Ron Baker: Why are diamonds more expensive than water?
Ed Kless: Yes. It’s a great …
Ron Baker: After all, I mean, you can live without diamonds, but you can’t live more than what, seven or ten days without water.
Ed Kless: No, I think it’s less than that, my friend. I think without water, it’s like three.
Ron Baker: Yes, and this conundrum confounded great thinkers throughout the ages … I mean, people like Adam Smith that certainly have higher IQs than I do. That’s what we’re going to tackle on today’s show titled, ‘The First Law of Marketing, The Value of Values’. Welcome, everybody and welcome, Ed.
Ed Kless: Glad to be with you, Ron as always.
Ron Baker: Ed, as you know, this is known as the ‘Diamond Water Paradox’. It’s something that confounded Adam Smith. He even wrote about it in his famous book, ‘The Wealth of Nations’ which is published in 1776, the same year that we declared our independence, and certainly, we declared our independence last week from the tyranny of Taylorism.
How do you think Adam Smith solved this, or how did Adam Smith solved this problem?
Ed Kless: I don’t think he ever really solved it. I mean, in a sense, he just skirted around it and said, “I really can’t quite explain it, so I’m going to give you a partial theory and say that it might be labor that might be the real key here,” but he never really solved it per say.
Ron Baker: He didn’t. The closest he got for a theory was that, “Diamonds are more scarce than water.”
Ed Kless: Yes.
Ron Baker: After all, water covers what, 71% or so of the earth’s surface. I think if you were to ask a lot of business people today, they would still say to this day that diamonds are more valuable than water because they’re more scarce.
Ed Kless: Yes.
Ron Baker: We know that scarcity doesn’t explain value. After all, if it did, then those drawings on your refrigerator, Ed by your kids would be Picasso’s. I mean, they’re one of a kind.
Ed Kless: No, absolutely true. There’s also … I don’t know if you’re aware of this, Ron, a planet that’s called ’55 Cancri e’. It was discovered … I don’t know, 2004 or something like that. It’s going around a neutron star. It’s twice the size of the earth, but scientists believe that it’s actually made completely out of a diamond. It’s about 40 light years from here.
Imagine, if this were the case, if diamonds were about a scarcity and therefore, we value them, what would happen if this planet broke free and crashed into the earth? I guess we’d go, “We’re all wealthy now.”
Ron Baker: Absolutely. It’s really fascinating, and these ideas of value are so relevant to business enterprise today. I mean, that’s what I find so interesting about the history of economic ideas. I mean, these ideas don’t just drop out of the sky, they come from real live humans based upon our experience with for instance, how we interact, how we barter, how we exchange and how we buy things. Therefore, I think it’s worth exploring a little bit, the different theories of value that came through the ages.
We always talk about the physiocrats, Ed, the group of economists from France who thought the only value was extracted from the land, right?
Ed Kless: Right. Right. I believe something like if you were a shepherd, you’re okay, but if you sheared the sheep and then knitted a hat, you are exploiting the shepherd, so kind of bizarre.
Ron Baker: Right. That’s obviously bonkers. Then of course, the most famous theory came from Karl Marx. Of course, this theory actually, you can trace it all the way back to Aristotle and even St. Thomas Aquinas. It’s known today as the ‘Labor Theory of Value’, and this is what Adam Smith thought as well that the more labor that goes into a commodity, a good or a service, the more valuable it is to the consumer. Then, this is what’s known as the ‘Labor Theory of Value’.
When you subject this to the real world, it fails to explain how you and I buy things.
Ed Kless: No question. I mean, we don’t … and we’ll talk about this in the future shows as well. I think we mentioned it last week, but customers don’t care about your costs or your inputs. I beg people when I talk to them to please do not try to justify your price by talking about your costs to your customer because they don’t care. I mean, none of us walks into a hotel and thinks, “I hope the Hilton here has their cost structure figured correctly,” right? We don’t do that.
We have booked the hotel room because we need it, because we value it and we sought a price for it, but you don’t care about the cost, but businesses try to do this all the time and major businesses, the airlines especially, fuel surcharges, and they start to throw … They put out press releases about, “The costs have gone up, so therefore we have to adjust it. We’re justifying our price,” and it’s just insane.
Ron Baker: it is, Ed. The way I like to think about this is it’s like when a loved one or a friend has a baby, right? You want to see the baby. You don’t want to hear about the labor pains. Focusing on the cost is the labor pains, and the client, customer doesn’t care about that. They care about the baby, the result, the output, the value …
The interesting thing about your point about justifying price based upon cost is this has been true throughout history. I mean, even if you go back to medieval English, the word ‘Acre’ is the amount of land, a team of [inaudible 00:05:47] oxen could plough in a morning. I mean, we’ve always equated labor and especially time with money whether you could trace it back to Benjamin Franklin’s line times money or just the idea that effort and labor equated to value.
It’s false. I think it’s worth explaining also that not only that Adam Smith who was a genius in explaining a free market system, not only did he kept this wrong, but also David Ricardo, another famous economist who gave us the Law of Comparative Advantage, right?
Ed Kless: Yes.
Ron Baker: He got it wrong too. He actually was lying on his deathbed, Ed and pondering the conundrum of why a bottle of wine becomes more valuable with age when no more labor went into it.
Ed Kless: Right, or why a tree that grew to be a mighty oak with only two pensive of labor put into it ever was then worth a hundred pounds once it was cut up.
Ron Baker: Right. Luckily, a group of economists did come along and falsify the Labor Theory of Value. Before we talk about them, let’s talk about how they falsify that. One of my favorite examples of this, and it goes back to your diamond story is if the Labor Theory of Value were true, then a rock found next to a diamond in a mine should be of equal value because after all, it took the miners just as much labor to extract and find the rock as it did the diamond, and yet, I don’t see jewelry stores with rocks in their display cases.
Ed Kless: It’s even interesting that there’s a biblical story that talked about the Parable of the Laborers in the vineyard, right? …
Ron Baker: Right.
Ed Kless: and how the vineyard owner hired some in the morning, some in that noon, and then some I think later in the day, and then paid them all the same wage. The folks who are hired in the morning were ticked. They were not happy with the price, right?
Ron Baker: Yes, sure.
Ed Kless: They’re not happy about this. The vineyard owner says, “Who are you?”, and of course, the tie in here is this idea that it was more spiritual, is that, “Who are you to question the authority of the owner?” There’s also an economic explanation for that if you really think about it, not that I believe the Bible as an economics textbook by the way, but that you could say, “Maybe the vineyard owner thought there was going to be a frost that night, and the grapes that were harvested later in the day were of more value because otherwise, they were going to be ruined.”
Ron Baker: Right. You know what? I can think of a lot of scenarios where it makes perfect sense, or just the fact that he was happy to get the extra help that late in the day. Right?
The thing about the Labor Theory of Value that is really wrong is Karl Marx ignored the consumer, because if you think about it, I mean …
Ed Kless: He hated consumers, Ron. That’s why.
Ron Baker: Yes, and he hated profit too. If you think about it, I mean, if the Labor Theory of Value is right, then today maybe for lunch or dinner, you’ll have pizza, where your tenth slice should be just as valuable as your first or second. Your tenth shot of tequila should be just as valuable because it took the same amount of labor to produce, but obviously, there’s a law of diminishing returns here for us. The more we consume of something, the less valuable it becomes. That’s the big hole in the Labor Theory of Value is it ignores the consumer.
Ed Kless: Right. That’s where I think that the marginalists then picked up on this which we’ll talk about later. Let’s go back to this Labor Theory of Value, Ron. Why do you think it’s so pervasive today? Why you think it … because it just makes sense, doesn’t it? I mean, if you don’t look at it deeply, it just makes sense.
Ron Baker: There is a visceral and intuitive reasoning behind it. I mean, after all, if I’m making this elaborate piece of furniture and there’s a lot of skill and craftsmen, then … or a Stradivarius violin. Think of the labor that goes into that, the loving labor.
Obviously, it’s going to command a higher price, and if you’re cranking out for a nurture on an assembly line, but the problem with it is that there is no correlation between labor, time and value. I mean, I could spend decades of my life writing a book that doesn’t sell. What can I say, that the world owes me a living because I spend all this time? No. it’s obviously false, but there isn’t a certain intuitive sense to it, isn’t there?
Ed Kless: Yes, and didn’t Marx actually think that was … Didn’t he think that his family should basically support him because he was doing the important work?
Ron Baker: Absolutely. I mean, the guy was a real pauper. He never repaid his debts, and his mom had a great line about him, said, “I wish Karl would spend more time creating some capital rather than just writing about it.”
Yes. I do think that … Even Adam Smith said that it cost twice the labor to kill a beaver as it does to kill a deer, and therefore, obviously, the one beaver should naturally exchange for two deer. Yes, that makes intuitive sense, but it’s absolutely wrong because again, it ignores the consumer.
Ed Kless: Right, who is ultimately the arbiter of value.
Ron Baker: Right. I would actually say the soul arbiter of value because the consumer like we’ve discussed doesn’t care about a business’s costs and they don’t care about how much profit a business makes, they care about the value to them. I guess this leads us to our first law of marketing, and it’s not about the value of value. We could probably say it’s actually the value of having the correct theory of value.
Ed Kless: Yes.
Ron Baker: The correct theory of value is … Go ahead. I’ll let you say it.
Ed Kless: The value of understanding of what value is.
Ron Baker: Right.
Ed Kless: That’s what we meant by the value of value.
Ron Baker: Right. Right, a clear understanding or a clear theory of value, and that is that all value is subjective.
Ed Kless: It just can’t be, Ron. It just can’t be. It’s just too easy.
Ron Baker: I know. Then, people say to us, “There can never be absolute so you can never use all,” but I do want to make that point that all value is subjective. It is like beauty. It’s in the eye of the beholder. If it wasn’t true, Ed, then if you and I went to a movie, we should like it equally well because after all, it took the same amount of labor to produce that movie for both of us to be able to watch it, and yet, I might come out of the movie hating it and you love it.
Ed Kless: Ron, we’ve talked about the Labor Theory of Value, and then we then have suggested that there is this other theory of value, the Subjective Theory of Value, and this isn’t just you and I coming up with this. This was put forward by a group of economists in the late 1800s. It’s called ‘The Marginalists’, right?
Ron Baker: Yes, and thank heavens for these folks because there’s three guys basically who came up with this heory of subjective value … three different countries separately. It was William Stanley Jevons from Great Britain, Leon Walrus from France and Carl Menger from Austria. They basically …
They first off falsified Marx’s Labor Theory of Value, citing some of the same examples that we just talked about, Ed, and then they posited that all value is subjective. Again, like beauty, it’s in the eye of the beholder. What they also said was that there’s no such thing as intrinsic value. Value is not intrinsic to goods. We only use goods or resources because they serve some purpose for us.
If you think about it, the only thing on this planet that has intrinsic value from an economic standpoint would be human life, but products and services don’t. I mean, we used to use whale oil, and we don’t use it anymore because we found better substitutes. If we ever find a better substitute for oil, we won’t use that anymore, so there is no such thing as intrinsic value.
Ed Kless: I want to leverage off that point because this is a huge, huge challenge for most folks in business, and that is to recognize that we … We mentioned the physiocrats earlier, the guys who thought it was the exploitation if you wove the wool into a hat. Business people all of the time make the same category mistake when they think that their stuff, whatever it is … their product, service, knowledge has some kind of objective value that you can say, “This is what it’s worth, and therefore it has value.”
They’re making that same category mistake which is obviously nuts in adjusting that. I think I find this fascinating that has so endemic in business thinking that our stuff must have value because we say it does.
Ron Baker: Right. I’m always challenged and advised somebody about gold. They say, “Gold has intrinsic value.” If we found out tomorrow that gold was a carcinogenic, what will its value be? I mean, gold doesn’t have intrinsic value. It only has value because people believe it does. It’s a spiritual source of value.
Another reason that show is called ‘The Spirit of Enterprise’ because we’re not just trying to explain the material here, we’re also trying to explain the spiritual, and money and gold and value is all spiritual.
Ed Kless: Woah. Woah. Woah. Woah. Woah. Money is spiritual, Ron?
Ron Baker: Yes, it absolutely is. I mean, I know we have little numbers printed on it, and that makes it look objective, but the only reason you think a five dollar bill from me is because you trust that it’s worth five dollars when you go to buy something else.
Ed Kless: Yes. There’s a great story that … I believe it’s Milton Friedman tells in his book, ‘Money Mischief’ about the island of stone money. I think it’s the Island of Yap, somewhere in the Pacific. The deal is that … and I’m sure you know the story, but there’s the money in this society was due to this limestone tavern that they found at this other island, and they brought these huge rocks over from this other island. They’ve been here hundreds of years, and that was then considered to be the value for the society. They’re like all over the place.
They’re in front of people’s houses, they’re in the middle of the village, and the way that it works is to make payment, you just say to someone, “Okay. This rock here is not mine anymore. It’s yours.” It’s then just known throughout the village … “Okay. The big one at the corner of fifth and Lamar, that’s Fred’s now,” and everybody just agrees.
In fact, it’s to the point where there’s legend of one of these rocks getting sunk when they were transporting it. There was a storm that arose just before they landed, and it’s a couple of hundred yards off shore, and it’s still agreed that this belongs to the richest family on the island. It just happens to be at the bottom of the ocean, and people don’t realize that … They think that this is crazy, but that’s the same thing that money is in our society, right?
My dad was a Latin teacher. ‘Fiat’ means ‘So it is’.
Ron Baker: Right. Right. No, that’s exactly right. It’s a great story too. That’s out of Friedman’s book, ‘Money Mischief’, isn’t it?
Ed Kless: Right. Yes it is. Yes.
Ron Baker: Yes. That’s great. Two other points on this, Ed about the Labor Theory of Value contrasted with the Subjective Theory of Value. Karl Marx would say that pearls have value because people spend labor diving for them, whereas the marginalist economist who posited the Subjective Theory would say, “No, no. People dive for pearls because other people find them valuable,” right?
If I find a pearl walking down the street, I’m going to be able to sell it for the same amount as if I work five weeks to find one, right? It’s not the inputs that matter, it’s the output, and it’s the value to the consumer.
Ed Kless: Isn’t this a little bit … I think we’re getting a little bit ahead of ourselves, but this is the whole really supply side thing, and I’ve got a really terrible name, and perhaps we need to do an entire show on debunking the debunking of supply side because it really is. It’s about, “What is it that you’re providing?,” right? “What is it that you are providing to the customer that is of value to them?” and it starts there.
Ron Baker: It does. Not only that, but as we talked about exchange, when you buy something as a consumer … a cup of coffee at Starbucks, you’re only doing it because it’s worth more to you than what you’re paying. One of the problems with accounting and the whole debits equal credits view … the accountant’s view of life is in the real world, debits don’t equal credits, not only hopefully to Starbucks make a profit on that transaction, but the customer does as well, because exchange is based on unequal perceptions of value.
It’s not to that cup of coffee is worth five dollars to you, it has to be worth more than five dollars to you, otherwise, you wouldn’t have bought it.
Ed Kless: Right, but not necessarily monetarily, right? That gets into the whole idea of that money in a sense of spiritual because yes, you’re trading this five dollars for it, but there is the good feelings, there is the pleasure of sipping the hot cup of coffee that are more valuable to you than the five dollars, and money is really just this medium of exchange for it, but it’s the trade where the value is actually created really on both sides, right? I mean, it’s clear to people who are doing accounting that, “Okay. We have all of our revenue minus our cost as our profit,” but what they don’t see is the fact that, “It’s actually on the other side creating more value than the price.”
I think this is referred to in a lot of cases as that weird ‘Double Thank You’ moment, when you go into some place and buy something and you say “Thank you” to the clerk, and they say “Thank you” back, right?
Ron Baker: Right.
Ed Kless: Why is that? Because we both wanted this trade to happen. Now, this is not to say that all trades are always creating value on both sides, right? There’s such thing as ‘Buyer’s Remorse’, there are sometimes when people are forced into having to buy something, there are times when there isn’t necessarily value created, and especially when prices are being manipulated in some way.
Ron Baker: Right. Right. Sure. The great majority of transactions happen because I value whatever it is I’m buying more than the money I’m giving up. The problem is we can book that from an accounting standpoint on the businesses books no problem, but I don’t book the profit that I earn from that cup of coffee that I bought at Starbucks this morning. Where that does get booked on my home accounting system?
Ed Kless: Right. One of the things that I’ve talked about with people is people sometimes think that they’re getting exploited by their employer, right? They think, “I’m doing way more … The stuff that I’m doing is way more valuable to my employer than the amount that I get paid.” I’m like, “Yes.”
Ron Baker: Right.
Ed Kless: That’s the way it’s supposed to work. You are working whether it’s providing in a sense your a labor, but also and I think more importantly your knowledge to someone, and they want it more than they want the salary that they pay you, otherwise you wouldn’t have a job.
Ron Baker: Right. Right. No, it’s a great point. I mean, Ed, about a couple of months ago, I was at San Francisco Airport boarding an airplane. You would not believe this conversation the two women were having right in front of me. You know how you can just overhear when you’re standing right behind somebody in line, getting ready to board a plane. They were talking about this word ‘Value’.
They were saying, “It’s the biggest buzz word. The company is using it, but we don’t know what it is. How do you measure value? How do you quantify value?”, and they went on and on. I couldn’t contain myself anymore, so I had to butt in and say, “I couldn’t help overhearing you, ladies talk about value. I’ve written a few books on this.” I said, “I’d love to have a discussion with you on it,” and they asked me real quick as walking down the jet way, “Give us a definition of value.”
I said, “Think about it this way. Let’s say you’re in the desert and you’re dehydrated and you’re about to die. What would a bottle of water be worth to you? It’d be priceless because it would save your life? Now, imagine you’re home washing the dog or dishes with the same quantity of water. Now, what’s that water worth to you? Obviously a lot less. If you’re flooded in your basement with water, now what’s it worth to you? Obviously negative and you have to pay somebody to come out and pump it out.”
I said, “Notice in each of those examples that we didn’t change at all the physical characteristics of the product. It’s still H2O. In fact that if you think about it even from a cost accounting perspective, the cost of getting that water to those three locations doesn’t change that much, certainly not enough to drive it from infinite value to negative value.” What changes is the context you’re in and the job you’re trying to perform, in other words, the subjective perception of value to you, the consumer.
Ed Kless: How did they feel about that, Ron?
Ron Baker: They thought it was great. By the way, folks, one of the books I wrote about this is called ‘Pricing On Purpose’. I was actually sitting across the aisle from one of the gals, and she actually bought my book when we were flying on the plane and started reading it. That made me feel really good, but they really understood with that example that, “Yes, that makes complete sense, that it depends on my context what something is worth to me, not the cost of getting it to me.”
Ed Kless: Exactly. Just on that water thing just to follow up for those of us and we’ll post this as part of the show notes, but got to take a look at Penn & Teller’s video where they created a water steward at a restaurant and fill up the bottles with the hose water, but yet the perception of value is … and the people actually say, “Woah. This tastes so much better.”
Ron Baker: Yes, and the range of prices they charge for that is absolutely stunning as well.
Ed Kless: Right. Ron, we had said that we’re going to tell one of the most fantastic stories I think I’ve ever heard you tell, and that is about a favorite winery of yours called ‘Far Niente’. Just to set this up, ‘The Far Niente’ is a winery in Napa Valley that they have a great cabernet, Ron that you absolutely love.
By the way, ‘Far Niente’ is Italian for ‘Do nothing’ which is just the absolute perfect name for a winery I think, right? … Do nothing
Ron Baker: By the way, I like it so much.
Ed Kless: Yes, exactly. You’re right, ‘Do nothing’. Marx would have liked it for sure.
Ron Baker: Right.
Ed Kless: It always sounds better if you put it in a foreign language, like instead of [Louie’s 00:25:33] place, we need to call that [Shade Louie 00:25:34].
Ron Baker: Right. Right.
Ed Baker: There’s an example of subjective value too by the way. Anyway, to finish off the story, you did a tour of ‘The Far Niente’?
Ron Baker: Yes. Like you said, I particularly enjoyed one particular vintage of cabernet that they make. It’s a reserve that’s limited … a state bottle that’s about $150 more than their typical cabernet. I buy it for people for gifts … special gifts, wedding anniversaries … things like that, and everybody who’s drunk it has really, really enjoyed it. It makes you feel good.
Finally, I got to tour this winery, and he takes us down into this barrel room and he starts explaining that, “This is where we bottle this particular vintage.” Now, Ed, it’s really important to understand that I had been buying this particular vintage for about seven years long before I took the tour, long before I knew anything about how they made this wine.
He is explaining to us how they and why they can’t bottle this wine automatically using their bottling machines. He says, “We have to hire people to come down here, stand at the barrels and fill the bottles by hand, and then cork it manually and all of that.” He turned around to the group, and there was about 12 of us, and he said, “And that’s why this wine is more expensive.” Everybody nodded their head and went on, just like you said about “Business is to justify higher prices because of higher cost.” Everybody just got it, and I guess the perception of fairness.
I didn’t have the heart to give this guy an economics lesson and ruin the tour, but he’s wrong. He’s got the cause and effect completely backwards. That wine is not worth more to me because they bottled it by hand. In fact, I had no idea they bottled it by hand or that it cost than more to make, nor do I care. I still don’t care, and I know all about it, because to me, that’s the labor pains and not the baby.
What I think was missing was the reason ‘Far Niente’ is willing to incur those additional labor cost is because people like me value the wine so much that I’m willing to pay a price that’s high enough to cover those additional costs. The chain works exactly the opposite of what he said on the tour.
Ed Kless: Right, and we’ve pointed this out on the number of sessions that we do. By the way, if those of you who want to see us live, please come to our New York City version of ‘Firm of the Future Symposium’. You can find out more about that by visiting ‘VeraSage.com/fotf’ for ‘Firm of the Future’.
This [arrow of causation 00:28:15] … I mean, so many people think it’s costs that drive price, price that drives value, and then that value is then justified to the customer. What is so fascinating … I remember the first time that you and I talked about this is the epiphany that I had, I realized and said, “But where does the customer come in that chain?” Dead last in that chain.
Ron Baker: Right.
Ed Kless: They’re the last ones that are considered which is exactly why Marx got it wrong, right? He didn’t consider as you said the consumer or the customer in this whole equation because he didn’t even consider them, nevertheless think that they actually came first in it, right? Yet, business people today say, “The customer comes first. The customer comes first.”
Okay. Let’s live that. If the customer comes first, then they are the soul arbiter of value, the value then will determine what the price is, and then the price then justifies the cost which I think is the lesson of ‘The Far Niente’ story, right? It justifies. Price justifies cost, doesn’t come from.
The challenge of course is that there are lots and lots of systems out there that you put them in place, say, “How are you going to price this item?” “It’s a percent mark up.”
Ron Baker: Right.
Ed Kless: Right? It leads us to believe that it’s based on marking up all of our costs. Apple doesn’t do anything that way.
Ron Baker: Right.
Ed Kless: Coming back to this idea of value, Ron, let me ask you the question, and now we need to answer. We set this up 40 minutes ago. “Why are diamonds more valuable than water?”
Ron Baker: Right. I mean, obviously, there is a subjective value component, but this was really also … It’s kind of part two of the marginalist explanation of value. It’s actually known as ‘Gossen’s Law’, this German economist by the name of Hermann Heinrich Gossen who basically said, “The market price is always determined by what the last unit of a product is worth to people.”
Obviously, the first bottle of water that’s going to save your life when you’re dehydrated in a desert is going to be priceless, but as you consume more and start washing the dog and your car and the driveway, then those last gallons at the margin are going to be worth a lot less, and the market price tends to flow to the last marginal value used, but the marginal value of a second diamond, Ed, even if you’re Liz Taylor is pretty high.
Ed Kless: Right. Tie this in because the objection that I usually get when talking to folks about this is, and we haven’t talked about this at all, what about supply and demand? What about supply … I can almost hear people in our audience saying, “You haven’t talked about supply and demand.”
Ron Baker: Yes, and we will deal with that and we’ll especially deal with that in part two of this series. Let’s go back to this idea of the marginal unit, the next one. That’s what the margin means, the next one.
Ed Kless: Right.
Ron Baker: Take a look at example … and I don’t even think you can find these much anymore, but think about the old newspaper racks. Remember those that sold ‘The New York Times’ … maybe you put in eight quarters and two dollars or whatever? Notice that ‘The New York Times’ didn’t design those racks to only pull out one paper at a time.
You could reach in there and theoretically take all the papers you wanted, but yet, if there was a Coke machine nearby that rack, it’s got this elaborate Rube Goldberg mechanism to make sure that you only pull out one Coke. Why is that?
A sociologist, a criminologist looking at this might say, “Obviously, ‘New York Time’ readers are more honest than Coke drinkers.” That’s not a very good theory, right?
The theory of marginalism explains this better because the second ‘New York Times’, I would argue the fist, but the second ‘New York Times’ isn’t worth that much, right? Whereas the second Coke or third or fourth can be stored and enjoyed later. That’s why Coke is more concerned and will spend more money to make sure people when we get one at a time, and that’s why water is so much cheaper than diamonds, because if you think about it, if water companies could know that you are in the desert, of course they would charge you a higher price.
They do this if you think about bottled water, we pay more for bottled water than we do for gas.
Ed Kless: In some cases, yes. Absolutely. I mean, if you’re going and buying it out at a ball field of worse, the U.S. Tennis Open which where I hear water is just incredibly expensive, and you’re not even allowed to bring it in, you’re going to pay more for it than you are for gasoline. I mean, you’re absolutely correct.
Ron Baker: Of course it’s because it’s convenient, right? I mean, you can take water with you when you ride your bike or jog or whatever, and so we’re paying for that convenience, but it’s really the idea that the market price tends to gravitate. It’s a tendency, not a rule. It tends to gravitate towards the last marginal use, and in water’s case, that’s pretty low value.
Although, let’s face it, water is not that cheap. We pay enormous taxes for it.
Ed Kless: Yes. Exactly. Just getting back to your crack about ‘The New York Times’ I would argue, it would also depend on whether or not Paul Krugman had a column in it that day or not, but …
Ron Baker: Exactly. Back to your other point, Ed about ‘The Far Niente’ story and what it illustrates about, how it’s value to me that determine the price I was willing to pay for that wine, and it was at higher price I was willing to pay because the value is so great to me that they were able as a winery to hire those additional labors and still make a profit. Think about if this theory wasn’t true. Let’s talk about that just for a second.
If this wasn’t true, if our cause and effect here, the way we’re explaining wasn’t true, then why would any business go bankrupt? It’s not that difficult to put a price above your costs that include some profit, right? The reason businesses go bankrupt is because they make things that other people don’t value.
Ed Kless: Yes. No. My five-year old daughter could figure out a way to put a price above her costs. She understands the differences between numbers and that one number is bigger than another number.
Ron Baker: Yes. It’s not that difficult, but businesses fail because they don’t produce same things of that. I just read or heard the other day or yesterday that isn’t GM recalling 17 times more cars than they sold this year?
Ed Kless: That whole GM story is just absolutely incredible. Unfortunately, GM has become a pension fund that happens to make cars.
Ron Baker: Cars, right. Right. I mean, it’s a classic example of cost plus pricing. They’re saying, “Hey. Because we have cost and because we have shareholders that expect some profit, therefore, Mr. Consumer, you have to cover our costs even if we produce crap.” That just is not the way the real world works.
Ed Kless: As incredible as it sounds, I think it was 2009 or 2010, GM and Toyota produced … I remember reading this. I can’t cite it. I’ll try to look it up and put it in the show notes, but they made within 50 cars of one another or were sold within 50 cars of one another in the United States.
Ron Baker: Right.
Ed Kless: Yet, Toyota did it at this incredible profit and GM did it at a loss.
Ron Baker: Right. Right. Ed, it’s worth pointing out because trying to make all of this practical and bring it back down into the business enterprise so people can think about this in the context of their own business that if you look at a company like Toyota, they do not have a standard cost accounting system. Now, as a former cost accountant, that absolutely blew my mind.
The reason is, it’s because Toyota understands that, “What drives what the price of their cars is the perception of value to the consumer.” Before they even build a car, they know what the price is going to be, and then their job is to incur costs less than that price to make an adequate profit.
Ed Kless: Exactly. Maybe when we return, we’ll have you tell the story of an executive at Ford Motor Company back in the day that actually understood that.
Ron Baker: Yes, because it’s what I call the ‘Tale of Two Automobiles’, but it is a great story.
In the 1950s after people were returning from World War 2, there’s a lot of pent up demand, they had been over in Europe, they had obviously seen some sports cars, and a particular automobile company thought the market was right for a sports car, so they gave their engineers car launch, it was kind of a Skunkworks project, then they say, “Hey, you guys. Build the car of your dreams … high performance, sexy, sporty … all of that,” and these engineers went to town on this car, and in I think it was ’53, they put out a car that sold for I think it was $3,490, Ed.
You can go into a Harvard Business Review case study, and you can see how they price this car. They added up all the cost of production, [RD 00:37:33], materials, labor … blah, blah, blah. They added a certain amount of profit per car, and then of course they projected how many units they thought they were going to sell, and so it was a traditional cost plus pricing formula.
The car bombed in its first year. I think it only sold 400 units, so they lost money. In ’55, by 1955, it turned around, they started making money on it, and this car is still made to this day. As this car was getting out there and was getting rave reviews and people really liked it, another automobile company and another executive would talk to people, and they’d come up to him and they say, “We really love that sports car.” He said, “Why aren’t you driving one?” “It’s too expensive.” He started asking people, “What would you like in a sports car? What features?”, and they would tell.
I mean, he says, “What would that be worth to you?” He came up with a target price of $2,500. Now, it obviously had to be less than this other car, otherwise they would have just went and bought that one.
Ed, the important part is like in ‘The Far Niente’ story, he went back to his engineers and said, “Can you make this car with these features that we can sell at this price at a profit we can live with?” The engineers scratched their head because this isn’t how automobiles were made in the post World War 2 era, right? This is how we got the big fins on automobiles that anything they built they could sell.
The engineers figured it out and the car was released in 1964. It actually came in under its target price of $2,500. I think it was retailed at $2,390 or something and it came out in ’64, and then the first two years, it made $1.1 billion in profit for this company.
Now, just to put that in context, this other car from 1953 even up to 2010 is about one third of that $1.1 billion in profit. I think this illustrates really well the idea of starting with value to the customer and working backwards, right/ Of course the two cars I’m talking about are, the first one is the Covette which is still being made, and the Mustang which is also still being made, in fact, it’s having its anniversary this year.
I just love that story because what it illustrates is that even pricing for value doesn’t necessarily always mean a higher price, right? The Mustang was cheaper.
Ed Kless: Yes, and the Ford executive was a fellow by the name of Lee Iacocca.
Ron Baker: Yes. He wrote about the story in his first autobiography, and the Mustang was an enormous success and everybody wanted to take credit for it … the classic line that “A failure is an orphan, but success has many different fathers or many different mothers” as they say.
It does illustrate, and that’s by the way how Toyota builds cars, and in fact all the Japanese automakers build cars with that same process. They start with value to the customer. That determines the price and then they work backwards to engineer the cost.
Ed Kless: It’s called ‘Targeted costing’, right, Ron?
Ron Baker: Yes, it’s called ‘Target Costing’. The Japanese use it, have been using it for quite a long time. They moved a long time ago away from cost plus pricing. Also, Ed, folks in your sector in the technology sector … Apple and software also use this as well.
Ed Kless: Right. No, absolutely, and we do use it. It’s a great methodology, because it does the antithesis of what Marx was talking about, and that it puts the consumer or customer first in the value chain. I think that’s really the big difference.
Ron Baker: Right. I guess the moral problem that I have with cost plus pricing, it’s like the world, [those 00:41:32] we are living because we’ve incurred all these costs, we have overhead, we have profit desires, and therefore, Mr. and Mrs. Consumer, you have to pay a price that covers all my cost even if I produce something that’s of no value. It just doesn’t … It’s almost like an entitlement mentality, Ed.
Ed Kless: Yes, and you and I have talked about this. We work primarily with people in what we call ‘The service sector’, but it can also be called ‘The Knowledge Worker Economy’. They think they’re in the service sector, and in many cases, they’ll use the same ideas like, “But I worked on that for ten hours,” so therefore, it must have value to the customer or client to them.”
The reality is that, “Okay. Here’s the problem is you’re taking a theory of value, the Labor Theory of Value primary put forward and codified best by Karl Marx which thought that profit was evil and you’re trying to build profit into the system.” I mean, it completely makes no sense, and in a way and on record, he’s saying this, is that “If one people [billed 00:42:45] by the hour, they’re practicing Marxist.” I mean, that’s the reality.
Ron Baker: Absolutely. I mean, I know people get upset with that, but that’s where this .. Again, these theories don’t just drop out of the sky, they came from somewhere. If you’ve ever been charged by the hour from your plumber or your attorney or your accountant, it’s the Labor Theory of Value in action. Just because they spent more time, it should be worth more to you. That’s just patently absurd.
Ed Kless: Yes. We’ve got about two minutes left, Ron, so let’s try to set up a little bit of next week’s show which we will answer the question by the way that I brought about halfway through, this whole idea of supply and demand. We are going to bring this together because we have of course … there’s the first law of marketing and it follows that there must be at least a second law of marketing.
Ron Baker: Right. Ed, that’s a great point. The first law and I just really want to make sure this is very clear is that all value is subjective, and you can think of that as the first law of marketing. Now, to bring supply and demand into it and to bring competition, luckily, just because you value something at a very high price, doesn’t mean that that’s what you’re going to pay for, right? Because of competition and because of other factors, you may actually pay a lot less for something that you value dearly, and therefore earn a large profit as a buyer, right? That’s the second law of marketing which is all prices are contextual.
Ed, it’s even broader than that, isn’t it? I mean …
Ed Kless: Yes. It’s an amazing, amazing topic that we’ll explore next week. One of the things that we’ll talk about is how you can even create your own context which is just a fascinating idea.