Why Market Prices Don't Work in a Service Economy
Source
See the book: The End of the Market. Author unknown.
Discussion
Value creation in a service transaction
"Tangibles are invariably produced through a value chain.
For example, iron ore is found and extracted. It’s then shipped to a pelletising plant, often close by, that concentrates the ore to make it cheaper to transport. At a steel smelter, machines and people work together to transform pellets into ingots. The ingots are turned into billets and bars or rolled flat. These are then shaped into finished products like cooking utensils, car bodies and the wings of aircraft. They are sold to consumers who use them as they see fit. Production of tangibles is linear; going from raw material to finished product in stages. And at each point, value is added. At every stage of production, something is bought for less than it is sold for in its more processed form. This is the iron law of all tangible production, and not just steel. It goes one way.
Now let us consider value-creation in services.
Think of a hotel. A person arrives to check in. He or she is greeted by a receptionist. The guest responds, pleasantly you would hope. The receptionist then asks for the guest’s name and booking details. This might involve handing over supporting documents, even passports. At each point, the receptionist says thank you and smiles. After a couple of minutes, a door key is handed over, the guest’s luggage is collected and the receptionist wishes him or her an enjoyable stay.
Think of a doctor. A patient arrives at a clinic and is greeted by a receptionist. The booking is checked and the patient is asked to take a seat for a few minutes. Magazines are provided to pass the time. The patient is ushered into the surgery. The doctor greets the patient, asks some preliminary questions and begins the physical examination. At each point, the physician will be looking for a response from the patient. At the conclusion, the doctor makes some decisions based upon what he or she has heard and seen and the patient leaves with advice and, usually, a prescription.
These examples show how value-creation in services differs from value-creation in tangibles. Time has been spent, which involves an opportunity cost. The hotel receptionist could have been answering the phone or using the clinic’s computer. The doctor could have been playing golf. Something has been produced to deliver a happy guest and a satisfied patient. Money has been exchanged. From this perspective, there is no difference between what has happened in these two cases and the final outcome of a tangible transaction. There are inputs with a cost, an output with a value and a price paid.
But in services, value is created interactively between the consumer and the producer over time rather than in an act of production. Without the reaction of the guest, could the receptionist be able to make the small judgments about preferences that are vital to a guest’s enjoyment of a hotel stay? Without the response of the patient, could the doctor make a decent diagnosis? Could any value be created in any service transaction without the direct involvement of the consumer in the service production process? As these examples suggest, value creation in a service transaction is interactive, and usually repetitively so, with information being exchanged between consumer and producer to the increased satisfaction of both. The hotel receptionist has a better understanding of what he or she needs to do to improve the experience the guest has at the hotel. The doctor is helped in his or her capacity to make a sound judgment. This is not a linear process, as it is with tangibles where value-added flows one way and money the other in a predictable and linear direction.
Value creation in services can look like ergonomic chaos, production as a form of anarchy or, perhaps, anarchy as a form of production.
But that’s why it’s a service. If it wasn’t, then a machine could make it. It would be a thing; a tangible.
From tangible transactions to interactive relationships
With tangibles, manufacturing uses up materials and labour power. Once a unit of production is sold, all the value embedded in it is transferred to the buyer. It’s been sold for money or the promise of money. What is left is remembered competence -- technology stored in the minds of the person and the machines that made it.
In services, in contrast, value is shared rather than transferred. The transfer of the embodied value in a tangible between producer and consumer does not take place in intangibles. The idea of the precise division between producer and consumer itself breaks down in services. The rational producer will seek to maximise the constructive interaction with each consumer since this will increase the total value it creates. And the rational consumer will seek to do the same, because the more value created in a service transaction, the more there is to share.
There is a process of mutual reinforcement and encouragement in services which is impossible with tangibles. Value is created by people interacting because they encourage each other to create more value than they would if they were acting individually. A sports trainer succeeds only if he or she encourages an athlete to do more than he or she would do on his or her own. The elastic nature of the human capacity to create value is central to value-creating in services. This characteristic of human behaviour is pervasive and inescapable. And at its most basic, it explains how two human beings -- using nothing more than their inherited DNA, labour and imagination -- can produce another functional human being. This happens naturally, but not automatically. We are not machines.
Value is created in intangibles, just as it is in tangibles. Money is paid, just as with tangibles. And there are, as in the production of tangibles, costs involved. But how value is created is completely different. With intangibles, it is the result of a constructive interaction between human beings. The interaction is unique and cannot be scientifically compared with any other interaction, even if it involves the same hotel and clinic and the same receptionist and doctor. A sequence of interactions develop into a relationship where the market-clearing price affects the supporting tangibles but not the value-creating component of services.
We have stepped through the looking glass into a world of production that tangible economics cannot comprehend.
The impossibility of trading and storing relationship value
Tangibles are rarely manufactured in a single unit for one person, though this does happen. If you’ve got the money, you can probably get a car made that no one else has. Paintings are usually unique. But, in general, everything in the tangible world is to some extent produced in large quantities for a particular group of people comprising many consumers with similar tastes and levels of disposable income. The homogeneity of durable tangibles, things that are not used in a single act of consumption like food, allows them to be sold and bought and then sold and bought again.
The tradable characteristic of tangibles makes possible the development of markets, intermediary institutions that separate the people that make things from the people that consume or use them. There is no need for them to meet. With tangibles, distance can make the heart grow fonder.
All tangibles are subject to commodification: the capacity for them to be traded through the mediation of a market without producers and consumers directly interacting other than through the exchange of payments which in turn are mediated through impersonal markets for money and finance.
For durable tangible goods, this characteristic adds a massive dimension to the role of price because it also facilitates the scientific measurement of the extent to which a durable’s value diminishes over time. The prices of used automobiles help us understand how quickly a car is used up. This principle can be applied generally to guide investment decisions. The rate at which a durable tangible is consumed or decays underpins our judgement about how much we should pay for it. If a car costs $20,000 and its resale price falls to zero at the end of year five, then its actual average cost is only $4,000 a year. If this is less than the annual cost of using other methods of transport, then it makes sense to buy it.
Tangibility has equally important implications for companies. Tangibles that are used up in one year, like paper in photocopying machines, are treated as costs and are set against revenues generated in a single year. But a durable tangible can be deemed to be consumed much more slowly. The value embodied in a fleet of company cars is not used up in a single year, but over a number of years. The purchase of durable tangibles by a company, therefore, involves an element of investment, equivalent to putting their residual value at the end of each year in a bank. Buildings, which are used up slowly, can be deemed to depreciate over 50 years and more. Land, though it will have to be maintained and replenished to maintain its fertility, can be deemed to hold its purchase value in perpetuity. For most producers of tangible goods, tangible assets like land, buildings, equipment and stocks or inventories, account for the bulk of their perceived net worth.
This is all logical, tried and tested. It works for tangibles.
But can any of the principles of market mediation and commodification be applied to services?
The answer is yes, but up to a very limited point and usually for a very limited number of intangibles. The value created in the interaction between a hotel guest and a receptionist and a patient and a doctor is simply beyond resale. Would a guest say to a receptionist: “I would like to pay you for the service you are about to provide but I don’t want to consume it myself. I want to sell it at a higher price to someone else who will arrive some time in the future. I’d appreciate it if you treated him or her in exactly the way you might have treated me or I’ll have to pay compensation.”
Would the patient leaving with the doctor’s guidance sell it to someone else who believed he or she had the same symptoms?
The answer is: it’s possible, but so unlikely that it can be effectively eliminated as a practical option. And can the value in an intangible transaction be effectively stored?
Consider once more our hotel guest. He or she captures value in a constructive interaction with the receptionist.
Can this value be stored in the way that the value stored in a car is?
Can the guest the next day get up and retrieve the residual value of the interaction and, figuratively speaking, go for a drive in it?
The answer is no, or at least not in the way that the value in durable tangibles can be. The interaction at the reception desk the previous night that delivered value to the guest lives only in that guest’s memory. It’s not disappeared as if it never happened. But it’s gone in every way that an economist would understand. And since relationship value can’t be stored over time, the idea of depreciation that scientifically measures how a durable tangible degrades, or is used up, over time has no validity in services. Whether participating in a relationship today is better than waiting until some future date is itself a subjective issue over which the market-clearing price has no traction.
From transaction payments to the exchange of gifts
We can now turn to the role of price in value-creating interaction in service relationships. As we have learned, in the market for tangibles, price plays a critical role in reconciling human wants with scarcity. Unless you are prepared to cover the cost of making a product, there are few incentives for a producer to keep selling it to you unless there is no other option, as there invariably is.
And unless a producer is willing to price a product in line with what their customers can afford (or are prepared) to pay, nothing will be sold. The price of tangibles simultaneously acts as a reward and a compensation as well as an incentive and a compulsion to all those involved in tangible transactions. And it does this in a detached, unemotional and mechanical way. Who buys the good and who makes it is usually irrelevant. Buyers and sellers of tangibles prefer it that way. It makes it easier to discriminate coherently among the host of tangibles that money can be used to buy and to determine how many resources should be used in their production.
With intangibles, in contrast, emotion is rarely if ever detached from a transaction. For the buyer, there is an inescapable need during a service transaction to be constantly reassured that what is being paid reflects what the service is considered subjectively to be worth. And the idea of what is merited or deserved is never far from the supplier’s mind.
With tangibles, the transaction is mechanical, automatic and depersonalised. With intangibles, the transaction is self-conscious, pragmatic and highly personal. And there is no objective way that parties to a value-creating service relationship can attach a price to that relationship because, as has been argued, there is no homogenised market in services, only a mass of incommensurable transactions that cannot be scientifically analysed or coherently compared.
And yet, money is invariably exchanged during service transactions.
What determines how much is paid?
This requires another conceptual leap out of tangible-era thinking. To an extent that is rarely openly acknowledged, the provision of a service and the payment for it is closer in nature to an exchange of gifts, a tangible expression of the significance individuals attach to a relationship.
At anniversaries and celebrations, people give each other presents. Why do they bother? Why not just give each other money based upon a scientific assessment of the value that the relationships being honoured are worth?
Why not compare gifts, work out their relative price and haggle about whether the transaction was fair? Why not just give cash?
But people don’t do that, though an unsatisfactory gift can be a source of grievance. Gifts express, in a way that a price-based transaction never can, the importance the receiver has in the life of the giver. Often, gifts are preferred over money because it is a public expression of the value that relationship has for both parties. An exchange of gifts establishes a connection based on obligation. Both parties feel they owe the other something. The critical role it plays in services is that it turns a single transaction, or a one-off act of consumption and production, into a relationship; into an economic connection that endures through time.
Recent research has discovered that barter, or the exchange of things, was comparatively rare in human civilisations without money. The exchange of goods was usually an expression of friendship, kinship or alliance that would be finely gauged to sustain relationships among individuals and groups of individuals. In many parts of the world, prices are still only the starting place for a discussion between a buyer and seller that will develop into a relationship after a satisfactory exchange of gifts in the form of a discount from one and the payment of money by the other.
This is confusing for tangible-era economics which is based on the idea of satisfaction-maximising consumers and profit-maximising producers who seek to extract as much possible, in both subjective and objective forms, from every individual tangible transaction.
Another example might shed some light on the topic. Consider the feelings of those party to a service interaction. The provider of the service, a waiter for example, does something nice for a diner. The diner feels he or she owes something to the waiter. The diner then determines how much that should be and expresses it in the form of a tip, a reciprocal gift. The key to the exchange is this: unless the giver feels that he or she has received a satisfactory reciprocal gift, the relationship between them collapses. Value creation, which requires constructive human interaction, declines and may even disappear as a result. What are being addressed in service relationships are mutual obligations, not individual rights, that the service interaction must satisfy.
People buying and selling tangibles, in contrast, are principally concerned with the transfer of the right to use them expressed through a contract, written or verbal, which is underpinned by an enforcing agency like the state with police powers. Trade in tangibles needs a system of enforceable rights.
Service interaction, in contrast, depends upon the voluntary acceptance and discharge of obligations which are often implicit. This perspective on the nature of a service interaction helps us understand that the critical element is not that additional value is created. It is that it is shared in a satisfactory way between the parties who feel personally obliged to deliver what they have promised. If that happens, the foundations are laid for further interactions that establish relationships delivering value over time.
The role of the process
Those following this line of argument will point out that the amount of money paid for a service also must take into account the cost of providing the tangible things used in hotels and health clinics. There’s buildings, equipment and people trained to used and service them. If they weren’t there, there could be no service transaction and no consequent value creation. This is beyond argument.
Tangibles are invariably essential for a successful service transaction. But their role is to facilitate the value created in constructive human interaction. The bed in the hotel room used by the guest does not add value; it makes the value-creation process possible because the guest wouldn’t get a good night’s sleep without a bed. Doctors and patients need equipment, teachers and pupils need schools and English premiership football teams and spectators need football stadiums. The things that facilitate value-creation -- the processes -- degrade over time. It is, therefore, possible to establish a quantifiable connection between the productivity of having it now or in the future. This will establish time-preference based and opportunity cost options for all process investment choices.
But they will be subordinate to the subjective assessment of the impact on relationship value-creation of deferring or advancing a service interaction. Objective cost factors play a role, but the process investment decision will be driven by service relationship priorities.
The analysis of a service shown above, therefore, entails dividing it into a relationship component, where value is made, and a process component that facilitates its creation and distribution. It consequently divides the amount paid into two elements: a cost-covering part, which deals with the tangibles used in service delivery, and a gift-exchange part governed by subjective factors.
The first can be treated in line with the market-clearing price model originating in the Marshallian synthesis of 1890.
The second, however, falls outside the scope of scientific analysis as we know it. It depends upon human interaction in value-creating relationships underpinned by obligations. These are essentially intuitive and can be said to be irrational. And yet, they are essential to the well-being of every rational person.
The separation of process from relationship
The principles guiding value creation in services that have been explained can now be used to reconceptualise the changes in the economies of advanced countries in the past century. By stimulating the accelerated production of tangibles, the idea of the market-clearing price freed human beings from the struggle to survive. There were increasing amounts of time to devote to constructive interaction within value-creating relationships expressed in the form of the services which now account for the majority of output in the world’s most advanced economies. Initially subordinated to the tangibles they enhanced, services have turned the tables on their previous master to dominate value creation itself. Technology, the fruit of constructive human interaction in science, has liberated value-creation from the tangibles that had previously imprisoned it. Process and relationship are dividing with profound implications for the future.
An example, among many, can be found in the changes in the media industry. In 1977, when the author started as a junior reporter at Reuters in Fleet Street, the relationship elements of media service production were to be found in the same place as the process elements. Journalists and the advertisement and marketing teams -- the relationship specialists in media firms -- were located in the same building as the printing press.
This was not an accident or a mistake. It was because that was all the technology of newspaper production at that time allowed.
Technical change in general, and the rise of digital communications in particular, has radically changed what is possible. Today, the reporters don’t have to be in the same continent as the printers, let alone in the same city. Price has encouraged new methods of newspaper manufacture that reduced average costs and freed resources to increase the service component of what is made. It has also encouraged export of the process component of production to places where such costs are lower whilst allowing the relationship component to stay close to the consumers, the essential counterparty in service value-added creation. The separation of process from relationship in production, which has allowed the boom in services, is the supreme achievement of the idea of the market-clearing price. But it is also its undertaker.
The growth of services, and the technologies that separate process from relationship, mean that the market-clearing price can only affect the first, which is becoming increasingly insignificant to growth in advanced economies. It continues to encourage more technological development that will in turn reduce the average process cost of service transactions.
But the relationship component is now on a separate trajectory and stands on its own as the dominant influence on modern economies. Here the market-clearing price, in fact any price, is redundant. Another factor is driving value creation. This is the desire among individuals to find counterparts with whom to create value and form interactive relationships.
From markets for tangibles to intuitive service communities
As has been explained, value creation in a service economy is the product of constructive human interaction. The individual, as in a tangible economy, remains the engine of progress. But the interactive compulsion, the need to deal with other human beings for value creation and the mutual obligations that occur as a result, shapes collective economic behaviour.
The value-seeking individual establishing interactive relationships with other individuals is promiscuous. Invariably, people will seek several interactive relationships where value can be created in different ways. The value-seeking individual will subjectively assess the relative productivity of each relationship by a process of comparison that will take into account the amount of value created and the perceived value of the gifts exchanged.
But the mental picture that develops will invariably fail to conform to the systematic pattern that the theory of utility requires. Attitudes to relationships will vary from day to day and will be affected by the needs, mood and maturity of those involved. An individual’s mental map of the complex network of relationships that he or she creates is unstable and constantly changing. And so a further blow is dealt to the institutions associated with the tangible era.
In tangibles, people dealt with segmented markets and industries. In intangibles, these stable, predictable arrangements give way to intuitively-defined and overlapping communities. Individuals seeking to create value through human interaction require little direction to find the communities that serve their particular purpose. They will gravitate naturally towards others with the value-creating competences that are relevant at particular moments during a day, week, year or lifetime. The resulting communities are neither exclusive nor stable.
In the tangible era, the individual was active in a hierarchy of managed organisations including the family, the company and the state. The requirements of tangible production tended to lead to the emergence of stable institutions capable of organising information about tangible production and consumption and mobilising the capital required for it. Laws and contracts enforced the system of rights essential for tangible production and consumption to occur. The institutional arrangements suited the technical challenges tangible production entailed.
The rise of the service economy and the separation of process from relationship in services makes such systems redundant. In societies dominated by service production, individuals need to be free to work horizontally and simultaneously across communities that lack command structures. They will normally include, at a minimum, a work community, a social community and a family community, though individuals will participate in dozens, sometimes unconsciously.
Markets comprising producers and consumers are consequently being replaced by overlapping and unstable communities of value-creating individuals that are intuitively obvious to its members but unquantifiable and even mysterious to those that are not.
Outside the context of a particular community, the people that make it up may have little in common. No market research could ever forecast who might participate in a service transaction within a particular community at a particular moment. No analysis would be able to conclude what they had in common once the interaction has been completed.
An example among many is Manchester United Football Club. For most of the time, most people who support Manchester United are unconcerned about football. They are of all ages, both sexes, all professions, many nationalities and faiths and they often don’t live in Manchester or have ever been there. But on match days, they become a global community of millions of people interacting constructively with each other, inspiring their team and enjoying its success. Out of this massive creation of value, broadcasters and advertisers will be able to secure many millions of dollars of revenue. On the day that Manchester United played Barcelona in the UEFA Final on May 2009, the Manchester United football players, management and supporters for a couple of hours constituted one of the most profitable businesses on earth. Only it wasn’t a business, an industry or a market. It was a community of value-seeking people creating value by interacting constructively with each other, though it didn’t work on that occasion. Manchester United lost.
The Manchester United community is essentially unmediated and largely unmanaged. It is spontaneous, not controlled. And it is largely based on an irrational factor: a shared and interactive passion for a football team that cannot be scientifically analysed or explained.
In tangible production, rationality is the most important value. Rational consumers buy things from producers who in turn act rationally, at least a priori. Prices and costs are measurable and, consequently, satisfy the rational mind. The reason why the idea of a market-clearing price is so compelling is that it makes sense.
In intangibles, irrationality is the required condition for effective value-creation. Since what is being produced and consumed cannot be seen, touched or scientifically measured, service transactions require an act of faith from both parties that what is being exchanged actually exists and what has been promised will be done.
The most compelling example of the separation of relationship from process and the rise of spontaneous, horizontal, unmanaged and unstable communities can be found on the worldwide web. The internet is the most dynamic process the service era has so far produced. It is facilitating unmediated and spontaneous human interaction on a scale and of a nature that has no parallel in history.
Through the web, the concepts developed in this chapter have become a daily reality.
It proves that the separation of process from relationship is not only logical and potentially beneficial.
It is an irreversible fact that every household, business and government on earth cannot ignore.
But how should we respond to the process-relationship divorce made possible by the dynamic but increasingly redundant role of the idea of the market-clearing price?
This question will be addressed in the following chapters. But this one closes with the market-clearing price deposed as the master of economic thought and practice.
Subjective value, the product of interactive relationships within intuitively-defined communities, and objective cost, which measures the efficiency of the service process, have been restored as concepts that economists once again have to consider separately and seriously." (https://sites.google.com/site/theendofthemarket/chapter-2-the-renaissance-of-value)