Welcome to my blog.  I’ve created it with the purpose of exploring some ideas I have about the social nature of business.  As an economist, I’m convinced that socially responsible business is the most effective social mechanism available to help society at large to answer both its mundane and most profound problems.

Back in the late 18th century, Adam Smith penned his famous Wealth of Nations.  Within it he argued that the pursuit of self-interest motivated individual agents to pursue behavior that coincidentally forwarded the common good.  Roughly a century later, Vilfredo Pareto introduced the concept of Pareto efficiency, a state where resources could no longer be reallocated without making at least one party worse off.  In its opposing state, it is possible through the reallocation of resources to make someone better off without making anyone else worse off.  Doing so then seems a necessarily socially responsible course of action.  Finally, in the mid-twentieth century, Friedrich Hayek described the social role of prices in effectively communicating information about the relative opportunity costs of resources to a broad and diverse array of decision makers.

It is this idea that underlies the concept of value creation – the central theme of my interests.  It is the self-interested pursuit of profit that most efficiently motivates the reallocation of resources from lower to higher valued use.  The entrepreneur who successfully recognizes the opportunity to hire resources away from other market uses in order to produce a good or service of greater value in effect creates value for society.  Value that the entrepreneur rightfully may claim some portion of for her or himself.  Conversely the business owner who fails to recognize and remedy the reduction in value-generation from her or his activities reduces value to society and often, though not always, will see a corresponding reduction in her or his own financial success.

Value Creation

When a business engages in a value-generating activity it uses existing resources (e.g. labor, capital, and material) – resources that would otherwise be used in some alternate activity.  But this now foregone alternative also had some value.  And so “value” is only created if the new use provides more value to the market than the alternative. 

Fortunately markets to some extent insure this.  Imagine that an old building is being used as a warehouse.  It has value in this use.  But then a real estate developer sees an opportunity to redevelop the building as loft apartments.  How much will she have to pay for the building?  The current owner’s own valuation will be directly proportional to the revenue the building currently generates as a warehouse, which in turn reflects its use value to the current occupants.  If the building has greater value as loft apartments, then the real estate developer will be able to pay enough to compensate the current owner for the loss of this revenue and still profit from the redevelopment.  Otherwise, no transaction will take place.

This is a fundamentally important concept for any potential business owner.  A business enterprise can be successful only to the extent to which it is able to identify opportunities to generate net increases in market value.  And so, the essence of business is the search for such value-increasing opportunities.

Value Drivers

Value is created when resources are diverted from less valuable to more valuable use.  Uber, for example, created value by connecting otherwise idle resources (drivers and their personal automobiles) with individuals in need of a ride.  Such innovations are perhaps the most popularized source of value creation.  In addition to ridesharing, social networking, frozen yogurt, and online music streaming were all important innovations that created significant new market value.

Additional drivers include improvements in quality, market reach, and operational efficiency.  Quality is the overall extent to which a product or service meets customer expectations.  Fred Smith, the founder of FedEx, increased quality by reducing delivery time and increasing predictability of parcel deliveries.  Likewise, Darn Tough Socks uses an emphasis on durability to create a premium product in what is otherwise largely a commodity market. 

Market reach is simply the expansion of an existing value proposition to a new or wider market segment.  The publishing platform Medium created value by expanding publishing opportunities to writers who might have otherwise had difficulty finding an outlet for their work.  Satellite television provided expanded programming to customers in rural markets underserved by cable television.

Finally, operational efficiency is the process of accomplishing a given activity with the least possible use of resources.  However, with efficiency, the value generated is done so only indirectly.  If the production of an automobile requires the use of 100 pounds of aluminum, and this can be reduced to 80 pounds, the excess 20 pounds can be redirected to another valued use.  It is this new alternate use that is the actual source of the value creation. * 

*Efficiency can be controversial however, particularly when it involves labor resources.  It may be possible to train a data entry clerk to enter 200 orders per hour instead of 100, ostensibly freeing a second clerk for other use.  But the implicit costs imposed on the remaining clerk may (and often does) offset these more readily measurable gains. 

Value Capture

any increase in value and then capture enough to sustain the business.  This has become increasingly difficult with the transformation of business from product to service to information.  The result is a proliferation of business models.  But generally, these reflect one of two broad value capture models: direct or indirect payment.

In a direct payment model, the consumer of the product or service pays for it her or himself.  For most products and services this works well.  It is true that the seller must determine an appropriate price that yields sufficient revenue to cover both direct and indirect costs while not compromising competitiveness.  But these methods are widely understood and generally practiced.

The same is not true however in the marketing of information.  Even when it is possible to control access and so avoid the free rider problem, many potential buyers balk at the suggestion of direct payment.  And so, content providers must adopt indirect payment models.  With an indirect payment model the payer and the consumer are different.  The classic advertising model is an example of an indirect payment model.  The advertiser is willing to make payment to the original content provider in exchange for access to that providers’ customers. 

Overview

Why leave something straightforward when you can so easily add a diagram.  The following outlines the preceding discussion.  It’s the role of business to reallocate existing resources from a lower valued alternate use.  The source of the value gain can either come from a new higher valued use or from the more efficient use of resources.  Either way value is created that is shared between the customer in the form of “consumer surplus” and the business owner and other related parties.

I appreciate you visiting this blog.  I’ll be adding thoughts I have as quickly as I find the time.  Please do share your feedback.  Right now, simply click on my photo to access the contact page.  I look forward to hearing from you. 

Steve