CREATING VALUE and CAPTURING VALUE

CREATING VALUE

• Value Creation (also called Value Added)• Value is created anytime an action is taken for

which the benefits exceed the costs, or anytime an action is “prevented” for which the costs exceed the benefits.

• This applies to several aspects of production: quantity, quality, entry, innovation, method of production. Also applies to relationships between the firm and its employees, e.g., job safety.

CAPTURING VALUE

• The concept of value creation says nothing about profit. The benefits are measured to the consumer; the costs to the firm—you can’t determine profit just from that.

• The selling price determines the amount of value that is “captured” by the firm—that contributes to the firm’s profits. (Producer Surplus)

• The other value isn’t lost. It is retained by the consumer. It is the difference between what the consumer would have been willing to pay and the price. (Consumer Surplus)

RELATIONSHIP BETWEEN CREATING VALUE AND

CAPTURING VALUE

• The two don’t have to be related.• One can create value without capturing any of it.• You can’t capture value without creating it, but

you can capture more value while creating less.• Human nature often means that there is no

incentive to create more value unless one can capture some of the value that is created. Or, people will create more value if they can capture more of the value they create.

CREATING / NOT CAPTURING

• When a monopoly lowers prices “too much,” it creates more value (since the benefits of the extra units > the costs), but captures less (since the price has gone below the profit maximizing level).

• (Ratchet Effect) An employee discovers how to make the product twice as fast and shares it with his coworkers, then the boss requires twice as much output from all workers. (Employee perspective.)

• I get the salvage fixed so it no longer pollutes.

CAPTURING / NOT CREATING

• Whenever two firms conspire to raise prices, together they create less value, since less people are buying units for which benefits > costs, but they are capturing more of the value they create. This is anticompetitive behavior and outlawed by the antitrust laws. Our capitalist system is “biased”—properly—toward activities that create value. (That’s not biased against capturing value.)

• The employer in the previous example.• I sign up for dental insurance just before I get a

crown put in. (I’d have gotten the crown anyway.)

WHY THE VALUE CREATION PERSPECTIVE IS USEFUL

Why Not Just Focus on Value Capturing, or On Profit Directly?

REASON THE FIRST: IT MAY BE YOUR OBJECTIVE

• It is reasonable to suppose in many health care institutions, particularly not-for-profits, that value creation is the objective.

• In a health care context, value creation means in essence providing as much care, and as good care, as you can as long as the benefit exceeds the cost. Value capture would mean only undertake actions that increase profit.

REASON THE SECOND: IT CAN BE A USEFUL “TRICK” IN FIGURING OUT

HOW TO CAPTURE MORE VALUE• If you create more value, you can (at least in

theory) capture at least some of it for yourself.• Focusing on value creation initially may help you

find ways to better serve the customer and, in the process, profit yourself.

• Often one of the problems you uncover is that the “agent” would not capture any extra value that would be created and so does not create it.

• The Theater example. (Also 2 HW problems.)• Don’t get me started!!

REASON THE THIRD: CREATING MORE VALUE MIGHT BE THE ONLY WAY TO

CAPTURE MORE VALUE• When markets are highly competitive one must

increase profits through value creation. Trying to capture more value without creating more value will make many customers go to competitors.

• It is competition that forces the close link between capturing value and creating value.

• This is why “competition” and “information” (which drives competition on the buying side) are so important for market efficiency.

Application: Encouraging Good Health Habits I

• Good health habits, such as good diet, regular sleep, and exercise, will create value to the extent the benefit of the improved health exceeds the cost of having these habits.

• If the individual was an uninsured hermit, all costs and benefits would accrue to that person and so we assume the appropriate choices are made. However, an insured individual has the consequences of poor health habits subsidized and will confer external benefits of good health to loved ones. Therefore we expect underprovision of good health habits.

Application: Encouraging Good Health Habits II

• So our objective is to encourage “appropriately good” health habits in the face of incentives for “good habit underprovision.” Consumers will underprovide even if they are perfectly informed about the consequences of health habits. We need to correct these incentives or provide counterincentives, and will capture value if the savings in health expenses exceeds the cost of the incentives.

• So, how? Experience rating, tying arrangements…

MANAGED CARE, VALUE CREATION, AND VALUE CAPTURE

• Two main “instruments” of HMOs—UR and Prospective Payment—are instruments of value creation. They try to limit procedures for whom benefit < cost. How much of this value is captured by consumers depends on market competition.

• Selective Contracting is more about value capture: since the physician and hospital markets are not highly competitive, it is possible to use market power to extract lower prices from “suppliers.” However, this incidentally also increases value creation in the market by making prices more competitive.

THE ROLE OF COMPETITION

MARKETS ARE DYNAMIC!

• Markets change for many reasons: changes in preferences, costs, technology, politics, etc.

• Health care markets are facing many of these challenges: changes in labor costs, technology, regulation, insurance, etc.

• Because there is believed to be considerable inefficiency in the health economy, some of this is about creating more value.

• Because many health markets are not highly competitive, some of this is also about value capture (without necessarily creating extra value).

INTERMEZZO ABOUT DYNAMICS OF THE

PERFECTLY COMPETITIVE MARKET

Order Out of Chaos• Now we see what was behind Arrow’s survivor

principle: competition would ensure that only those business practices would survive that delivered the best value to the consumer. Over a long time frame, this also maximizes value creation in the market.

• Given enough competition, business practices that create the most value will survive, and the competition will ensure that consumers capture most of that value. This is because of personal greed, not in spite of it! (This is Adam Smith’s “invisible hand.”)

• Managed care fits well into this framework: it is a competitive market in which self-interest has led to innovations that, if successful, will ultimately create value and lower prices to consumers. However this market has had trouble finding successful innovations!

GENERAL FORCES DRIVING MARKET DYNAMICS

• Innovation. The incentives for innovation depend on how much value can be created and how much of it the innovator gets to capture.

• Replication. Replication of successful ideas ultimately erodes the profit from those ideas and returns most value created to the consumer.

• Entry and Exit. Entry into markets also erodes profit and returns most value created to the consumer. Exit helps restore “normal profits” to firms. The speed of entry depends on many factors, which are often regulated in HC markets.

ILLUSTRATION: MKT. FOR PHARMACEUTICALS

• Innovation. Supported by patents on successful drugs. Development costs are high and success chancy—thus large incentives are needed.

• Replication. When a patent expires formulae are easily replicated, so generic markets develop quickly.

• Entry and Exit. Firm entry in the brand name market difficult, because of high entry costs and the difficult of developing expertise in R&D. Thus market had a long string of profitable years. Entry is easy in generic market so profits are more reliably “normal profit” and price stabilizes fast.