The value that is created by activities in a business is potentially complex and diverse. It results from  relationships with other players in the economy including its customers, suppliers and other businesses that deal with those same players, ie, competitors and complementors. Given this, it is useful to consider a stylised representation of the process of value creation in order to state a definition of value that is readily applicable to realistic situations.

A very simple way of defining value is to track a particular activity of a business. Recall that a business utilises inputs from suppliers and turns them into products that it’s the customers desire. The flow of product from suppliers, through the business, to the customers is referred to as the value chain of production, which is depicted in the figure below. It shows the vertical flow of goods and services and also money between customers, your business and suppliers.

These flows will only occur if the relevant decision-makers -- customers and suppliers -- are willing to engage in their respective transactions. Customers must be willing to exchange money (the product price) for the business’ product and suppliers must be willing to accept money (input payments) for the provision of inputs. Finally the business will only be willing to participate in the value chain if there is a positive gap between product price and input payments, ie, some “money on the table”. It is only when there is such a gap that value is created.

Creating Value Through Exchange

There will only be value created if the highest possible price exceeds the lowest possible input payments. The highest possible price is, by definition, the customer’s willingness-to-pay for a product while the lowest possible price is defined by the supplier’s willingness-to-sell. Therefore, additional surplus will only be created if a customer’s willingness-to-pay exceeds suppliers’ willingness-to-sell. Thus, the total surplus is the difference between the customers’ willingness-to-pay for a product and the suppliers’ willingness-to-sell that product (this is the additional value created through exchange).

As an example, suppose that a customer’s willingness-to-pay for an ice cream at a sports stadium was $3. An ice-cream vendor at that stadium has a willingness-to-sell of $1 he sells an ice cream to that customer. Therefore, if an exchange or transaction were to occur, the total surplus would be $2; equal to the difference between the customer’s willingness-to-pay of $3 and the vendor’s willingness-to-sell of $1. So long as one can determine the willingness-to-pay and willingness-to-sell associated with a particular transaction, one can easily quantify that transaction’s total surplus.

Businesses can appropriate some of the value created by bringing customers and suppliers together in completing the value chain. However, it will not usually appropriate all additional value because price will often be less than a customer’s willingness-to-pay, and input prices may exceed suppliers’ willingness-to-sell. So it is the difference between price and input price that will determine a business’ profitability. The first step for business is, therefore, to ensure that it assists in creating value.

To see how to identify customers and suppliers, click here.

Value Creation with Many Agents

The above discussion considered trade between a customer and a supplier. However, many trading situations involve more than two agents. Here we briefly review two of the most important of these (i) when there are many customers and sellers and (ii) when there are several providers of complementary goods.

Many customers and sellers

In addition to building the building blocks of value, willingness-to-pay and opportunity cost are directly related to the economic concepts of demand and supply, respectively. Indeed, by definition

For each unit price of a product, the quantity demanded for a product is the quantity of output for which a customer’s willingness-to-pay for a unit of output exceeds price.

For each unit price of a product, the quantity supplied of a product is the quantity of output for which suppliers’ willingness-to-sell for a unit of output exceeds price.

Notice that, given this definition, as the price falls, quantity demanded for a product will rise, as more customers are willing to pay for more units of output. On the other hand, as price falls, quantity supplied is likely to fall if suppliers face diminishing returns

Not only are the concepts of demand and supply related to the underlying sources of value, they are also useful concepts in determining what level of output would maximise the total value created. To see this, suppose that a market for a product consists of four customers, with willingnesses-to-pay of $1,000, $800, $600 and $400 for a single unit of the product, and four suppliers who are able to produce one unit of output each at willingnesses-to-sell of $900, $700, $500 and $300. Recall that there is value created when the willingness-to-pay of a customer exceeds the willingness-to-sell of a supplier. So it would be tempting to think that supplier 1 could supply customer 1, supplier 2 could supply customer 2, etc. In this case, the total value created in the market would be $400 as each customer’s willingness-to-pay exceeds their supplier’s willingness-to-sell by $100.

This matching of customers and suppliers would not maximise the total value created. Consider an alternative matching whereby customer 1 is matched with supplier 4, customer 2 is matched with supplier 3 and the remaining two customers and suppliers do not trade at all. In this case, the total value created is $1,000 (= 1,000 - 300 + 800 - 500), which is higher than the situation where all four customers are supplied. Moreover, notice that, given this, if either of the other customers were supplied, value created would be lower as those customers’ willingnesses-to-pay would be below the suppliers’ willingnesses-to-sell. So to maximise the value created, customers 1 and 2 must be supplied with suppliers 1 and 2 and no other trades should take place.

This example illustrates a more general principle: in order to maximise the total value created, the customer with the highest willingness-to-pay should be matched with the supplier with the lowest opportunity cost, the customer with the next highest willingness-to-pay should be matched with the supplier with the next lowest opportunity cost and so on. Moreover, trades should not take place beyond the point where the willingness-to-pay of the next customer is less than the willingness-to-sell of the next supplier.

It is important that the matching exercise is used to order customers and suppliers to form demand and supply curves and find their intersection. In our example, so long as two units are sold from suppliers 3 and 4 to customers 1 and 2, the total value created is maximised. Thus, customer 1 could purchase from supplier 3 and customer 2 from supplier 4; generating the same level of value.

This situation can be depicted graphically where we rank customers from highest to lowest willingness-to-pay and suppliers from lowest to highest willingness-to-sell. This is done in the following figure. The line of customers’ willingnesses-to-pay is what is called the market demand curve for the product while the line of suppliers’ willingnesses-to-sell is the market supply curve. Notice that the value created is maximised where the two curves intersect: that is, where demand effectively equals supply.

By considering willingness-to-pay and willingness-to-sell in terms of demand and supply, it becomes easier to see what quantity will the greatest value. As we will see in segment 4, market forces, whereby prices change in response to shortages and surpluses, can ensure that demand equals supply and hence, the total value created is maximised.

To see a commentary of how demand and supply might assist in understanding whether or not to invest in new products to save time, click here.

Co-Operating with Complementors

A more subtle form of value creation comes from dealing with complementors.

An agent is your complementor if customers value your product more when they have the other agent’s product than when they have your product alone.

Interdependent industries often co-operate to achieve greater profitability. Such co-operation is called “coopetition”.

This is perhaps easiest to see with complementary products. The existence of and demand for complementary products can improve industry profitability. After all, complementary products stimulate demand for an industry's products. For example, a customer is willing to pay more for shaving cream and razors when they are both available than razors and shaving cream separately.

Coopetition occurs in the computer software and microprocessor industries. The demand for the processing power supplied by microprocessors results in part from the development of complex computer software. In addition, the introduction of complex computer software necessitates microprocessor advancements that can execute software commands. As a result of their interdependence, these industries co-operate with open exchanges of information, which benefits both industries.

Another way of viewing complementarity is on the supply-side.

A player is your complementor if it is more attractive for a supplier to provide resources to you when it is also supplying the other player, than when it is supplying you alone.

If a particular supplier has a greater willingness-to-sell to you and another customer together than to each separately, then you and the other customer are complementors in supply. For instance, some customers might use a broadband Internet connection during the day while others might use it at night. If both types of customers are available, an Internet provider can provide the service to each at a lower price than it could if only one type were available.

Click here to see how specialisation can be a means of achieving coopetition.

Click here for a discussion point.

Topic Summary

In this topic, you have learnt how to

• identify value-creating trading opportunities in a vertical chain by comparing a customer’s willingness-to-pay to a seller’s willingness-to-sell

• relate willingness-to-pay, willingness-to-sell and value created to the demand and supply in a market

• identify the potential for value creating co-operation between complementors

Now go on to topic 2.4, “Dividing Value”.