Consumer's reservation price approximates consumer benefit

Statement

The reservation price of a consumer (i.e., the maximum price the consumer is willing to pay for the good) is a good approximation of the money value of the benefit that a consumer receives from buying a good.

Caveats

Transaction costs

In many cases, the consumer's reservation price indicates not the total benefit received by the consumer, but rather, the difference between the total benefit and the other transaction costs that the consumer needs to incur to buy the good. These transaction costs include costs of storage and maintenance, search costs, opportunity costs and others.

Wealth effects

Further information: Wealth effect

Due to poverty or the lack of funds, a consumer may be unwilling to pay a high reservation price for a good even though that person values the good highly. In other words, just having a little more money may make that person willing to pay a higher reservation price -- the income-elasticity of demand is very high.

Wealth effect measures the effect of a person's income or wealth on the person's private benefit of consumption. While wealth effects are always operational, they tend to be most severely distorting when the price of the good forms a large fraction of the person's income or wealth. For instance, a common food item may not be subject to much wealth effect for a middle-class consumer, but it may be subject to wealth effect for a person living from hand to mouth. Other possible examples include medical care, education, and leisure.

Reservation price reflects expectations rather than actual benefits

In situations where the consumer has no direct experience of using the good, the consumer's reservation price may not reflect the actual benefit the consumer would derive from the good. This includes, for instance, experience goods (whose value cannot be determined without actually purchasing them) and credence goods (whose value cannot be determined even after purchasing and using them).

Asymmetric information, in particular adverse selection, is an example of a situation where this happens, and leads to market inefficiencies.

Endowment effect

Further information: Endowment effect

The endowment effect is a phenomenon whereby the amount of money a consumer is willing to pay to buy a good is greater than the amount at which the consumer is willing to resell the good. This difference should be significantly greater than what can be explained by transaction costs. An explanation for the endowment effect is that consumers invest emotionally in a good after buying it, and thus, the value of the good to them is greater than the reservation price.