Economic Value Analysis

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University of Rochester

William E. Simon School of Business Administration

Professor Greg Shaffer MKT 414/STR423
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Economic Value Analysis

Components of EVA:

• Reference Value: What you are willing to pay for the next best alternative? • Differentiation Value: What are the relative benefits and costs of your product?

From Utility Theory:

• Let Vi = a consumer's value or utility from consumption of product i. • A consumer's value or utility from NOT consuming is often referred to as the "outside." For simplicity, we assume this is zero: V = 0.

The Economics Approach:

Consider a market with a single firm:

In a monopoly setting, a consumer is willing to pay the difference between her value from consuming and her value from not consuming. Thus, WTP = V - V = V. This willingness to pay is sometimes referred to as the consumer's reservation price.

Consider a market with two or more firms:

How does the above calculation change in a competitive setting? We want to calculate the WTP for brand 1 in a market with N brands. Assume the prices of brands 2 to N are fixed. A consumer's surplus from brand i is Vi - pi. If a consumer were to select from the set of brands 2 to N, she would choose the brand with the greatest surplus. Let i* equal the max of (Vi - pi) for i = 2 to N and let S* be the surplus a consumer receives from consuming brand i*.

What is this consumer's willingness to pay for brand 1? In the monopoly case it was the difference between V and V. In the competitive case, it is the difference between V1 and S*.

WTP1 = V1 - S*. (1)

Thus, this consumer must be offered at least S* in surplus. If not, she will purchase brand i*.

The EVA Approach:

EVA arrives at exactly this same answer, but in a slightly different manner. In the EVA approach, we first ask a consumer what is she is willing...
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