New Theory for Economic Value

We all know the microeconomic theory that "price is a function of supply and demand." What if this theory were missing an essential variable? What if that missing variable had major implications to economic outcomes?

In this article, I will demonstrate why "business model" is that missing variable.

Price is a function of Supply and Demand

For simplicity, let's start with what is currently understood, illustrated as a simple formula:

Price = Demand / Supply  (e.g., P = D / S)

As demand increases or supply decreases, the price rises; and as supply increases or demand decreases, the price increases.

Simple enough, which is why it's taught at the very beginning of every basic economics course.

The term "supply and demand" was first coined in 1767 by James Denham-Steuart (thank you, Wikipedia), at a time when the common person had access to only one model: CASH. Subscriptions were available but were paid by cash in advance, and lines of credit were available only to the very rich.

250 years later, we live in a radically different world.  The average consumer has access to many different models, including debit cards, credit cards, layaway, digital subscriptions, reward programs, loyalty programs, and so on. Each model can encourage transactions--but the unavailability of a particular model can prevent a transaction.

But what happens with price, supply, and demand in the modern world?

Let's look at some examples.

Example 1 - Cash only

You walk into a Chinese restaurant to buy a meal.

You identify the dish you want, they have all the necessary ingredients, and you place your order.

However, you then discover that the business accepts only cash, but you want to pay by credit card.  So you leave with an empty stomach.

There was supply. There was demand. Both parties agreed on price.

Yet the economic value was zero, because no transaction occurred.

Example 2 - Negotiating price

You visit an electronics retailer to buy a new television for your grandparents.

After comparing various features and products, you select one with an acceptable price.

You then decide to practice your negotiating skills by haggling on price. Eventually, the retailer agrees to a 10% discount for your efforts.

However, the retailer wants cash, but you want to use an advertised interest-free option--which they won't combine with the discounted price.  So you leave empty handed.

There was supply. There was demand. There was an agreeable market price.

Yet the economic value was zero, because no transaction occurred.

Example 3 - Alternative

The TV dealer understands your frustration and offers you an alternative:  You could receive the discount you negotiated by putting the TV on layaway (or lay-by, in some countries), and paying it off over 4 weeks.

However, you want the TV now, not in 4 weeks. For all you know, your grandparents could be dead by then.

We're back to the economic value of zero, because no transaction occurred.

Example 4 - Digital media

You want to watch a TV episode online (obviously - that television wasn't for you).

It's available on a subscription streaming service. But you're not a subscriber, and you don't want to subscribe to watch only one episode, or even one season.

There was supply. There was demand. The price?

Some will argue there was a problem with the price of the subscription; however, 'all you can eat' subscriptions shift the risk to the consumer as 'breakage'. If you subscribe and watch only the single TV episode, you lose money. If you subscribe and watch many TV episodes, then you save money. And let's face it, subscriptions require a commitment, and most of us are commitment-phobic--especially toward strangers who want to sell us monthly commitments.

You don't want to subscribe for one 45-minute TV episode at $9.99 per month.  Once again the economic value was zero because no transaction occurred.

Example 5 - To rent, or buy?

You find an alternative streaming service that offers the TV episode for $3.

However, they want to sell it to you, but you only want to watch it once.

You believe $3 is too much to watch the episode once. After all, a 45-minute TV episode for $3 makes no sense, especially when 3 hours of a $200M production of Lord Of The Rings costs you $5 to rent.

Economic value? You've got it--zero!

Example 6 - Piracy

Finally frustrated with your TV viewing options, you do a quick search online and download a pirated copy of the episode.

The content owner screams "You're stealing from me", to which you respond, "go fuck yourself - I tried to buy your TV episode but you wouldn't rent it to me at a fair price for one viewing".

The owner threatens legal action, and you resort to encrypting your internet behavior, making it impossible for the owner to identify you and enforce his legal threats.

Plenty of supply. Plenty of demand. A disagreement on price, with no ability to negotiate.

And the economic value is once again zero, because no transaction occurred with the legitimate owner of the content. In fact, this situation might result in negative value, because of the administrative overhead of enforcing Draconian laws.

You get the idea. It's all insanity fueled by a poor understanding of human behavior and business mechanics.

The pattern

If two parties can't agree on how to do business (even if there is supply and demand and they agree on price), then no transaction occurs, and the economic value is zero.

Economic Value is a function of Model and Price

How transactions are performed is usually defined by a business model, or for simplicity, a Model.

Let's illustrate this new theory as

Value = Model * Price  (e.g., V = M * P)

Let's treat Model as a discrete variable with the possible values: 0, 1 (Disagree = 0; Agree = 1).

Disagree (0)

If no single Model is acceptable to both parties, Model = 0, and the effective Value is also 0.  Price, supply, and demand simply do not matter. When you consider the examples provided earlier, that's precisely what happened. A disagreement on model equals zero economic value, even where price is agreed upon.

Price * 0 = 0

Agree (1)

If a Model is acceptable to both parties, Model = 1, and a transaction occurs. Then the mechanics of price come into play, and the economic value usually reflects the price.

Price * 1 = Price

Expanding the theory

It's conceivable that the Model can act as a multiplier.

For example, when there is a choice of cash or credit, cash can sometimes provide a discount (e.g., Model = 0.9), whereas credit can impose a penalty (e.g., Model = 1.05). In fact, the Model might have a significant multiplier effect in some industries, such as luxury goods (e.g., Model = 2 or more).

Quantifying the value of a business model is an entirely different problem, and that problem helps explain why the discrete version is preferred.

The implications to business

Multiple Models are better than one Model.

By increasing the number of Models available, you increase the odds that buyers and sellers will find a mutually agreeable Model. This subsequently increases the likelihood of transactions occurring.

Of course, you need to have the necessary business infrastructure to support many models, but those are operational and marketing problems. Some businesses have cleverly incorporated two models, such as eBay's Auction and Buy Now buttons.

Are you an economist?

This is a rudimentary introduction to this theory.

As an engineer, I don't have much time for academic rigor, although we have filed a patent on the high-speed application of this theory of economic value.

That said, I'd welcome discussion of these insights with any economist over a drink. Hell, I'll buy - and we can discuss that model too.  :)


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