CREATING VALUE and

CAPTURING VALUE

CREATING VALUE
Value Creation (also called Value Added)
Value is created anytime an action is taken for
which the benefits exceed the costs, or anytime an
action is prevented for which the costs exceed
the benefits.
This applies to several aspects of production:
quantity, quality, entry, innovation, method of
production. Also applies to relationships between
the firm and its employees, e.g., job safety.

CAPTURING VALUE
The concept of value creation says nothing about profit.
The benefits are measured to the consumer; the costs
to the firmyou cant determine profit just from that.
The selling price determines the amount of value that is
captured by the firmthat contributes to the firms
profits. (Producer Surplus)
The other value isnt lost. It is retained by the
consumer. It is the difference between what the
consumer would have been willing to pay and the price.
(Consumer Surplus)

RELATIONSHIP BETWEEN
CREATING VALUE AND
CAPTURING VALUE
The two dont have to be related.
One can create value without capturing any of it.
You cant capture value without creating it, but
you can capture more value while creating less.
Human nature often means that there is no
incentive to create more value unless one can
capture some of the value that is created. Or,
people will create more value if they can capture
more of the value they create.

CREATING / NOT CAPTURING

When a monopoly lowers prices too much, it
creates more value (since the benefits of the extra
units > the costs), but captures less (since the price
has gone below the profit maximizing level).
(Ratchet Effect) An employee discovers how to
make the product twice as fast and shares it with his
coworkers, then the boss requires twice as much
output from all workers. (Employee perspective.)
I get the salvage fixed so it no longer pollutes.

CAPTURING / NOT CREATING

Whenever two firms conspire to raise prices,
together they create less value, since less people are
buying units for which benefits > costs, but they
are capturing more of the value they create. This is
anticompetitive behavior and outlawed by the
antitrust laws. Our capitalist system is biased
properlytoward activities that create value.
(Thats not biased against capturing value.)
The employer in the previous example.
I sign up for dental insurance just before I get a
crown put in. (Id have gotten the crown anyway.)

WHY THE VALUE CREATION

PERSPECTIVE IS USEFUL
Why Not Just Focus on Value
Capturing, or On Profit Directly?

REASON THE FIRST: IT MAY BE

YOUR OBJECTIVE
It is reasonable to suppose in many health care
institutions, particularly not-for-profits, that value
creation is the objective.
In a health care context, value creation means in
essence providing as much care, and as good care,
as you can as long as the benefit exceeds the cost.
Value capture would mean only undertake actions
that increase profit.

REASON THE SECOND: IT CAN BE A

USEFUL TRICK IN FIGURING OUT
HOW TO CAPTURE MORE VALUE
If you create more value, you can (at least in theory)
capture at least some of it for yourself.
Focusing on value creation initially may help you
find ways to better serve the customer and, in the
process, profit yourself.
Often one of the problems you uncover is that the
agent would not capture any extra value that would
be created and so does not create it.
The Theater example. (Also 2 HW problems.)
Dont get me started!!

REASON THE THIRD: CREATING MORE

VALUE MIGHT BE THE ONLY WAY TO
CAPTURE MORE VALUE
When markets are highly competitive one must
increase profits through value creation. Trying to
capture more value without creating more value
will make many customers go to competitors.
It is competition that forces the close link between
capturing value and creating value.
This is why competition and information
(which drives competition on the buying side) are
so important for market efficiency.

Application: Encouraging Good

Health Habits I
Good health habits, such as good diet, regular sleep,
and exercise, will create value to the extent the
benefit of the improved health exceeds the cost of
having these habits.
If the individual was an uninsured hermit, all costs
and benefits would accrue to that person and so we
assume the appropriate choices are made. However,
an insured individual has the consequences of poor
health habits subsidized and will confer external
benefits of good health to loved ones. Therefore we
expect underprovision of good health habits.

Application: Encouraging Good

Health Habits II
So our objective is to encourage appropriately
good health habits in the face of incentives for
good habit underprovision. Consumers will
underprovide even if they are perfectly informed
about the consequences of health habits. We need to
correct these incentives or provide counterincentives,
and will capture value if the savings in health
expenses exceeds the cost of the incentives.
So, how? Experience rating, tying arrangements

MANAGED CARE, VALUE

CREATION, AND VALUE CAPTURE
Two main instruments of HMOsUR and
Prospective Paymentare instruments of value
creation. They try to limit procedures for whom
benefit < cost. How much of this value is captured by
consumers depends on market competition.
Selective Contracting is more about value capture:
since the physician and hospital markets are not highly
competitive, it is possible to use market power to
extract lower prices from suppliers. However, this
incidentally also increases value creation in the market
by making prices more competitive.

THE ROLE OF COMPETITION

MARKETS ARE DYNAMIC!

Markets change for many reasons: changes in
preferences, costs, technology, politics, etc.
Health care markets are facing many of these challenges:
changes in labor costs, technology, regulation, insurance,
etc.
Because there is believed to be considerable inefficiency
in the health economy, some of this is about creating
more value.
Because many health markets are not highly competitive,
some of this is also about value capture (without
necessarily creating extra value).

INTERMEZZO ABOUT
DYNAMICS OF THE
PERFECTLY COMPETITIVE
MARKET

Order Out of Chaos

Now we see what was behind Arrows survivor
principle: competition would ensure that only those
business practices would survive that delivered the best
value to the consumer. Over a long time frame, this
also maximizes value creation in the market.
Given enough competition, business practices that
create the most value will survive, and the competition
will ensure that consumers capture most of that value.
This is because of personal greed, not in spite of it!
(This is Adam Smiths invisible hand.)
Managed care fits well into this framework: it is a
competitive market in which self-interest has led to
innovations that, if successful, will ultimately create
value and lower prices to consumers. However this
market has had trouble finding successful innovations!

GENERAL FORCES DRIVING

MARKET DYNAMICS
Innovation. The incentives for innovation depend on
how much value can be created and how much of it the
innovator gets to capture.
Replication. Replication of successful ideas ultimately
erodes the profit from those ideas and returns most value
created to the consumer.
Entry and Exit. Entry into markets also erodes profit
and returns most value created to the consumer. Exit
helps restore normal profits to firms. The speed of
entry depends on many factors, which are often
regulated in HC markets.

ILLUSTRATION: MKT. FOR

PHARMACEUTICALS
Innovation. Supported by patents on successful drugs.
Development costs are high and success chancythus
large incentives are needed.
Replication. When a patent expires formulae are easily
replicated, so generic markets develop quickly.
Entry and Exit. Firm entry in the brand name market
difficult, because of high entry costs and the difficult of
developing expertise in R&D. Thus market had a long
string of profitable years. Entry is easy in generic market
so profits are more reliably normal profit and price
stabilizes fast.