The Roots of Value Based Pricing

Jonathan Stark recently shared an interesting life story about how we determine value. His enewsletter made me curious about the definition of value and how it has been explained by economists. Value based pricing is a hot topic among independent professionals, but few understand the economic theories that this model comes from. I’m reposting my response to Jonathan and my initial research discoveries:

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I agree with your statement that “Value is a perception in the mind of the buyer.” The digital skin/build-a-bear example is an example of the paradox of value (the “diamond water paradox”) introduced by Adam Smith in his work The Wealth of Nations.

Your son did not determine the value of the skin based on the amount of labor it took a 3D designer to create it, rather because he thought it looked really cool and different than everyone else’s knife skin. That difference made the skin “rare” and scarce in the “market” of that game. And because it was really cool, he subjectively valued it higher than the other in-game skins at a lower price or free. In that game’s market, the marginal utility for the skin was very, very high in terms of enjoyment, identification, uniqueness. Its utility outside the game is almost zero as it only exists in the virtual world of that one game.

Most of what you are encouraging independent professionals is to move away from Adam Smith’s labor theory of value and toward the subjective theory of value. This is a daring and I’m sure daunting endeavor. Adam Smith’s labor theory of value is so ingrained in us from our youth (the entire US educational model is set up on a factory, production model).

In setting prices for a client project, the value of what a client is ascribing to a service/product is influenced by the marginal utility, culture, situation, availability, environment, urgency, social influence, etc. This makes subjective value difficult to consistently measure across clients and services/products. Assigning a consistent unit of value like time just won’t work well, for the reasons you consistently point out.

And determining value subjectively has other challenges, such as setting value across multiple projects with the same client. For example, this month a client wants a single landing page designed and developed to test a product/service viability in the market. Important to them but not so much so that they place great value on the landing page. Next month they want another product/service landing page that is of tremendous value to them. Both are landing pages, both are for a single product. One not that important, the other hugely important. Same client. The first project of low client value you price low. The next high client value project comes along with the same client and you price it three times as high because they value it three times as much as the first though the project requirements with the first are almost identical. Subjective valuation probably won’t go over well here with the client unless you have a corner on their market for services, they need it so fast they can’t explore other options, you can convince them the project isn’t the same as the first, and/or you have an “anything you say goes” type relationship of trust and respect with the client.

This is what makes subjective valuation more difficult and also more rewarding for independent professionals. It also makes your project pricing appear less transparent and consistent with the same client. Thank you for blazing a trail and introducing us to a different value model.

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