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Value creation and value appropriation
Simon Rodan
Assistant Professor of
Organization and Management
College of Business
San JoséStateUniversity,
One Washington Square,
San José, CA95192-0070
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Please do not quote or reproduce without the author’s prior agreement
Handout for Business 189 undergraduate course in Strategic Management
Value creation
In any economic exchange between two parties, be they people or firms, value is (or at least should be if one assumes rationality) created. Why? A long and involved answer would deal with heterogeneous tastes and gains from specialization. However, a quick illustration will suffice.
If you buy a product, you are presumably happier after the transaction now that you own the product than you were before when you had the money you used to make the purchase. You may even have been prepared to pay a little more than you did to get the product. Similarly, the manufacturer is presumably happier after the transaction since (one hopes) it has sold the product for more than it cost to make.
The value that is created in this exchange is the difference between what it cost to make the product and the highest price you as a customer would have paid for the product. This is why economic activity, in theory at least, creates value.
In the diagram the left hand ‘T’ represents the highest price you might have paid for the product. The right hand ‘T’ represents the value created manufacturer’s costs. The difference between these two is a measure of the economic value created in the exchange.
Note that we have assumed rationality – that you will never pay more than you think the product is really worth and that the firm will never sell a product for less than it cost to make. In assuming rationality, we guarantee value is created. If both parties in the exchange behave rationally, the price charged must be greater than cost of manufacture and less than highest value you place on the product. This means that value must be equal to or exceed cost and value is created.
Note that the price you actually paid does not appear in this picture. That’s because the value created doesn’t depend on the price, only on the benefit you derive from owning the product (or its dollar equivalent) less the cost of making the product.
Value appropriation
Now we need to bring the price you actually paid back into the frame. We begin by assuming rationality as before, so that that value is created in the exchange.
The value appropriated by the producer is simply the difference between the price charged and the cost of manufacture. This is essentially the firm’s profit. However, note that this is not all the value created in the transaction – there is also the value you appropriate, the difference between what you might have paid if pushed and what you actually paid. This is the ‘consumer surplus’, a measure of the degree to which you feel you ‘scored’ a bargain.
In a perfectly competitive market, the price you pay will be exactly equal to the long run average costs the producer incurs to make the product. Here the value appropriated by the firm is zero – their receipts are exactly equal to their marginal cost plus their cost of capital. You, on the other hand, did very well since the price is far lower than you would have been prepared to pay.
In a monopoly market with perfect price discrimination, the monopoly firm charges each buyer a price equal to his or her highest value. In other words, for each transaction, the price charged is exactly equal to the highest price the buyer is willing to pay. Here, you as the buyer, appropriate nothing while the firm appropriates all the value created. Normally even in monopoly market, price discrimination is not perfect so there is some consumer surplus. Most markets fall somewhere between theses two extremes of perfect competition and perfect price discrimination monopoly. That is there are several firms and non are able to appropriate all the value from each of the products they sell.
If the value created in each transaction is the same irrespective of the price, why are monopoly markets considered economically and socially undesirable?