last one. After all, everything was fine before he got there.

Value depends entirely upon the utility—a measure of pleasure or satisfaction—the customer will receive. Where psychiatrists speak of subjective well-being, economists use the term utility. Each are conveying the same idea: you engage in activities you receive pleasure or satisfaction from, not because others have toiled. People do not smoke to make the tobacco companies rich and happy, but rather from the utility they derive from doing so.

Besides being abundant, water tends to be priced based on the marginal satisfaction of the last gallon consumed. The German economist Hermann Heinrich Gossen [1810-1858] developed what is known as Gossen's Law: The market price is always determined by what the last unit of a product is worth to people.

While the first several gallons of water may be vital for your survival, the water used to shower, flush the toilet, and wash the dishes is less valuable. Less valuable still is the water used to wash your dog, your car, and clean your driveway. The market price of water reflects the last uses of the good for the aggregate of all consumers of water. On the other hand, the marginal satisfaction of one more diamond tends to be very high (even for Elizabeth Taylor).

If water companies knew you were dehydrated in the desert they would be able to charge a higher price for those first vital gallons consumed, and then gradually adjust the price downward to reflect the less valuable marginal gallons. Since they do not possess this information—the cost of doing so would be prohibitive—the aggregate market price for water tends to be based on its marginal value.

Marginalism can also explain other aspects of human behavior not normally associated with the field of economics; like why don't newspaper company racks have elaborate antitheft protections that ensure customers only extract one newspaper at a time, similar to vending machines for soda or candy? Can one conclude from this observation that buyers of The New York Times are more honest than buyers of Coke, as a sociologist or criminologist might reason? Economists would answer no, it is because the marginal value of a second, third, or fourth newspaper is not as valuable as the next Coke, which can be saved and enjoyed later.

What About Supply and Demand?

Alfred Marshall [1842-1924] drew the supply and demand curves you studied in your introductory economics course. With the supply curve reflecting a cost of production concept of value, and the demand curve the utilities of buyers, Marshall merged the classical and marginalist schools together in one diagram.

Marshall believed that prices, over the long run, were based on the costs—including profit—of production, thereby resuscitating Smith's theory. The value (price) of a good was determined by "the scissors of supply and demand." Did one play a more important role than another? Marshall believed they were equally powerfully at influencing price, stating, "We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost." Marshall thought there was a "natural" price, or what he called the long-period price, around which a commodity gravitated, represented by the e (equilibrium) where the two curves crossed.

The Austrian school, however, has some difficulties with Marshall's concept of a long-period price, determined by the interaction of supply and demand. First, they point out that Marshall misunderstood the Marginalists, because the issue is not which blade of the scissors creates value. A price is paid because someone values it, and the price cannot exceed that value no matter what the cost of producing it is. Hence, the supply curve—tallying up costs—does not cause prices to be paid. You can spend a lot of money producing something customers reject.

Second, Marshall's demand curve does not represent how much you want a good, but rather how much of a good you want, at various prices. The former is determined by marginal utility—since it is based on how much you already have, and the subjective value you place on the good—while the latter is depicted by the demand curve showing various quantities demanded over a range of prices. This is why your 15th beer is not as valuable as your first.

As Gene Callahan points out in his book Economics for Real People: An Introduction to the Austrian School:

The notion that prices equal costs is an expression of a tendency in the market, not a description of a state the market ever achieves. "Objective costs" don't necessarily determine price in the long run, because costs are prices themselves. Costs are not objective, both blades of Marshall's scissors are honed by subjective valuation.

Finally, Austrian economists are not obsessed with equilibrium, which they believe is an intellectual abstraction, but not much value in the real world. They contend that free markets work best because of how they deal with disequilibrium, as a dynamic adaptive social system, beautifully illustrated by Schumpeter's phrases "creative destruction" and "dynamic disequilibrium." Equilibrium is for tires, not an economy. Once again, Callahan explains this crucial difference:

Prices and quantities only change as the result of human action. Where in the world can a new price come from if not a human bidding or asking above or below the market price? Supply and demand curves give us a rough picture of market behavior as an effect of human action, and certainly not the cause of it. No one acts with the goal of bringing supply and demand into balance.

In summary, the Austrians contend that what a good costs to produce cannot directly determine its value, but it will determine the quantity that will continue to be made. And since there are rarely "single price" markets, many businesses have the capability of segmenting customers and charging different prices to different groups based on subjective value.

None of this is meant to imply that businesses cannot create the demand for a product. No one "demanded"—or subjectively valued—a Sony Walkman or the Apple iPod before they were produced and offered in the market. Quite often, supply does indeed create demand, especially as it relates to innovations and new technologies. But there is no guarantee of value just because costs were incurred, or there is scarcity; the high rate of product failures is a testament to this fact. Nonetheless, in the long run, a good will only continue to be produced if people value it, and its price can cover its full costs of production.

This is how all markets work. What the proponents of Value Pricing are advocating is charging a price commensurate with the subjective value the customer receives from the purchase. This is far different than pricing based on summing up the costs of inputs and adding a profit.

It is also different than believing there is a "market price" for what you sell. There is no such thing as a market—only us people buy things, not markets. And humans value things subjectively. The Marginalists were (and are) right—that is, until someone posits a better theory.