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What Does Reservation Price Mean in Economics?

What Does Reservation Price Mean in Economics?

In economics, reservation price is the price at which the buyer is willing to purchase or the seller is willing to sell. The buyer will not accept a price above that amount, and the seller will not sell his product for less than his reservation price. This Buzzle article tells you more about this reservation price with the help of some examples.
Neha B Deshpande
Did You Know?
Even in an auction, you'll find minimum bidding prices, which is nothing but the reservation price quoted by the seller for the bidders. In silent or online auctions, the minimum bid price is mentioned along with the product details.
Every buyer and seller has his own capacity of buying and selling, respectively. Consumers enjoy goods and services after paying a price for them. Sellers need to earn profits as remuneration for their entrepreneurship. However, every consumer has his own purchasing capacity, above which, he will not be willing to purchase that product. Similarly, the seller has his own costs, and a certain limit below which he will not be willing to sell his product.

Thus, when there is a consensus between the seller and the buyer, and they agree to a price, the sale is complete. The seller will be willing to sell at a price above his reservation price, and the buyer will be willing to buy at a price below his reservation price. The difference between them is their surplus. According to different buying potentials, consumers will have different consumer surpluses.
Reservation Price in Economics: Examples
Example 1:

Imagine two friends, Kate and Janet, are out shopping. They both spot a pretty blue dress, which both want to buy. Kate looks at the price tag, which reads $400, and keeps it down sulkily. On the other hand, Janet looks at the dress and exclaims, "This is so pocket-friendly!", and rushes to the sale counter to buy the dress.

What do we realize? Kate did not buy the dress because its price was more than her reservation price. On the other hand, Janet had more buying potential, thus, her reservation price was higher than the actual price. Hence, she was more than happy to buy it.

Through this simple example we can imagine a market with a huge number of buyers and sellers. Thus, in every economy, there are potential buyers and sellers with their respective buying prices.

The reservation price is the point beyond which the buyer or seller will walk away.

Example 2:

On the other hand, imagine two firms 'X' and 'Y'. Both are retail outlets of clothing garments. 'X' is an old player in the market, and has a well established goodwill for his business. On the other hand, 'Y' is a new entrant in the market.

'Y' is trying to advertise its name in the market, and hence, is giving heavy discounts to attract more customers. Imagine both of them selling the same blue dress. A 'Y' retail outlet sells the same dress at a concessional rate of $300, whereas, 'X' is selling it at $400. Thus, the reservation prices of both the firms are different, though the product is the same. There can also be other reasons why the reservation prices can be different for various sellers.

Brand loyal customers who have the buying potential will still tend to buy from 'X', and those who have a lesser reservation price will buy it from the new retail outlet of 'Y'. Perhaps, we might see Kate rushing to the retail outlet of 'Y'!

For manufacturers, of course, the difference is due to the cost of production. Other than that, there can be various reasons, such as subsidy, taxes, state laws, geographical location, economic condition, inflation, etc.
Price Discrimination
In first degree price discrimination, the seller attempts at gaining information of the reservation price of various customers. Thus, based on their reservation prices, the seller will charge different prices, taking maximum benefits from all the customers. Every customer has a different buying potential. The seller takes the maximum advantage of it, by collecting information from his client/customer. In marketing, this is an effective technique to target those customers that have higher reservation prices.
How to Calculate Reservation Price
Calculation of a reservation price depends on many factors. Each individual has his own situation and background to consider. There cannot be any fixed parameter or a formula to calculate the reservation price of every individual. Every individual, as a buyer, analyzes his own purchasing potential, considering his income after provisioning fixed costs. Similarly, every seller should at least sell at a price so that he can recover his cost of production. Thus, he determines his price after calculating his cost of production and the profit margin that he expects.
Positional Bargaining
'Positional bargaining' is a terminology used in negotiations. In this, the seller and buyer both stick to their 'positions', citing their own quotes. Eventually, they both compromise and come to a concluding price. The sale is complete at this price. Typically, we might have all bargained with a street vendor. Once the sale price is not fixed, we start negotiating, and after negotiations, we come to a point that will be beneficial for both parties.
An economy will have a large number of potential buyers and sellers. The demand curve of the buyers will be determined as per their reservation prices. Accordingly, the supply and demand forces will decide the final price of the product, making it a win-win situation for both, buyer and seller.