Wednesday, May 29, 2013

Deriving Value

If you've read a significant amount of economics research you've probably noticed that economists love to reward participants with money.  This phenomenon is not a result of economist's love for currency. Rather it's due to a simple fact, monetary preferences for a rational being are obvious and intuitive.  Any logical being would rather have five dollars than four, rather four dollars than three and so on and so on. On the other hand when economists compensate experiment participants with goods or services another wrinkle is added to the interpretation of results.  Not only do experimenters have to account for preferences for a given decision, but for a given reward as well.

Here's an example. Suppose we constructed an experiment to determine how potential reward affected effort. We give people a simple task in which they have sixty seconds to turn a crank. As they turn the crank a line of lights illuminate indicating levels of reward. After five lights light up they receive a dollar, after ten lights two dollars and so on and so on. Thus we can create a model associating effort and reward rather easily.

However, suppose instead of currency we rewarded participants with fruit. After five lights they'd receive an apple, after ten lights a pear, after fifteen lights a peach etc etc. Now interpreting the participants efforts becomes much more difficult. Does the individual reduce effort after ten lights because rewards have severely diminishing impact on effort, or do they simply not like peaches?

In essence monetary rewards are used so frequently because they have a relatively uniform and predictable valuation between individuals. While a wealthy man may value a ten dollars far less than a middle class man we can usually assume they both value ten dollars more than five dollars and less than twenty dollars.

Outside the laboratory questions of value are rarely so simple. In fact, researchers aren't entirely sure how we determine value for ourselves.

Imagine for a moment that you go to a new restaurant. You're presented a menu with a single item on it that you've never heard of before. You're given a small sample, which is enjoyable, and shown what you would be served if you choose to eat at the establishment.  Assuming you're asked how much you'd like to be charged how would you decide what to pay?

Probably you'd think of what dinner usually costs you at a restaurant. Perhaps you're used to paying approximately fifteen dollars for a meal.  Then you might consider your surroundings. If the eatery featured neon signs and checkered table clothes you are likely to want to pay less than if leather and hardwood are prominent. Of course the taste and presentation of the food probably feature prominently in your decision as well.  Everyone would go through this same process and yet everyone would come to very different conclusions. Many diners would value the dinner at ten dollars while others would pay ten times that amount. So what causes these wildly different valuations?

The core difference generally speaking is experience.  Those who are used to paying more would usually opt to be charged more than those who are used to paying less.  So if past experience is the primary factor in valuation does value just become a constant process of adjusting past evidence to current reality?

One theory of valuation is that value is instilled during youth, primarily by parents. From then on value is simply a continuous process of updating expectations. I remember as a child gas cost slightly under a dollar a gallon. Since then, slowly but surely, gas prices have risen. As has my understood valuation of fuel.  Conversely as a youth computers were rare and valuable commodities which have now become nearly disposable in their commonality.

Their are implications in business for this theory as well. The designer coffee phenomenon that began in the 90s demonstrated this phenomenon clearly. At the time coffee was cheap, quick and grabbed on the go from a gas station or doughnut shop.  Starbucks transformed the coffee experience from fast and cheap to slow and expensive by transforming their product. Had they simply sold a medium coffee like every other corner store it's unlikely anyone would have been willing to pay six dollars a cup. However, by selling a venti double shot low foam latte they caused consumers to separate their value expectations of Starbucks from that of coffee. Although they were selling essentially the same product they differentiated it sufficiently that consumers did not apply their low coffee valuations to the product, allowing Starbucks to successfully demand a much higher price.

There's still a great deal of mystery surrounding how value is created. The presented theory seems plausible and is backed by a great deal of research, but it is not the only theory, nor is it conclusive. In time, with additional research, a consensus on value formation will arise. Until then the discussion of possibilities is half the fun.

Until next week stay safe and rational.

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