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Firm creates value

How does a firm create value and what must it be able to do to capture that value?

A company creates value when it’s producing and delivering its goods and services at a certain
cost that is always lower or relatively lowers than what the clients or customers are willing and
able to pay for the goods or services being offered. The company is owned by the shareholders
who capture the profits after all the expenses have been paid. A company also creates value that
ultimately flows out as consumer surplus which they appreciate and enjoy as long as the price is
lower than what they are willing to pay. The total of the economic value that’s created by
company is always equal to the total sum of the entire producer and the consumer surplus.
Innovations and improvements associated with a product or service normally contribute
positively to the increase of its value. These innovations and improvements increase the
consumers’ willingness to pay more. (Bowman and Ambrosini, 2000)
Value capture of the value created can only be captured by the company’s consumers and the
producers. The total consumer surplus normally increases with if there is decrease in the value of
its price or if the product quality improves without a parallel increase in its price. The

Economics 2
shareholders of the companies are able to capture a much higher increment of the economic rent
when the company is actually able to improve the quality of its products in a way that it also
enables the company to sell its products at a price which is higher than its cost. (Brandenberger
and Stuart, 1996)
For instance, If Ford Motors can produce half a million vehicles in a year, then later the
following year it produces the same number of vehicles at 10% less the cost of raw materials and
labor used previously, then its efficiency i.e. the total factor of its productivity has increased by
10%. Alternatively if the Ford motor group can produce similar quantities of vehicles at the same
cost but these time the consumers or customers are willing to purchase the vehicles at an extra
10% more than its previous price because of its improved performance then it has created a 10%
economic value.
A company’s revenue is always equal to its factor payments. In the following equation, the
incremental value created by a company is equal to the value distributed or captured.
(Change Y/Y-Sl (changeL/L)-SK (Change/k)-Sm (changeM/M) =SL (change r/r) +Sm (change
m/m) – (change p/p) where p = price of the company’s product. Y = company’s total output, L =
labor quantity, K = capital employed by the company, M = materials and other inputs, w = wage
and r = rate of return on the capital.
If Ford produces 10% extra cars then with the same production cost and the consumers are
willing to an extra 10% the R=10%. The economic value that has been created by the company is
distributed and captured by the shareholders, consumers, employees including the management
and the suppliers of the company.

Economics 3
R = SL (change w/w) + SK (change r/r) + Sm (change m/m) – (change p/p)
The first part of the equation shows and represents the gains on labor, the second shows the gains
on capital; the third part shows the gains captured by the suppliers while the last part shows the
benefits gained by the consumers or customers. (Hulten, 2000)
A company creates and captures value when it adds value to its products like in the case of Ford
when it actually improved its performance, reliability and fuel consumption efficiency thereby
increasing its sales and distributing its benefits and gains to the shareholders, suppliers,
employees and all other stakeholders.

Economics 4


Brandenberger, A.M., Stuart, H. (1996) Value Based business Strategy. Journal of Economics
and Management Strategy. 5 – 25.

Bowman, C., Ambrosini, V. (2000) Value creation versus value capture: Towards a coherent
definition of value in strategy. British journal of management, 11: 1-15.

Hulten, C.R. (2000) Total factor productivity: A short Biography. National Bureau of Economic
Research, working paper 7471.

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