Pricing, and the Economics of Value Creation

I’m not an Economist; during my high school and college, economics was for me in the category of “couldn’t be more boring.” But time has passed and both events of the world and my life have increasingly interested me in economics, especially as they relate to making business decisions. And I’ve read a lot about the topic econmics in recent years including books and magazines. I love to pick up the Economist from time to time, but since it takes me a week to read an weekly issue, I don’t subscribe to it for fear I’d get nothing else done! :)

Anyway, today I’m writing about a concept I’ve both witnessed and studied many times over the past several decades: the economics of value creation. I’m going to use examples, but am trying to keep it very short so I won’t be referencing other factors that might complicate the picture.

Clayton Christensen argued in Innovator’s Dilemma that good companies trend “Northeast” by which he meant companies typically strive to increase prices and margins (the direction Northeast refers to the trend of the graph of margin over time.) If you speak to any enthusiastic sales rep, you’ll see the same desire; to close as big a deal as possible.

So the tendancy to strive for higher prices is ingrained but often, doing so it counterproductive. What I believe people often fail to consider is the value provided to the potential customer. Yes there are value-based pricing models, but those are focused on convincing a prospect of the “value” to justify a higher price. Instead, I’m referring to the value that can be derived from each and every potential customer; the lower the price the more potential customers can derive value from the service or item sold. Further, I’m focusing specially on services and items used by businesses to create things of even greater value.

Let me explain by using a contrived example:

Let’s assume a small US town somewhere in the 1800s far away from any other town or city (i.e. essentially a closed system.) Let’s assume most inhabitants were farmers, and someone opened a fertilizer plant. Let’s consider two of the farmer’s crops: squash and tomatoes.

Each crop requires a certain amount of fertilizer; let’s assume one (1) unit to grow a squash and three (3) units to grow a tomato. Further, let’s assume that one (1) squash produced twice (2 times) as much food as a tomato, but the town’s people would buy twice as many tomatoes if price were no object.

At first the fertilizer plant owner charged 0.2 cents per unit of fertilizer, and the market set the prices for squash and tomatoes at 5 cents each prior to adding the cost of fertilizer. The town’s average monthly purchases for squash and tomatoes were 10,000 and 20,000, resectively. The fertilizer plant owner made $370 per month, and the farmers made $1640 per month in aggregate for those two crops.

Later, the fertilizer plant owner decided he could raise his prices since he had a local monopoly. He increased by 0.3 cents per unit to 0.5 cents. This forced the farmers to raise their prices to six (6) cents for squash and seven (7) cents for tomatoes. Times being hard, that extra cent for the tomatoes caused the townspeople to rethink their spending habits. Consumption changed to 17,500 squash and only 5000 tomatoes (remember that a squash provided twice as much food as a tomato.)

Guess the net result? The fertilizer plant owner lost $101 per month in sales, and what’s far more tragic, the farmers lost $352.50 per month in aggregate because of a decision they could not control. Well the squash farmers were dancing a jig while the tomato farmers were devastated, but that’s not the point. :) Here’s a table showing the details:

Prices Description Squash Tomatoes Totals Units of Fertilizer Req’d 1 3 Food Units Produced 2 1 Fertilizer Unit/Food Unit 0.5 3 Original Price of Fertilizer = 5 units for 1 cent 0.002 Original Fertilizer Price/Food Unit 0.002 0.006 0.05 Original Food Unit Price as Farmed 0.052 0.056 Original Food Items Consumed 10,000 20,000 Original Fertilizer Units Needed 5000 60000 Original Food Units Consumed 20,000 20,000 40,000 Original Fertilizer Revenue $10 $360 $370 Original Aggregate Farmer’s Revenue $520 $1120 $1640 New Price of Fertilizer = 2 units for 1 cent 0.005 New Fertilizer Price/Food Unit 0.005 0.015 0.05 New Food Price as Farmed 0.055 0.065 New Food Units Consumed 17,500 5,000 New Fertilizer Units Needed 8750 15000 New Food Units Consumed 35,000 5,000 40,000 New Fertilizer Revenue $43.75 $225 $269 New Aggregate Farmer’s Revenue $963 $325 $1288 Lost Revenue Totals Lost Fertilizer Revenue ($33.75) $135 $101.00 Aggregate Lost Farmer Revenue ($442.50) $795 $352.50

Real life is not as clear cut as my example so the fertilizer plant owner would probably not realize the direct cause and effect. Of course in the world today someone would notice that the fertilizer plant owner was raping the farmers, build a second fertilizer plant, and possibly put the first out of business. Hopefully you can see from my example that raising prices doesn’t automatically increase revenue. Sure you might bring up the well known supply and demand curve as evidence this is a no-brainer, the most discussions of supply and demand don’t contemplate the effect of value creation downstream such as the value created by the fertilizer in producing tomatoes. At a reasonable price consumers would buy the tomatoes even though they provided less food. Once the price got too high, their consumption dropped, and so did the fortunes of the fertilizer plant owner and the farmers who grew those specific crops.

Let me bring it back to the real world and give more direct examples:

• Imagine if a business having a toll free telephone number cost $10,000 per year and $1 per minute. How many business would never have started using them, and imagine how much business based on toll free access just would not happen?
• What if the least expensive computer cost $5000 each, like the first PCs used to? Think about how many businesses that offer services today using computers couldn’t offer those services because they couldn’t afford those computers.
• What if there had been no free browser software; if browser software was sold for $199 each, for example? Do you think the world-wide web would have developed?

I could go on and on with examples, but they all boil down to the following:

Items and services used to create added-value items and services follow a different economics model than pure supply and demand. If the price it too high for those initial items and services, overall value creation will be retarded. Conversely, if the price of those initial items and services is lowered, it can empower greater value creation, and the demand for the original items and services may increase exponentially. This definition assumes the value ultimately created supplies an existing demand, or empowers creation of new goods or services for which demand evolves.

I’ll finish with this final example and follow it with a few parting rhetorical questions:

Imagine you invented a process to create an alternative for oil that did not pollute, only cost you one (1) dollar per barrel to produce, and you had no limits on the quantity you could produce. Let’s also imagine you were able to secure exclusive worldwide rights to this process. You could price your oil alternative competitively with the current price of oil or even higher because it did not pollute. If you were a modern day oil company, you would probably do that. Since you controlled the process, you’d probably maintain your high price indefinitely. However, imagine if instead you priced it at half the cost of a barrel of oil? You’d quickly become the leading supplier of fuel in the world (and you would devastate the Middle Eastern economy, but I digress.) And then imagine you continued to slowly lower your price, approaching “essentially free” over time. In this scenario, if fuel were essentially free and it did not pollute, how many entrepreneurs do you think would find ways to create value in new and previously unconsidered ways? How much of your fuel do you think would ultimately be consumed?