Sunday, July 4, 2010

Sources of Economic Value

Lately, my kids have gotten more interested in how they can earn money to supplement their allowances.  My son, in particular, is also trying to understand why certain jobs pay more than others.  Answering their questions has forced me to go back to basics.

The first thing I had to clarify is the difference between social value and economic value.  I define social value as what a person contributes to society as a whole, whether it is monetarily compensated or not.  Economic value, on the other hand, I define as that which a person contributes for which someone else is willing to pay some form of compensation.  The reason I want to clarify this to my kids is that I don't want them thinking that pay is the measure of social value.  Unfortunately, while capitalism has much to commend itself as an economic system, because of the problem of externalities, there is often a disconnect between social value and economic value.

For example, you'll have a hard time convincing me that the social value generated by a stock trader on Wall Street exceeds that of a registered nurse.  And there is no way you're going to get me to believe that the $1+ million/year salary earned by a stock trader vs. the ~$75K/year earned by the nurse can be justified on social value grounds.  However, it is without a doubt a fact that the salary differential exists.  And this is due to the way economic value is generated.

Incidentally, one of the exciting aspects of the growing social business movement is that it may offer a way to close the gap between social value and economic value.

So what have I been telling my kids are the sources of economic value?
  • What you know - People pay for special knowledge, training, or your experience. This is where getting a good education is important.
  • What you can do for someone or what product you can provide to them that enable them to do something - People pay for the services that you can provide them or for products that you provide that enable them to do something.  For example, if they want their lawn cut, you can either cut it for them, or sell them a lawnmower.  Often, what you can do, stems from what you know.
  • What you control access to - If you control access to something someone wants, you can probably get paid for it.  Bridge tolls are an example of access control.  In most cases, unless you control some natural resource like oil or diamonds, access control is usually via some form of law.  For example, patents and trademarks are legal rights to control access to some intellectual property.  They are not inherent;  if they were, Gucci would not need to worry about knockoffs from China.  Interestingly, intellectual property usually has its roots in what you know and what you can do.  Other things where access can be controlled:  money and relationships.  These last two are major reasons why an investment banker can command a higher salary than a nurse.
These sources are then subject to the law of supply and demand.  The lower the supply vs. the demand for, the higher the resulting compensation.  It is this latter that tends to decouple economic value from social value.

So what I explain to my kids is that if they want to be paid well for something, they need to know things that most people don't but would like to know or be able to do something that a lot of people want but few people are able to provide.  This is why I don't pay my son much to cut the lawn (easy work that I'm quite willing to do myself) but why his grandfather pays him more to move large piles of dirt in his garden (hard work that no one else in the family wants to do).

This usually leads to another set of questions around where to find opportunities?  These stem from human needs and desires.  My simplified list:
  • Safety
  • Health which includes food, clothing, shelter
  • Companionship
  • Communication
  • Entertainment
  • Travel & Transport
  • Artistic Expression
  • To Know
  • Respect
I'm trying to get them to see that often times, opportunity lurks in the intersection of these different areas.  For example, all restaurants provide food.  However, the more expensive restaurants go beyond food to provide an environment that makes people want to spend time with other people (companionship), may have a theme or reputation that allows a host to express their taste (artistic expression, respect), and is conducive to discussion (communication), or even provides singing waiters or wandering violinists (entertainment). Something to ponder the next time you're paying $38 per adult/$16 per child at Goofy's Kitchen in Disneyland.

But its one thing to know where opportunity might be found and another to actually find or create it.  This is where creativity kicks in.  In a Harvard Business Review article entitled "The Innovator's DNA" by Jeffrey Dyer, Hal Gregerson, and Clayton Christensen the authors list five discovery skills that innovative people practice:  associating, questioning, observing, experimenting, and networking.

One skill I know my kids have down:  "Dad, how do they get fireworks to be different colors? "Dad, when are you going to be done writing that blog post so we can watch the fireworks?"

One down, four to go.

1 comment:

  1. Very nice post Ed , and indeed a subject that comes often !

    We have a somewhat similar discussions at times, but they start from different source: It happens when we go by the day-workers near San-Antonio, or when we see low-paying (yet quite hard jobs) at the car-washing, or 'waving signs' by the road (you know, the 'New Homes' signs etc that people wave with).

    Our conversations usually meander into a different area: Do you think these people are happy or not? What do you need money for? Do you have enough of it?
    In some sense, it goes to the basic question in the beginning of your post:
    " kids have gotten more interested in how they can earn money to supplement their allowances. "
    I would ask then: Why do you need more money? Is this what's going to fulfill all your needs? Certainly the answer is 'Yes' for some (Shelter, food, etc). What about companionship? happiness?

    If you need more money to get an iPhone/game, is this a worthy goal? do you really need it to be happy?

    Again, i like your 'analytic' explanations. Just wanted to add a more 'what is happiness? and do we need money for it?' kind of angle...

    -Zachi Baharav