Your hourly rate seems a little high…
Understanding the difference between price and value
The Story
A first-time developer hired me to help obtain approvals for an urban apartment project that was well along in design. At the time, he commented that my hourly rate seemed high, but he was in a bind: He had just learned that a key politician opposed the project because he had failed to consult with the community. He hired me because I knew the community, the approval processes, and the city staff and elected officials involved. My first job was to arrange meetings with surrounding building owners and the local neighborhood organization to explain the project and seek their support. I quickly made some calls, and within a couple of weeks, we had several positive meetings and several others on the calendar. Then, I received a call from a city staff person who administers a big grant program. He had heard that I was working on the project and called to tell me that the developer had applied for a $300,000 grant—a significant amount for the developer—but that the same politician was still opposed to the project and would be voting against the grant in a committee meeting that was starting in 30 minutes. The grant program ran on a six-month cycle, and with construction set to begin in a couple of months, it was now or never.
I sped downtown, and as I was walking down the corridor in City Hall, I texted the politician to let them know that I was working on the project, that we had met with several of the surrounding property owners and the neighborhood’s planning and zoning committee and received support, and that we were on the agenda for the neighborhood board meeting the coming week. My general message was that while we were still a little behind the eight-ball, we were much farther along than the politician had known. They texted me back, “Great, thanks for the update!” Then, I walked into the council chambers and took a seat. Ten minutes later, the committee approved my client’s grant request. In addition to getting the project back into the good graces of a key elected politician, I helped my client win a $300,000 grant, all for fees totaling about $15,000, or 5% of the grant. Yet when I submitted my final invoice, my client, again, made a subtle comment about my high hourly rate. What was he talking about?
The Theory
This story highlights the economic theories of objective and subjective value. The Industrial Revolution (1760-1840) and the emphasis on the mass production of commodities led Adam Smith, David Ricardo, and other economists to develop the theory of objective pricing. Marx expanded on Ricardo’s labor theory of value, integrating a rate of exploitation that went beyond economics to consider the moral and judicial implications of capitalism. This classical theory of objective pricing reflects an increased interest in the production of commodities rather than their exchange—an emphasis on cost over price, or supply.
But in the 1870s, at the beginning of the Second Industrial Revolution, William Jevons, Carl Menger, Eugen von Böhm-Bawerk, and others developed the theory of subjective pricing. This theory reflected a shift in focus towards the proposition that the value of goods is subjective and based on context and the preferences and perceptions of individuals—demand. Rather than production costs, the buyer’s judgment determines value based on how scarce or useful the product is. The subjective theory of value represents the mainstream in economic thinking today because the objective theory does not consider either utility or variations in consumer preferences.1
How do the ideas of objective and subjective value help us think about the pricing of professional fees? Adam Smiths “adding up theory”—reflecting the objective theory of pricing—still closely approximates how many professional services are priced today: You estimate the hours required to complete a task, multiply times an hourly rate, add profit (if it is not included in the rate), and that is the price. But price and value are two very different things.
(NOTE: For a different take on the idea of “value,” see “We couldn’t afford to worry about a few ducks.”)
What was it with that developer and my hourly rate?
Prior to becoming a developer, my client had been an architect, and he knew that I was an architect, although I hadn’t practiced traditionally in years. He was stuck in an objective pricing mindset, based on his knowledge of hourly rates for architects. But he misunderstood both my services and my value. My rate was higher than a typical architect’s rate, but I was not providing traditional architectural services or drawing plans—he had hired an architecture firm to do that; I was providing a different kind of service—and using a unique combination of skills, knowledge, connections, and reputation—to help his project secure required entitlements from the local government. On top of that, I helped him win a $300,000 grant that he was within 15 minutes of losing—something that wasn’t even in my scope. But I answered the phone, happened to be nearby, knew the staff, and was able to lend my credibility to the unknown developer and reassure the politician. I don’t think he ever understood it, but that developer got a whole lot of value for what he paid me.
The Lesson
When considering fees, it pays to differentiate between the cost of a service and the value you will receive from the service provider. If the service is a commodity, like a set of drawings, the price should be competitive with that of other providers. But if the service is more specialized and the provider offers a unique combination of knowledge, experience, connections, quality, brand, reputation, prestige, or some other benefit, then you might be getting more than just a commodity, and the value you receive could be many times greater relative to the cost. If you are getting more in value, you shouldn’t be surprised if the price is a little higher, and you should gladly pay that price.
“Price is what you pay, value is what you get.”
- Warren Buffett
King, J.E. and Michael McLure, “History of the Concept of Value,” Discussion Paper, The University of Western Australia Business School, 2014; Fogarty, Martin, “A History of Value Theory,” Student Economic Review, Trinity College Dublin, 1996.