It's like planting a single seed in the soil—just a tiny speck of life—but over time, it grows into a sprawling tree with deep roots and branches teeming with life. That can be the reservation price.
How value is created in a transaction
The reservation price is the maximum price that a buyer is willing to pay for a product or service. It reflects the perceived value the buyer associates with the item. For example, if a customer values a pair of shoes at €100 (their reservation price), they won’t pay more than that, no matter how much the seller wants to charge.
Similarly, for sellers, the reservation price could also refer to the minimum price at which they’re willing to sell an item. Below this price, selling doesn’t make sense for the seller.
The cost refers to the total expense incurred by the seller to produce or acquire the product or service. This includes:
Variable costs: Direct costs like materials, labor, etc.
Fixed costs: Overheads like rent, machinery depreciation, etc.
The "value" is the difference between the reservation price and the cost. This value represents the potential economic surplus created in the transaction and can be divided as follows:
Consumer Surplus: The benefit the buyer receives if they pay less than their reservation price.
Producer Surplus: The profit the seller earns if they sell above their cost.
Let’s illustrate this with an example:
Buyer’s reservation price: €100 (maximum the buyer is willing to pay)
Seller’s cost: €30 (minimum price to make a profit)
Total value generated: €100 (reservation price) - €30 (cost) = €70
This surplus reflects the economic value created in the transaction. The key is finding a price where both parties feel they’ve gained something:
The buyer pays less than their reservation price (perceived good deal).
The seller sells above their cost (profitable transaction).
Consumer and producer surplus
Why does this matter in pricing strategy?
Understanding the dynamics between reservation price and cost helps businesses:
Set optimal prices: Align prices closer to the reservation price to maximize producer surplus while remaining attractive to buyers.
Segment markets: Identify customers with higher reservation prices and tailor offers for maximum profit.
Create value-based pricing: Price products according to the value perceived by customers, not just costs.
Reservation price is not constant
Do you know the joke when a man says: "Fuel price changes don’t affect me, I always buy fuel for 50 euros"?
This highlights how people might misunderstand the concept of reservation price and price sensitivity. At first glance, the man seems to imply he’s unaffected by fluctuating fuel prices because he consistently spends €50 every time he refuels. But this statement misses the deeper economic reality: the amount of fuel he gets for €50 depends on the price per liter. Let’s see why this matters.
Imagine the price of fuel changes over time:
Scenario 1: When fuel costs €2 per liter, €50 buys him 25 liters.
Scenario 2: If fuel drops to €1.50 per liter, €50 buys him 33.33 liters.
Scenario 3: If fuel rises to €2.50 per liter, €50 buys him only 20 liters.
The man’s behavior remains constant (spending €50 each time), but the value he receives (liters of fuel) fluctuates with the price. His true reservation price—the maximum he’s willing to pay per liter of fuel—determines how much he values fuel overall and whether he continues to buy it at any given price.
This joke helps illustrate that reservation prices are influenced by several external and internal factors, making them variable. Let’s break it down:
A. External Factors
Price of Substitutes: If public transportation becomes more accessible and cheaper, the man might decide his maximum willingness to pay per liter (reservation price) decreases.
Market Trends: Sudden spikes in fuel prices during a crisis might push people to reconsider their spending priorities.
Income Changes: If the man earns more or less in the future, his budget for fuel and perceived value of spending on it might shift.
B. Internal Factors
Psychological Anchors: The man might set his spending at €50 due to a mental budgeting rule, even if his reservation price for fuel is flexible.
Usage Patterns: If his driving habits change (e.g., driving more for work or cutting back on leisure trips), the value he places on fuel may shift accordingly.
The joke underscores the importance of recognising behavioral patterns vs. economic reality:
Consumers may appear consistent (spending €50 each time) while their underlying value assessments change (liters bought decrease as price rises).
Sellers need to account for this variability in reservation price when setting prices or designing promotions (e.g., volume discounts or loyalty programs).
How to exploit reservation prices
Let’s dive into how businesses can exploit variable reservation prices to maximise profits effectively.
1. Segmenting the market by reservation price
Consumers have different reservation prices, and businesses can use this variability to target different segments:
A. Price discrimination
This involves charging different prices to different customer groups based on their reservation price. There are three main types:
First-degree price discrimination: Charge each customer their exact reservation price. For example, luxury car dealers negotiate prices individually with customers based on their willingness to pay.
Second-degree price discrimination: Offer volume-based discounts or package deals that appeal to varying reservation prices. For example, a gas station might offer lower prices per liter for larger fills.
Third-degree price discrimination: Charge different customer segments different prices based on observable characteristics. For instance:some text
Students might get discounts on public transportation.
High-income neighborhoods may see higher utility or service prices.
B. Dynamic pricing
Dynamic pricing adjusts prices in real time based on demand, seasonality, or customer data. Examples:
Airlines and hotels charge higher prices during peak demand periods.
Rideshare apps like Uber apply surge pricing during high-demand times, targeting customers with higher reservation prices.
2. Using psychological pricing to exploit behavioral anchors
Consumers' reservation prices can be influenced by psychological triggers:
Anchoring: Display a similar product at a higher price as reference to make the price of the desired product seem more attractive.
Bundle pricing: Offer products in bundles (e.g., a carwash + fuel deal) to appeal to customers who perceive more value in packages than individual items.
Framing discounts: For example, “Save €10 on your first 20 liters” feels like a better deal than “Save 50 cents per liter.”
3. Encouraging commitment with tiered pricing
Tiered pricing works by creating membership or loyalty tiers that adjust based on spending levels:
Fuel stations offer loyalty programs where frequent customers earn discounts as they purchase more. This motivates customers with varying reservation prices to increase their spending to unlock better deals.
4. Capturing value through versioning
Versioning creates multiple product options with varying features, targeting different reservation prices. For example, regular and premium fuels allow fuel stations to cater to customers willing to pay extra for perceived quality.
5. Using data to personalise pricing
Advances in AI and big data allow businesses to infer reservation prices and tailor offers:
Personalised Discounts: Online retailers track browsing and purchase history to send custom coupons based on perceived willingness to pay.
Behaviour-Based Offers: Apps like fuel trackers might notify users about nearby gas stations with discounts tailored to their spending habits.
6. Stimulating purchases with cross-financing
When you give away a certain amount of your surplus (margin) in one product and you try to cover that with cross-selling a higher margin product, you cross-finance the first product with the second one.
For instance, a fuel station might lower fuel prices slightly to bring in traffic, expecting to profit from higher-margin purchases like snacks, beverages, or car services.
7. Exploiting timing and urgency
Early bird pricing: Offer lower prices to customers who act early, incentivising price-sensitive buyers who are willing to take the time to find the best deals.
Last-minute premiums: Charge higher prices to customers buying close to the deadline (e.g., plane tickets or concert seats).
Now you can see that a seemingly simple concept like reservation price can offer so much you can play around.
Do you want to subscribe? Or would you like to discuss the topic?
