Wednesday, March 11, 2009

What is this funny thing called value?

The central tenet in a lot a economics and strategy is this concept called 'value'. These days, I seem to be ploughing through one engagement after another building all sorts of valuation models and therefore I present my (rather muddled) musings on this notion that has vexed me through many a sleepless night.

In its most basic sense, 'value' is said to be 'created' in an activity if the benefits exceed its costs (note that this could be economic, social, metaphysical, whatever). That is to say, if the outcomes exceed the effort you put into an activity, you have created value.

This notion is of course extendable to a group of individuals who come together to form, say a firm, and thus if they create something together thats worth more than their effort, the firm's created value.

The question is, who determines the worth of the outcome?

This is clearly relative. If the output is being consumed by the creators (say, if I wrote a piece of code to search my own data), then I determine the value (say, the amount of time it saved me from going through the data manually).

But in most situations, we are concerned about the worth of the outcome to the market. Value, in a market context, is set by the consumers who would benefit from the outcome. (In the same example, if I started giving out the piece of code to all, value is set by the benefit to all who utilize it).

Of course, this is a bit simplistic. What if there is a big group of similar producers (like a lot of people writing the same code) and consumers could ideally choose between any producer? Value created is then bounded by the how much of it can be consumed. In economic terms, this point is where the market 'clears' and a price is set.

The interesting question of course is, how much of this 'value created' will each of the creators and consumers capture? The answer, is clearly not easy to determine and (it seems) is dependent upon market structure and the bargaining power of each in the market.

If you would recognize, in a firm's context, this question is what a lot of strategy literature tries to answer. The whole notion of 'competitive advantage' or 'strategic moats' (and all those Porter 5-force models) is largely linked to identifying those elements that enable a firm to gather as much of value as is possible from its market interactions. In a micro-sense, this is the realm of pricing theory.

(These days, there is also this interesting field of research in coalitional game theory, thats trying to answer the question from a GT point of view. See this and this).

'Shareholder value' creation by a firm is therefore largely linked to its ability to participate in a marketplace that values its output and then its ability to appropriate as much as possible from its interactions.

Value creation is an oft bandied term. Whoever knew so much lay beneath.
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