Oftentimes, I am accused of being “too academic” in my presentations. Oddly enough this occurs more often when I perform present, a session entitled 'How to Set Price.'
During this session, I lead the participants through a detailed step-by-step process of developing a proposal for particular customer including prices.
“That was great, but it was too theoretical. You didn’t tell me how to calculate my price,” the professional will say to me afterwards. It is then that I understand their problem – they have the wrong theory. Ironic, right?
The Labor Theory of Value
Far too many professionals remain mired in the labor theory of value. This theory dates in some ways back to the ancient Greeks, but even the great economist Adam Smith fell for its deceptively simple and eminently practical formulation – the value of something equals the amount of labor it takes to create it.
However, it was Karl Marx who honed the theory in to what he called his Law of Value:
A commodity has a value because it is a crystallization of social labor. The greatness of its value, or its relative value, depends upon the greater or less amount of that social substance contained in it; that is to say, on the relative mass of labor necessary for its production. – Value, Price and Profit, 1865.
If all this sounds familiar, it is because many professionals have crafted a modern revision of this theory: Value = Rate x Hours. Yes, the billing (and sadly, pricing) system most en vogue throughout the professions is nothing more than a bastardized formulation of the Marxian Labor Theory of Value. Firms that bill by the hour, or even capture time to “allocate costs” are practicing Marxists!
The irony here surpasses the fact the many professionals tend to vote Republican, but extends to the notion that they try to use the theory of a guy who thought profit (he called it, surplus value, which is basically the exploitation of the worker in his view) was evil, yet they attempt to make a profit in their business using this same theory. This is ludicrous and, fortunately, easily disproved.
If the labor theory of value is true, how can the lump of coal extracted from behind the diamond out value the diamond? Similarly, if all hours are of equal value, then the hour devising a brilliant tax strategy saving someone tens of thousands of dollars must be equal to the hour spent finding a miscalculated formula on a spreadsheet. This is clearly false, yet most professionals pretend as if it is true anyway.
We Need a Better Theory
In science, once a theory is falsified, scientists who continue to insist that it is true are branded quacks. Since the labor theory of value has been falsified, the time has come for professionals to move on or be branded quacks. As futurist Alvin Toffler has said, “The illiterate of the 21st century will not be those who cannot read and write, but those who cannot learn, unlearn, and relearn.”
Fortunately, a better theory exists.
Only six years after Karl Marx published Value, Price and Profit in 1865, a revolution in economics began. Three economists, Williams Stanley Jevons, Carl Menger, and Leon Walras, working separately in different countries posited the subjective theory of value in 1871.
In essence, the theory postulates that value equals what the customer perceives it to be, i.e., it is subjective. The concept builds on an idea that had been kicked around for quite centuries, the idea of marginal utility – the value of something is dependent upon its position in relation to the margin. This why your value your fifth or sixth slice of pizza (or shot of tequila) is valued less than the first.
The theory also explains why the same quantity of water can have dramatic differences in the price that you are willing to pay. A pint of water at a sporting event might set you back a few bucks. However, if you are at home washing the dishes, you will pay a fraction of a penny.
If the water is flooding your basement, you will likely need to pay someone to remove it, i.e., it has negative value. Curiously, the cost of getting that same quantity of water to each of those three places is nearly identical.
Likewise, this is true with hours worked by a professional. It is clear some “hours” are “worth” considerably more than others. It is impossible for the professional, no less the customer, to distinguish the value of each hour. Sometimes a brilliant 15 minutes of high-value only follows after what appears to be dozens of low (or no) value hours.
How and Why Do People Buy
The door to understanding unlocks when we focus on the customer. If value is what the customer perceives (subjective theory) then we must have an understanding of how and why people buy.
My co-host, Ron Baker of the VeraSage Institute and I recently explored this topic in depth on an episode of our radio show, The Soul of Enterprise: Businesses in the knowledge economy, entitled Episode #152: The Psychology of How and Why People Buy.
We identified six theories that we regularly discuss on our show:
- Simon Sinek: people buy “why” you do, not “what” you do
- Theodore Levitt: people buy expectations
- Joseph Pine and James Gilmore: people buy experiences and transformations
- Michael LeBoeuf: people buy good feelings and solutions to problems
- Clayton Christensen: people buy a product to do a job
- Kevin Kelly: people buy “generative value” – the unique value this is created only at the time of purchase from you
All of these provide some terrific insights into the mind of buyers and are worthy posts unto themselves. More importantly, they are all significantly better than thinking value equals rate times hours.
Psychologist Kurt Lewin once said, “There is nothing so practical as a good theory.” If your theory is wrong, no amount of practical application will improve it.