The Philosophy of Value and Price

On Value and Price

There is one question I have been asked thousands of times during my career: ‘What is the most important aspect in pricing?’

My answer has always been ‘value’ or ‘value to customer’. To be even more precise, the best answer is ‘perceived value to customer’. Why do I say that? The customer’s willingness to pay a price and, thus, the opportunity of the seller to obtain that price, is nothing but the reflection of the value perceived by the customer.

This simple insight is not new. It derives from Latin, the language of the Romans, who used the same word, pretium, interchangeably for value and for price.

Value = pretium = price

Language contains a lot of philosophical wisdom. This linguistic truth from Latin is the eternal equation of pricing. Value and price must always be balanced. Business people who adhere to this simple equation avoid making big mistakes in setting their prices. The equation also applies to the buyer, who, as the saying goes, ‘gets what you pay for’.

The concept of ‘value equals price’ is so fundamental and universal that I would call it a philosophical equation. It tells us that pricing should not be primarily concerned with price as such, but with value instead. It also teaches us that understanding, creating and communicating value is the key challenge in pricing.

The equation can also be interpreted to mean that price has an impact on value. This causality has been proven many times, especially in the recent past under the terms ‘irrational consumer’ and ‘behavioural economics’ (Kahneman, 2012; Simon, 2009; Smith, 2021).

On ‘Value in Use’ and the Sharing Economy

The eternal equation begs the question: ‘What is value?’ One of the first known answers to this question comes from the Greek philosopher Socrates (469–399 bc) who said that ‘happiness does not come from ownership, but from the use of a product’ (McBrayer et al., 2011). In contemporary terminology, we speak of ‘value in use’ (Pfisterer & Roth, 2018). We can therefore consider Socrates to be the father of a very modern concept, the sharing economy. ¹ In the sharing economy, one does not own a car, a scooter or an apartment; one uses it, often only for a defined period. The increasingly widespread implementation of the sharing economy is radically transforming entire industries.

Why was this revolutionary Socratic idea not implemented earlier? The answer is obvious. Transaction costs of sharing were too high prior to the arrival of the Internet. Selling a scooter at US$1,000 requires one transaction. Sharing it in increments of minutes or hours means thousands of transactions over the life of a scooter. Offering a car on a per-hour basis or a bicycle on a per-minute basis requires an extremely efficient transaction process and the ability to bring together a critical mass of buyers and sellers. Neither is it possible without the Internet.

At the same time, Socrates denied the value of ownership. I consider this a flaw. Ownership can have intrinsic value, in addition to or even without ‘value in use’. Think of a Ferrari displayed in front of its owner’s house but never driven. Does the owner derive value from that car? Of course! There are two reasons for this. First, owning something is likely to convey more status than sharing something. In his famous classic The Theory of the Leisure Class published in 1899, Thorstein Veblen described this phenomenon, which is also called ‘snob effect’ (Veblen, 1899). A second, very modern, argument is that sharing is always based on an ‘incomplete contract’. This concept goes back to Nobel laureate Ronald Coase, who explained why firms exist and own their assets (Coase, 1990). Coase said that within a firm, transaction costs can be lower, and that sharing, renting or leasing is always based on an incomplete contract. Only ownership grants you the right to do anything with the object in question. You cannot repaint a leased car or an Airbnb apartment, nor can you sell it. But if you own it, you can tear it down, repaint it, sell it, dismantle it or whatever. Ownership has a higher value than anything based on an incomplete contract. The issue of incomplete contracts gains new importance with so-called smart contracts and blockchain technology.

Can the value of ownership versus the value of sharing/renting/leasing be observed in real life? I think so. Here is a current case. The ‘ownership price’ of a given BMW 7 series car is €110,510, while the leasing price per month is €1,231 for a leasing period of 3 years. Thus, in 3 years, the consumer pays a total of €44,316. Without financing costs, the payback period amounts to 89 months or 7.5 years. If you add financing costs there is hardly a way for the seller to get the ‘ownership price’ through leasing. A possible explanation is that ownership plus value in use creates higher perceived value than mere value in use, and that certain consumers are willing to pay the higher ownership price. Socrates may have missed this aspect.

On Value Differentiation

We owe many of the more sophisticated insights on value and price to the Greek philosopher Aristotle (384–322 bc). He observed that value in use can vary among individuals. This is the basis for the ubiquitous value and price differentiation we experience today (Aristotle, 1912; Simon & Dolan, 1998; Younkins, 2005). Aristotle also noted that the value in use declines as the quantity of goods increases. This fundamental law is better known as Gossen’s Second Law (Gossen, 1854), formulated by Hermann Heinrich Gossen (1810–1857). This law of diminishing marginal value is the foundation for non-linear pricing (Tacke, 1989).

Aristotle also mentions that the value of a product can depend on the use of another product. This insight provides a rationale for multi-product pricing and for so-called price bundling (Simon & Wuebker, 1999). He also observed that the value in use will increase if the good can be consumed conspicuously, which leads us back to the snob or Veblen effect. Finally, one can draw a direct line of reasoning between Aristotle and Karl Marx. Aristotle stated that labour as a commodity has value but does not create value. This essentially contradicts Marx’s labour value theory, which we will discuss later.

On ‘Just Price’

The concept of ‘just price’ dates back to Thomas Aquinas (1225–1274) (Tawney, 1984). Today, we use the term ‘fair price’ in a similar sense. Aquinas looked at pricing from an economic and an ethical perspective. His ideas were strongly influenced by the Christian tradition against usury and against interest in general. In his view, raising prices in response to increasing demand amounted to stealing. Aquinas also explicitly stated that charging higher prices in the wake of natural disasters is unethical and was against charging higher prices for higher values in certain situations.

This latter topic is highly relevant, as illustrated by the report ‘Price Gouging After Hurricane Sandy: Immoral or Law of Supply and Demand’ (Futrelle, 2012). It concerns the pricing for power generators during and after a hurricane in the USA. In such an emergency, a power generator obviously has a higher value than under normal conditions. Should the seller raise the price after a disaster? If the price is kept constant, the first buyers will buy several generators and resell them at a higher price. Is this just?

Another interesting case is Uber. After a terrorist attack in Australia in 2014, the demand for cars surged and the Uber programme automatically increased the surcharge (Vinik, 2014). This makes economic sense because the higher fees attract more cars to the site from which people want to flee. The value of immediate evacuation from the terror site is very high. But Uber got a very negative media response to that action. Uber now applies manual intervention if demand rises suddenly and sharply (Co, 2017). After a terror attack in London in 2017, Uber refunded the passengers who had paid the surcharge (Flynn, 2017).

Highly innovative life-saving drugs are another example. Kymriah, a gene-based therapy offered by Novartis, heals a certain type of leukaemia with one injection. What is the value and a just price for this product? In the USA, an application of this drug costs up to US$475,000. In the UK, the National Health Service covers a price of £220,000, but only for children. In Germany, the price is €320,000. Novartis chairman Dr Joerg Reinhardt defends these prices:

We firmly believe that therapies should be paid on the basis of their value. We are determined to set our prices according to this principle. In the future, costs for a genetic therapy will be justified by their value for the individual patient. (Frankfurter Astheimer & Mimh, 2018)

Even higher values and prices can be seen on the horizon. Spark Therapeutics offers a new gene therapy against a gene defect, which leads to blindness in children. The company ‘has said it plans to sell Luxurna in the US at a cost of US$850,000 a patient, but it wants to offer partial refund if patients don’t meet recovery targets’ (The Wall Street Journal, 2019). A recent addition of this kind is Zolgensma, which has been approved by the US Food and Drug Administration (FDA) in May 2019. It heals spinal muscle atrophy, a disastrous disease affecting babies, with a single injection. The price is US$2.1 million. A British institute has estimated the value of this revolutionary innovation by Novartis at US$4 million (Handelsblatt, 2018). Ultimately, one faces the question what the value of a human life is.

Would a different price system be more just? One idea is a refund if the treatment does not yield the promised effect. An alternative could be a price scheme where patients pay 50% of their annual income. A patient who earns US$100,000 per year would pay US$50,000. A patient who makes US$2 million a year would pay US$1 million. While such a system seems unrealistic at first glance, it is actually the basis for income taxes, which one can consider to be the price for government services. For public goods, theory suggests that the price paid by a customer should be equal to the marginal value of that customer (Samuelson, 1954). The income percentage can be considered as a proxy for this marginal value. Is such a life-saving drug a public good?

On Marxian Pricing

Are you a Marxist? You are likely to answer ‘no’. So my next question is: ‘OK, if you are not a Marxist, why is your pricing Marxian?’ While Marx’s labour theory is totally rejected today, it has survived in pricing. What a strange phenomenon! Let me explain why that is the case.

The most important contribution of Karl Marx (1818–1883) was his labour theory of value, according to which only labour creates value. He writes that the ‘values and prices of goods are determined by wages’ (Marx, 1951). Marx allows for differences in productivity and qualifications of workers, and thus for different values per unit of time. But the core of his theory is that only labour creates value. Consequently, labour costs are the sole base for price calculations.

In modern terminology, we call this method ‘cost-plus pricing’. Based on decades of observations around the world, I would guess that 80% of all prices in today’s markets are primarily determined on the basis of costs. And all costs are labour costs. If an automotive company buys parts from a supplier, these parts carry labour costs up the value chain. Lawyers, consultants and most other service providers charge prices for their time (hourly, daily, monthly rates). Whether the time input really reflects value remains a mystery.

On Subjective Value

The so-called subjective value theory could be expressed as ‘value is in the eye of the beholder’ (Mazzucato, 2018). It is widely, but not universally, accepted, and it is also not new. Publilius Syrus, who lived in the first century bc, said: ‘Everything is worth what a purchaser will pay for it’. What is this theory’s implication for pricing? It is ‘value extraction’ or, in the modern Internet vernacular, ‘monetization’ (Ramanujam & Tacke, 2016). These terms encompass all variants of price differentiation or price discrimination, across customers, across product variants, across space and time (for an in-depth treatment of price differentiation and quantification of subjective value, see Simon & Fassnacht, 2019). The Internet has radically improved the opportunities for price differentiation due to much better data and much lower costs of implementation.

However, there is a strong and increasing opposition against ‘value extraction’. Mariana Mazzucato from the London School of Economics is one of the outspoken critics. ‘Things are only getting worse’, she writes:

‘Rent seeking’ refers to the attempt to generate income, not by producing anything, but by overcharging above the ‘competitive price’, and undercutting competition by exploiting particular advantages, or blocking other companies from entering an industry, thereby retaining a monopoly advantage. (Mazzucato, 2018, p. 57)

Her views are seconded by Nobel laureate Joseph Stiglitz, who blames weak regulation and monopolistic practices for rent or value extraction.

A related key question is whether there is a level playing field between consumers and increasingly sophisticated sellers. I think there is. The reason lies in the much higher value and price transparency the Internet provides. Today’s consumers have all kinds of price comparisons at their fingertips. The same increasingly applies to value transparency, thanks to widely used customer feedback mechanisms. Marshall McLuhan’s ‘global village’, first described in 1962, has become a reality (McLuhan, 1962). Understanding value creation and delivery, on the one side, and value extraction (or monetization), on the other side, becomes critical for buyers and sellers. This applies to business-to-consumer (B2C) markets as well as to business-to-business (B2B) markets.

Society and Price

A journey through philosophy yields many additional insights on the role of values and prices in society. I highlight several of them in this final section.

Summary

Philosophy helps both buyers and sellers to better understand value and price. Many concepts, which seem current and modern, actually have ancient philosophical roots. But their implementation has only become possible, thanks to modern information technology and big data analysis.

The eternal equation of pricing will always remain ‘value = pretium = price’, an insight already expressed in Latin 2,000 years ago. While some theories of value and price like the ‘just price’ are generally ignored today, they still apply to certain situations. We do not have solutions for some ethical issues. The widely accepted subjective value theory advocates differentiated value extraction, but increasing opposition suggests that sellers should not overdo price discrimination.

This article provides only a very selective and limited review of the philosophy of value and price. It is by no means comprehensive. It would be easy to write a lengthy book on this topic. Nonetheless, buyers and sellers ignore the philosophy of value and price at their own peril.