Willingness to Pay is a term for the highest price a consumer will pay for one unit of a good or service. Willingness to pay (WTP) is a key component of consumer demand, and is critical knowledge for a business in the process of pricing their product. Demand is factored into determining the “best” price, which will satisfy both producer and consumer when the good or service goes to market.
Pricing impact on profits
Ultimately pricing becomes one of the most important factors in determining a company’s ability to profit. Setting the right price means you have optimized the potential profitability of your product. Setting the wrong price means you run the risk of losing sales by turning away consumers or setting the price too low compared to what a consumer would pay.
Pricing impact on demand
It is important to understand that minute fluctuations in price can have dramatic affect on a consumer’s willingness to pay, depending on demand. If the demand flexibility is high, they won’t be willing to pay a higher price. If the demand flexibility is low, then the consumer may be willing to pay a higher price. Thus, WTP is conditional on the type of a certain good or service.
Strategies for estimating WTP
A company’s ability to appropriately price their product depends on how successfully they read the demand of their market. In order to gain this insight, firms depend on strategies that indicate consumer’s WTP.
Direct Approach: The direct approach of determining WTP involves questioning consumers directly to ask what they would be willing to pay for a certain product. One method are open-ended (OE) questions, where the goal is to understand consumer’s personal values to better assess their willingness to pay.
Indirect Approach: An indirect approach to measure WTP provides consumers with choices. To use the indirect approach, provide consumers with a set of options and have them choose which option they are most willing to pay for. This method also includes a “none” option, to more accurately assess the consumers’ preferences.
All approaches to measure a consumer’s willingness to pay are widely considered as biased and inaccurate for psychological, contextual, and technical reasons. The main issue with these approaches of measurement is that they are executed within hypothetical circumstances.
Real, actual WTP cannot be determined for several reasons:
- Unknown. If the product is particularly innovative and unseen, the consumer has no way of knowing what value the product will have to them.
- Subjective. Value is a concept, and thus a subjective variable to measure.
- Context has a heavy influence on WTP. For example, a consumer will be more willing to pay for an expensive glass of wine on a vacation in Sonoma Valley than at a quick, casual restaurant at home.
Assessing consumers’ willingness to pay also plays a role in developing competitive strategies, new products, and value audits. Although hypothetical WTP can lend helpful insight to consumer demand, it should not be the only element involved in setting the right price for a good or service.