Tutorial 2: Reservation Prices
Go to a grocery or department store at any time
and stand (discreetly) in one area for a while. Watch how
buyers look at an item with interest and then check its
price. Notice that some buyers will immediately put down
the item and walk away. Others will ponder a while before
deciding to keep it or leave it. While others will smile
and immediately put it in their shopping cart. [If you see
them put it in their pocket you should immediately contact
store security!]
Why do different buyers have such different
responses toward the same item?
When buyers think about paying for a good or
service, they have a vague idea of the maximum they are
willing to pay for it. The maximum price a buyer is willing
to pay for one unit of a good or service, rather than do
without, is called his reservation price. Buyer reservation
prices vary due to differences in the strength of preference
for the good, their knowledge of the price of substitute
goods, their disposable income, and their expectations about
what will happen to their income or the price of the good
in the near future.
When sellers think about receiving payment for
a good or service, they have a fairly clear idea of the
minimum price they are willing to accept for it. The minimum
price a seller is willing to accept in exchange for one
unit of a good or service is called her reservation price.
Seller reservation prices vary, in part, due to differences
in the costs of production. Some firms may be subsidized
or taxed, face different prices for inputs, have different
expectations regarding how demand for their product will
change, or use different production technology.
Social Surplus 
Consumers buy a unit of a good because of the enjoyment
they expect it to bring them. Buyers' reservation prices
measure the most they are willing to give up to obtain that
enjoyment. Economists assume that buyers are solely interested
in paying a price as far below their reservation price as
possible. The difference between the actual price paid and
a buyer's reservation price is a measure of how much better
off he is from buying a good or service at a price below
his reservation price. This measure is called "buyer's
surplus". (Some economists use the terms "consumer's
surplus".)
Producers sell a unit of a good because of the profit they
expect the sale to bring them. Sellers' reservation prices
measure the least they are willing to accept to sell that
good or service. Economists assume that sellers are solely
interested in receiving a price as far above their reservation
price as possible. The difference between the actual price
paid and a seller's reservation price is a measure of how
much better off she is from selling a good or service at
a price above her reservation price. This measure is called
"seller's surplus". (Some economists use the terms
"producer's surplus".)
Fundamental Theorem of Exchange
"One of the most important principles of economics
is the Fundamental Theorem of Exchange: ... trade is mutually
beneficial. Voluntary exchange increases [net benefits]
for all parties involved."1
The buyer voluntarily exchanges cash for a good or service.
In so doing, he will enjoy surplus net benefits when he
pays a price that is less than his reservation price. These
surplus net benefits measure how much the buyer has gained
from the exchange. The worst that would happen is the buyer
will pay a price equal to his reservation price and receive
no surplus. He will still be no worse off as a result of
the exchange.
The seller voluntarily exchanges a good or service for
cash. In so doing, she will enjoy surplus benefits when
she is paid a price that is greater than her reservation
price. These surplus net benefits measure how much the seller
has gained from the exchange. The worst that would happen
is the seller will receive a price equal to her reservation
price and receive no surplus. She will still be no worse
off as a result of the exchange.
Markets
To facilitate these exchanges, our economic system uses
an institution known as a market to bring buyers
and sellers together. With markets, the cost of searching
for a buyer of one's product or a seller of what one desires
is greatly reduced. With markets facilitating exchanges,
the surpluses enjoyed by both buyers and sellers reach the
highest level possible.
The sum of the surpluses enjoyed by both buyers and sellers
(sometimes referred to as "social surplus"), is
a measure of how much better off society is by having a
given quantity of the good or service exchanged at a given
price.
Now it's time to "do the thing".
Click on the following link to download the
Reservation
Price Workbook. Work through Questions 1
- 14 to deepen your understanding of reservation
prices.
Return here when you have finished.
(Need help
downloading the Excel file?) |
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Synopsis
This tutorial presents four important concepts; reservation
prices, the Fundamental Theorem of Exchange,
buyer's and seller's surpluses, and markets.
With an understanding of these concepts, we see how exchanges
between buyers and sellers in a market, each pursuing his
or her own self interest, can lead to the highest possible
level of social welfare, as measured by social surplus.
This is the central message written by Adam Smith more than
200 years ago in The Wealth of Nations:
"It is not from the benevolence of the butcher,
the brewer, or the baker, that we expect our dinner, but
from their regard to their own interest."2
With this background, we can now turn our attention to
a detailed review of how markets determine the actual
price of a good and the quantity of it that is exchanged.
This is the goal of Tutorial 3.
Next: Tutorial 3: Supply &
Demand 
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Reservation prices