The history of economic thought regarding the concept of value is “a tale of two theories”. The Labor Theory of Value states that value is equal to the sum of the labor and materials to create something. The Subjective Theory of value states that value is the perception in the mind of the customer. Ron Baker and Ed Kless discuss these theories from chapter 8 of Ron's book Pricing on Purpose.
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Early Theories of Value
- What was Adam Smith's paradox?
- In The Wealth of Nations, published in 1776, Adam laid out the Diamond-Water Paradox.
- Nothing is more useful than water, but it will purchase scarce anything.
- Diamonds have scarce any value in use, but quite a few other goods may be had in exchange for it.
- Smith's answer was diamonds are scarce, but he was incorrect.
- Scarcity does not create value.
- Your kids drawings are scarce, but that does not mean they are valuable.
- Value is in the perception of the customer.
- Adam struggled with this philosophy his whole life.
- David Ricardo provided the theory of comparative advantage.
- On his deathbed, he struggled with why wine is more valuable over time.
- The lump of coal found behind the diamond is not worth as much as the diamond, despite the same amount of work to retrieve it.
- Undeveloped land should have no value if there is no labor in it.
- Finding a diamond should make it worth less.
- Labor on a movie is the same, so everyone should like it the same.
- David's theory affects knowledge work like commodities.
- In The Wealth of Nations, published in 1776, Adam laid out the Diamond-Water Paradox.
- Who were the French Physiocrats?
- They thought the labor theory of value was wrong, and the only thing with value was land.
- For example, if you raised sheep and got the wool, that was OK.
- However, if you took the wool, knitted it into a cap and then tried to sell it, you were exploiting the shepherd.
- Jean-Baptiste Say named them The Physiocrats.
- It is is the most-wrong theory of value.
- Fewer people are working in manufacturing, but we produce twice as much.
- Inputs do not measure the value; the outputs do.
- Some believe marketing does not create value, but that engineering does.
- Rory Sutherland talks about how intangible value was used to create a marketing campaign that saved Shreddies.
- What was the contribution of Karl Marx?
- He was the first to put a theoretical framework around the labor theory of value.
- He wrote Value, Price and Profit, saying that a product has value because it is a crystallization of social labor.
- In 1871, a group of economists demolished the theory once and for all.
- Many believe the labor theory of value is poor for pricing.
- However, to use a time sheet to determine your cost also uses the labor theory of value.
- How you allocate an hour is irrelevant.
The Subjective Theory of Value
- Why are theories of value a “gray area”?
- Economic ideas do not drop out of the sky.
- Ron believes he was the first to make the link between the Marxist theory of value and the billable hour.
- Steven Landsburg is an economist that Ron and Ed respect.
- The labor theory of value is cost-plus pricing and is a table stake of higher education.
- Earned Value is an attempt to understand the value by further convoluting the labor theory of value, developed by government accountants.
- A customer does not buy a bundle of assigned costs; they buy a finished product.
- Marx completely ignored the customer, as did the other philosophers, until the subjective theory of value was developed.
- Your first shot of tequila is worth more than the 19th, just like your first ice cream cone is more valuable than the 5th.
- What was the Marginalist Revolution?
- Between 1871 and 1874, three economists helped debunk the labor theory of value:
- William Stanley Jevons, Great Britain
- Léon Walras, France
- Carl Menger, Austria
- They each published books that said Marx was wrong, and that value is subjective.
- In Principles of Economics, Menger says that value is a judgment that a man makes about the importance of the goods at his disposal.
- Nothing, except human life, has intrinsic value.
- The subjective theory of value looks at it from the customer's perspective.
- A bottle of water in the desert is priceless.
- If you are home washing the dog, it has less value.
- If you are flooded in your basement with water, it has a negative value.
- The cost of getting the water to each place is about the same.
- The subjective theory of value changed economic theories tremendously, but business people are stuck in the labor theory of value.
- Philip Wicksteed, in 1884, wrote that a coat is not worth 8 times as much as a hat because it takes 8 times as long to make it, but rather that the maker is willing to put 8 times as much effort into making it because of its value.
- Alfred Marshall in the 1890s drew the supply and demand curves, which confused the issue as well.
- Most economists who came afterward spent the majority of their time measuring things to create economic math.
- You have to dismiss the economic math if you believe the subjective theory of value because it does not matter.
- If you go to a restaurant, you cannot separate the value of the experience from the chef and the janitor.
- Between 1871 and 1874, three economists helped debunk the labor theory of value:
Business and the Theory of Value
- Why does “business” not accept the Subjective Theory of Value?
- Perhaps, business schools are failing to education in this area.
- Intuitively and logically, the subjective theory of value is easy to grasp.
- It is extraordinarily difficult to put into practice.
- You can be 100% efficient at the wrong thing and make the situation worse.
- Alan Weiss said that all the theoretical books were written for economists, not businesses.
- For decades, cost plus accounting has been good enough.
- The labor theory of value requires a calculator; subjective theory of value requires courage and judgment.
- Attorneys are paid to apply their judgment, but are afraid to use that judgment to price.
- Ad agencies are another example of providing customers with excellent pricing power, but they commoditize their work through an hourly rate.
- Offering options can eliminate negotiation completely, or make it very specific.
- What is the future of the Subjective Theory of Value?
- Ed says that the future is irrelevant, because of The Great Enrichment.
- Everything will be value-less; the Star Trek universe is coming.
- Ron says that the subjective theory of value has made inroads.
- You have to convert one mind at a time.
- We do not have to understand aerodynamics to fly. We do not need to understand it the theory of value to act on it every day.
- The Answer to the Diamond Water Paradox is:
- The water in the desert is highly valued because it can save your life.
- The marginal gallons become less valuable.
- Gossen's Law says that the market price is determined by what the last unit of a product is worth to people.
- The water companies do not know if you are dying in the desert or flooding your basement.
- The marginal value of a second diamond is high because you can store it for later.
- The airlines understand the paradox.
- Price the customer, not the product or service.
About Ron Baker & Ed Kless
Ed Kless was a guest on Episode 2, The Value of Project Management, and Ron Baker on Episode 13, Value is Subjective, Pricing is Contextual. Ron and Ed are co-hosts of The Soul of Enterprise radio talk show.
- Talk Show Website: TheSoulOfEnterprise.com
- Ron on Twitter: @RonaldBaker
- Ed on Twitter: @EdKless
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