Consumer's reservation price approximates consumer benefit
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.
|Nature of caveat||Explanation|
|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 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.|
|Expectations versus 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||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.|
|Principal-agent problems||These occur when the person making the consumption decision, or deciding how much money to spend (the agent), is different from the person who will actually consume the good (the principal). For instance, a parent may be an agent for a child (the principal). The problem arises when the information, interests, and incentives of the principal and agent are not perfectly aligned. The maximum amount the agent is willing to pay may differ from the maximum value that the principal would be willing to put.|