Few factors are more important in business than ensuring your products and services are appropriately priced. Charge too little, and you leave revenue on the table—money you could use to expand your team, refine your offerings, and grow your business. Charge too much, and you might alienate and send potential customers to your competitors.
Whether you’re a professional responsible for determining your company's pricing strategy or an entrepreneur on the verge of launching a new product or service, it’s vital to understand how much your customers are willing to pay. Below is an overview of the willingness to pay concept and strategies you can use to estimate this crucial metric.
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What Is Willingness to Pay?
Willingness to pay, sometimes abbreviated as WTP, is the maximum price a customer is willing to pay for a product or service. It’s typically represented by a dollar figure or, in some cases, a price range. While potential customers are likely willing to pay less than this threshold, it’s important to understand that, in most cases, they won’t pay a higher price.
“What the concept of ‘willingness to pay’ is telling us is that whatever your willingness to pay for a product might be, and wherever it comes from, you’re just not going to pay more than that [amount] for it,” says Harvard Business School Professor Bharat Anand in the online course Economics for Managers.
Willingness to pay can vary significantly from customer to customer. This variance is often caused by differences in the customer population, typically classified as either extrinsic or intrinsic.
Extrinsic differences are observable. They’re factors you can generally determine about a person without needing to ask them directly. A customer’s age, gender, income, education, and where they live can all be extrinsic differences that impact their willingness to pay.
Intrinsic differences, on the other hand, are a person's characteristics you wouldn’t know about without asking them directly. They’re hard to observe and often called “unobserved differences.” An individual’s risk tolerance, desire to fit in with others, and level of passion about a given subject are all examples of intrinsic differences that can impact their willingness to pay.
Other Factors Affecting a Customer’s Willingness to Pay
It’s important to note that your customers’ willingness to pay a certain price for your product or service isn’t static. In addition to extrinsic and intrinsic differences, numerous factors can cause a customer’s willingness to pay to rise or fall.
“We often wonder why people might be willing to pay for a product when another seemingly identical one was available for a cheaper price or free,” Anand says in Economics for Managers. “That shouldn't be surprising. Price isn’t the only feature that matters to customers. For example, legality, packaging, and brand name might matter as well.”
When a customer has an urgent need that your product or service can address, they may be willing to pay a higher price than when their need is less urgent. Similarly, an actual or perceived shortage in supply could make them more willing to pay a higher price than when there’s a surplus.
Conversely, a customer’s willingness to pay may fall due to the emergence of a new competitor with stronger brand recognition or the perception that your product or service is outdated. This is especially true in the tech space.
How to Determine Your Customers’ Willingness to Pay
By determining customers' willingness to pay, a company can set its prices at a level that allows it to maximize profits and customer satisfaction.
“You often see companies and managers immediately honing in on the question of ‘Where should we price?’” Anand says in Economics for Managers. “But it's often far more useful to start by thinking about customers' willingness to pay and how that's different for your product than for others.”
With this understanding, a business can work backward to determine the appropriate price that maximizes profits without alienating customers. Here are four methods you can use to estimate and calculate your customers’ willingness to pay for your products or services.
1. Surveys and Focus Groups
One of the surest ways of determining your customers’ willingness to pay is to ask them. While surveys tend to be more affordable than focus groups, both are an excellent way of doing so. Surveys typically collect a large amount of quantifiable data, while focus groups often result in more nuanced, qualitative information.
Relying on surveys and focus groups can come with challenges. If they’re not designed in a way that encourages respondents to answer truthfully, or if they rely on a poor sampling of consumers, they can result in erroneous data. This can have adverse effects on your ability to make business decisions.
2. Conjoint Analysis
Conjoint analysis is a specialized type of survey, in which respondents are asked to rank different bundled features. The responses are then used to assign a numerical value to each feature (called a “part-worth”) to determine consumers’ preferences.
The values can then be used to predict how a consumer will react to a given product and help determine which features make it into the end result.
Auctions are often a more effective means of eliciting a consumer’s true willingness to pay because they tie the act of revealing one’s preference for a product or service to the probability of obtaining it. Although auctions can be useful tools for a seller with little to no information about consumers’ willingness to pay, they can result in uncertainty for consumers. This uncertainty and delay can cause some consumers to prefer fixed prices.
There are several auction types that can help reveal willingness to pay. Some of the most common include:
4. Experiments and Revealed Preference
It’s increasingly possible to use data about consumers’ past choices to determine their true willingness to pay. This is known as revealed preference because the insight is based on what the consumer does instead of what they say. A challenge of this approach lies in the possibility that missing variables might confound the interpretation of data.
One solution to this challenge is to run experiments designed to determine consumers’ willingness to pay. For example, you might adjust prices to see how sales are impacted. By randomizing treatments and using control groups, you can avoid the problem of confounding variables.
The Importance of Getting It Right
Businesses have an incentive to determine consumers’ willingness to pay for their products or services. By estimating WTP and working backward to determine price, firms can confidently maximize profit margin while capturing as much value as possible from the consumer.
Of course, this is just one aspect of what it takes to manage a business properly. Other economic principles should be used in conjunction with willingness to pay to set prices and make other business decisions. While trial and error can be an effective means of learning these skills and principles, taking an economics course is a way of doing so much more quickly.
Are you interested in deepening your understanding of how to calculate your customers’ willingness to pay and use other key frameworks? Explore our eight-week course Economics for Managers and other strategy courses to learn more about how to develop effective pricing strategies. Download the free flowchart to find the best strategy course for you and your goals.
Demand in economics is the consumer's desire and ability to purchase a good or service. It's the underlying force that drives economic growth and expansion. Without demand, no business would ever bother producing anything.
The law of demand governs the relationship between the quantity demanded and the price. This economic principle describes something you already intuitively know. If the price increases, people buy less. The reverse is also true. If the price drops, people buy more.
But the price is not the only determining factor. The law of demand is only true if all other determinants don't change.
In economics, this is called ceteris paribus. The law of demand formally states that, ceteris paribus, the quantity demanded for a good or service is inversely related to the price.
There are five determinants of demand. The most important is the price of the good or service itself. The second is the price of related products, whether they are substitutes or complementary.
Circumstances drive the next three determinants. The first is consumer income, or how much money they have to spend. The second is buyers' tastes or preferences in what they want to purchase. If they prefer electric vehicles to save on gasoline, then demand for Humvees will drop. The third is their expectations about whether the price will go up. If they are concerned about future inflation they will stock up now, thus driving current demand.
The demand schedule is a table or formula that tells you how many units of a good or service will be demanded at the various prices, ceteris paribus. Here is an example of a demand schedule:
If you were to plot out how many units you would buy at different prices, then you've created a demand curve. It graphically portrays the data that's been detailed in a demand schedule.
In the chart above, price is on the x-axis, and quantity bought is on the y-axis. At P2, the higher price, the consumers will only buy Q0, the lower quantity. If the price drops to P1, then the quantity bought will increase to Q1.
When the demand curve is relatively flat, then people will buy a lot more even if the price changes a little. When the demand curve is fairly steep, then the quantity demanded doesn't change much, even though the price does.
Demand elasticity means how much more, or less, demand changes when the price does. It's specifically measured as a ratio. It's the percentage change of the quantity demanded divided by the percentage change in price.
There are three levels of demand elasticity:
Aggregate demand, or market demand, is the demand from a group of people. The five determinants of individual demand govern it. There’s also a sixth: the number of buyers in the market.
Aggregate demand can be measured for a country. It's the quantity of the goods or services the country produces that the world's population demands. For that reason, it is composed of the same five components that make up gross domestic product:
All businesses try to understand and guide consumer demand. They seek to understand it with market research. They attempt to guide it with marketing, including public relations and advertising.
Companies with a competitive advantage draw more demand. One advantage is to be the low-cost provider. For example, Costco provides bulk purchases with low prices per unit. Another is to be the most innovative. Apple charges higher prices because they are the first to the market with new products.
If something is in high demand, businesses make more revenue. If they can't make more fast enough, the price goes up. If the price increase sustains over time, then you have inflation.
If demand drops, then businesses will lower prices. They hope that's enough to shift demand from their competitors and take more market share. If that doesn't work, they will innovate and create a better product. If demand still doesn't rebound, then companies will produce less and lay off workers. If that happens across the board, it can cause an economic contraction. That phase of the business cycle creates a recession.
The federal government also tries to manage demand to prevent either inflation or recession. This ideal situation is called the Goldilocks economy.
Policymakers use fiscal policy to boost demand in a recession or lower it during periods of inflation.
To boost demand, it either cuts taxes or purchases more goods and services. It can also give subsidies to businesses or benefits to individuals such as unemployment benefits. It increases demand by raising confidence and creating enough jobs. Research shows that the best ways to create those jobs is government spending on mass transit and education.
To lower demand, Congress can raise taxes, cut spending, or withdraw subsidies and benefits. This often angers beneficiaries and leads to the elected officials being booted out of office.
Most inflation fighting is left to the Federal Reserve and monetary policy. The Fed's most effective tool for reducing demand is by raising interest rates. This shrinks the money supply and reduces lending. With less to spend, consumers and businesses might want more, but they have less money to do it with.
The Fed also has powerful tools to boost demand. It lowers interest rates and increases the money supply. With more money to spend, businesses and consumers can buy more.
Even the Fed is limited in boosting demand. If unemployment remains high for a long period of time, then consumers don't have the money to get the basic needs met. No amount of low interest rates can help them, because they can't take advantage of low-cost loans. They need jobs to provide income and confidence in the future. That's when Congress must step in with expansionary fiscal policy.
Demand-side economics is another way of referring to Keynesian economic theory. During the Great Depression, British economist John Maynard Keynes promoted the theory that demand is the driving force in an economy. He believed stimulating demand can improve struggling economies. This is the opposite of supply-side economics.
Excess demand occurs when there isn't enough supply to meet demand at current prices. In other words, there is a shortage or scarcity of supply.