Intangibility

The economic theory of intangibility

The fact that conventional microeconomic theory founders when applied to intangibles doesn’t mean an economy where services are dominant is beyond comprehension.

In a hairdressing salon, someone sits in the chair and another wields the scissors. In a shop, there is a customer and shop worker. In a theatre, there are actors and an audience. In all three instances, a service transaction is taking place. People are creating something and people are paying for it. You can think of further types of service transaction; the variety is bewildering. But they all have a common characteristic and one that is the only consistent feature of a service whether it’s in finance or football: it involves people. But the way they create value is completely at variance with that which neoclassical economic ideas suggest.

Tangibles are invariably made through a value chain.

Consider the way direct reduction steel is produced. 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 by combining raw material, labour, machines, land and technology. 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 value-creation in tangible production, and not just steel. It goes one way.

With tangibles, once a unit of production is sold, all its value is transferred to the buyer. It’s been sold for money or the promise of money. What is left are remembered competence – technology stored in the minds of the people that produced it – and the machines that made it.

Let us now 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 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 between the consumer and the producer in an interaction 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 satisfactory diagnosis? Could any value be created in any service transaction without the direct involvement of the consumer in the service production interaction? The answer must be no.

In tangibles, value is transferred from seller to buyer in return for a payment, which is also a transfer, this time of purchasing power. But this can’t be said about the distribution of value in services. A doctor is creating value with his patient but he or she retains some of the value created in the interaction in the form of greater knowledge of the patient and of the medical condition he or she has treated. This is true of all service interactions. Not only is value the result of an interaction. It is shared among the participants in the service interaction and not wholly transferred.

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 as a result 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 and a tangible.

How can two people in a service interaction create additional value? The answer is that there is a process of mutual reinforcement in every successful service transaction. Value is created by people interacting because they encourage each other to create more value than they would if they were acting individually.

This is intuitively obvious in every service transaction. A sports coach succeeds only if he or she encourages an athlete to do more than he or she would do on his or her own. Students respond to the enthusiasm of teachers. Patients react to the expert guidance of doctors. As every business school on earth now teaches, the critical capacity a chief executive needs is the ability to lead, not to manage, because it encourages his or her colleagues to more than they would without that leadership. And as we all know, our own performance depends upon the strength of motivations upon which others can have a decisive influence.

The elastic nature of the human capacity to create value is central to value-creation in services. It is something that things, intangibles, do not possess. No matter how much encouragement you shout at a car that won’t start, it’s not going to make an iota of difference, though it might make you feel better. Animals of course can be trained, but we are not yet at a point where we would rely upon our household pets to do the shopping. This characteristic is pervasive and inescapable in human behaviour. And at its most basic, it explains how two human beings – using nothing more than their inherited DNA, labour and imagination – can produce another. This happens naturally, but not automatically. We are not machines.

Powerful conclusions can be reached by carefully considering service transactions. Value has been created. If it hadn’t been, why would the parties to the transaction spend time interacting? The value is intangible and invisible and only exists in the minds of the parties to the transaction. There are tangibles supporting the interaction. Doctors’ surgeries have chairs. Shops have electronic point of sale equipment. Restaurants have knives and forks. Theatres have lighting. Schools have white boards. Management consultants have lap-tops. But these facilitate value-creation in services; they do not create value. So long as the parties to a service transaction are interacting constructively, then value-creation would happen without them, though perhaps not so efficiently. And finally, value in services is exclusively the result of constructive human interaction that encourages people to do more than they would have done without it.

Choice in intangibles

As has been argued, value created in service transactions is intangible and, consequently, solely perceptible at the level of the individual. It is solely the result of constructive human interaction, though tangibles will play a supportive role.

We can move on to address further questions. What determines the choices consumers and producers make about intangibles?

An answer is indicated by an examination of the behaviour of an individual seeking to make a choice between two. Let them be called intangible bananas and intangible biscuits. As with their tangible equivalents, there is a price ratio between the two products on offer. The consumer has preferences and an income constraint. The consumer will consider the merits and the relative price of intangible bananas and of intangible biscuits. This, logically, will entail interaction with the suppliers. How will the consumer, otherwise, know what he or she is buying? The consumer will form a view of what is on offer and compare the happiness (or reduced dissatisfaction) he or she might enjoy by buying a particular amount of each. A decision will made. An amount of money will be paid for the intangible bananas and for the intangible biscuits. So far, the approach confirms the validity of conventional microeconomic theory.

But consider what were to happen if the consumer decides not to make the decision at the moment and defers it for a day. He or she returns to the market for intangible bananas and intangible biscuits with the intention of buying some of each. The first question would be whether the intangible bananas and the intangible biscuits the consumer is considering are the same as, or similar to, the ones he or she was considering the previous day. After all, there are no physical characteristics to confirm that they are. This must involve a further round of questions being put to the producers to satisfy the consumer that what is on offer today is identical or similar to what was on offer the previous day. But even if every question is satisfactorily answered, how confident can the buyer and supplier be that today’s intangible bananas and intangible biscuits will be identical to the ones that were on offer yesterday? What is on offer has no material composition. It is not like looking for the second time at a shirt which has physical characteristics to substantiate the belief of both buyer and seller that it is the one previously seen. With nothing tangible to validate what they are doing, there is only one option. The buyer has to believe what he or she is being told by the supplier, and the supplier has to reassure the buyer that that is in fact the case. An act of faith is necessary is if a transaction is to occur.

Consider a person making a choice between being taught French and being taught to play the guitar. He or she has an income constraint which fixes the maximum number of hours of French tuition he or she could afford at the given price ratio and, at the other extreme, the maximum number of hours of guitar lessons. From this perspective, it seems the choice is the same as if the consumer were choosing between bananas and biscuits. But the lack of tangibility in the music and French lessons complicates the decision to a degree that makes it qualitatively different to choosing between the fruit and the cookie. The decisive factor is the feelings he or she might have about the teacher. This can change between lessons. But it can also change in the course of a lesson itself. And the quality of what is being imparted depends critically on the attitude of the teacher, or the supplier of the service, to the person he or she is teaching. To what extent can it be said that the student actually consumes an hour of French lessons in the way he or she might ingest a banana and a biscuit? In tangibles, something is produced, exchanged and consumed. But in intangibles, production, exchange and consumption are subsumed into an interaction between the supplier of the service and its consumer.

The value that a consumer attaches to a particular service might also not diminish as the amount of it consumed increases, as logic suggests it ultimately must in tangibles. A student, impressed by the quality of the French teaching, might decide to consume more of it as he or she progresses through a teaching programme. Demand for guitar tuition might disappear as a result. The logic of diminishing marginal returns, the cornerstone of equimarginal choice, begins to founder because it depends upon the observable truth that human beings can always have enough of a single tangible, however initially desirable it might be compared with all other tangibles. But that is conceptually untrue of intangibles. Given the choice between good advice and bad advice, people will always choose good advice and continue to consume it. You can never have too much good advice. No one is going to say: “That’s enough good advice, I think I’ll have some bad stuff now.” No one is going to say: “That good advice is a bit expensive. How much is your bad advice?”

Economists have dealt with the phenomenon of desire for a product growing as more of it is consumed by defining it as addictive, like nicotine and alcohol. Such items are considered to have characteristics that undermine a consumer’s capacity to make rational choices and, by definition, are exceptional, or at least unusual. They are tangibles. But in services, practically everything exchanged has this capacity.

The critical factor motivating a service transaction is not price. It is the state of the relationship between the buyer and the supplier. If the parties to a service transaction do not believe that what is being offered reasonably corresponds with the enjoyment likely to be derived from actually consuming it, then an impediment might develop that will prevent the transaction being completed. From the buyer’s perspective, fear that the service will be below the standard promised will discourage purchase. From the supplier’s point of view, doubts that a consumer is honestly expressing the desirability of what is being offered might have the same impact.

Put at its simplest, people won’t buy a service, no matter what the price, if they dislike or have doubts about the honesty of the service supplier. And people will be reluctant to supply a service if they dislike – or have doubts about the honesty of – the service consumer. That is overwhelmingly because all service transactions involve a personal interaction.

In tangibles, in contrast, most transactions are impersonal and detached. For most Americans, the Chinese Communist Party is repugnant, but this is largely irrelevant to people in a mall in Minneapolis that buy a running shoe made in a Guandong sweat-shop. They don’t think about the conditions of the workers or the attitude of the management because they don’t have to. Through the mediation of the market, the relationship between workers, managers and owners of shoe-making factories in China is obscured. In services in contrast, the behaviour and character of the supplier is inescapable to the buyer.

Further examples can be developed to illustrate the way that the relationship at the level of the individual service supplier and the individual service provider will both determine the price that might be paid for a service and whether a transaction occurs at all.

Would a person with a toothache pay for dentistry if he or she fears the dentist is incompetent and won’t relieve the pain? Would he or she contract a lawyer who they felt was a liar. Would a restaurateur be prepared to serve a customer who falsely complains there’s a fly in his or her soup in order to get a discount?; or seek compensation for falsely claiming he or she has suffered food poisoning from a meal consumed in the restaurateur’s premises?

There is a further dimension to the way value-creation and distribution in services differs from the way it occurs in tangibles. In tangible production, manufacture involves repetitively making identical goods. The inherent or intrinsic characteristics of each are identical. In mass production, the first car made on a production line should be in physical and technical terms no different to the last one. The difference comes from the way one individual views and uses an identical good compared with the way another individual does.

In contrast, each intangible is inherently different from every other because it is the result of co-production between the producer and the consumer in each service transaction. But repetitive transactions also have an impact. The more that a specific doctor deals with a specific patient, the more tailored the service interaction becomes. Over time and through iterative service transactions, a relationship develops between the individual service provider and the individual service consumer that encourages an increase in the amount of value the parties to those transactions perceive has been created.

That can’t happen with tangibles. People consume tangibles; cars; shoes, cornflakes etc. They often say they like them. But no rational person will believe that sentiment is reciprocated by the tangible in question. That can only happen in an interaction between human beings.

In intangibles there is no market, only a mass of individual transactions which involve the creation of a service that is unique in the eyes of the participants to each one. Price conditions the terms of a transaction, including whether it takes place at all. But the determining vector is the quality and nature of the relationship between the participants. If there is no relationship, there can be no constructive interaction and, therefore, no value-creation. Choices made in intangibles will be constrained by price. If a service is unaffordable, a consumer won’t buy it. But the selection of an affordable service will be mainly driven by the expected or actual state of the relationship between the parties to a service transaction.

From markets for tangible goods to communities of service-value creators

As has been argued, there can be no mass market in intangibles. Each service interaction is unique to the parties involved. The value created in an interaction is shared and not transferred. But that does not mean that there are no collective arrangements in intangible transactions.

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 comparison that will take into account the amount of value created and the perceived value.

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 tangible economic thought.

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 is making 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 it consists of may have little in common. No market research could ever accurately 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, 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. Their team 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 are assumed to 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 seems to make 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.

 

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 reassured that what is being paid reflects what the service is considered subjectively to be worth. This evaluation is usually unstable and can vary wildly even as single service transaction takes place. And the idea of what is merited or deserved is never far from the supplier’s mind. 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? Answering this question requires another conceptual leap beyond 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.

Gift-giving is embedded in practically all human communities. 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?

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 also establishes a connection based on obligation. Both parties feel they owe the other something. The critical role it plays in services is that it helps turn a single transaction, or a one-off act of consumption and production, into a relationship; a connection that endures through time. This rarely happens in the sale and purchase of tangibles because the price asked and paid captures, at least in principle, all the value embodied, or perceived, in the good sold or bought. In services, in contrast, the value is embedded in the relationship between parties to a service transaction and can’t be wholly transferred or accepted as it can be in tangibles. The tangibles supporting service transactions are often the channel through which services are delivered. These are sometimes essential if a service transaction is to take place. But no one’s buying the chairs in a doctor’s surgery or the whiteboard used by a university lecturer. It’s in the intangible where value is located in every service transaction.

Recent research has demonstrated 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 restaurant 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 only 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 further value over time.

This line of argument establishes knowledge as being something that cannot be separated from individuals and, consequently, from the communities of which they part. The next question is: can such knowledge be treated as capital in the same way that economics has treated durable tangibles?

This issue will be tackled in the next chapter.