Reservation price

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Definition

The reservation price is defined as follows:

  • For a potential buyer or consumer, it is the maximum value the buyer is willing to pay in order to buy a good.
  • For a potential seller or producer, it is the minimum value the seller is willing to accept in order to sell a good.

Related notions

Consumer's reservation price approximates consumer benefit

Further information: Consumer's reservation price approximates consumer benefit

A consumer's reservation price is an approximation for the total benefit that a good confers to the consumer. For this reason, the consumer surplus generated when a person buys and consumes a good is defined as the difference between the consumer's reservation price and the price the consumer needs to pay for the good.

Producer's reservation price approximates production cost

Further information: Producer's reservation price approximates production cost

The minimum price a producer is willing to accept to sell a good is an approximation for the total cost to the producer of making the good. For this reason, the producer surplus generated when a producer is able to sell a good is defined as the difference between the price at which the producer sells the good and the producer's reservation price.

Difference between reservation prices approximates social surplus

Further information: Difference between reservation prices approximates social surplus

If the consumer's reservation price exceeds the producer's reservation price, the consumer's buying the good generates value for society -- this value being measured as the difference between the reservation prices. This total is termed the social surplus.

This analysis may be wrong for two reasons. First, the consumer's reservation price or producer's reservation price may not reflect the true benefit or cost to the consumer or producer. Second, there may be externalities -- external costs and external benfits.

If the market price is between the producer's reservation price and the consumer's reservation price, the transaction does occur, and the social surplus is created. Where the market price is located between the reservation prices determines how the social surplus gets distributed between producer surplus and consumer surplus. If, however, the market price is not in between these reservation prices, the deal does not occur and there is a deadweight loss.

Conversely, if the consumer's reservation price is less than the producer's reservation price, the consumer will not buy the good no matter what the price, unless there is force or subsidy involved.