William E. Simon School of Business Administration
Professor Greg Shaffer MKT 414/STR423
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...