Willingness to Pay (WTP) is a practical concept for buyers in online auctions, such as those on eBay. A common strategy is to determine the maximum price you are willing to pay for an item and set that as your maximum bid. [1, 5] eBay's automatic bidding system will then place incremental bids on your behalf to keep you as the highest bidder, but only up to your specified WTP limit. [1, 2, 3, 4] You will win the auction only if the final highest bid from all participants is less than or equal to your maximum bid. [1]

Using Willingness to Pay in Online Auctions

The market for used university textbooks exemplifies how market principles operate, from traditional, decentralized interactions to modern online platforms. In past scenarios, transactions relied on direct negotiation between buyers and sellers to determine a price based on individual willingness to pay (WTP) and willingness to accept (WTA), a dynamic similar to the historical grain markets that economist Alfred Marshall studied to create his supply and demand model. Contemporary versions of this market have shifted to online platforms, streamlining the process of connecting student buyers and sellers.

Market for Second-Hand University Textbooks

An individual's willingness to pay (WTP) for a good is influenced by several personal factors. Using the example of students buying a textbook, these determinants can include how diligently the student works, the perceived importance of the book for their studies, and their personal financial situation for purchasing books.

Factors Influencing Willingness to Pay

Willingness to Accept (WTA) is the minimum price a seller will accept for a good or service. It functions as the seller's reservation price and is an indicator of how much they value the good, as they would prefer to keep the item rather than sell it for a lower amount.

Willingness to Accept (WTA)

A demand curve is constructed by arranging potential buyers in descending order of their willingness to pay (WTP). The WTP represents the monetary value a consumer places on a good, which is equivalent to their private benefit or gain in utility. The resulting curve shows the quantity of consumers willing to purchase at or above any given price. It can also represent individuals with a negative WTP—those who would need to be paid to consume the product.

The Demand Curve as a Representation of Willingness to Pay

Willingness to Pay (WTP) represents the maximum price an individual is prepared to pay for a good, reflecting their personal valuation of it. This valuation is subjective and can differ significantly among consumers based on factors such as how important they consider the good, their work ethic, and their available financial resources. A consumer will only purchase a product if its price is less than or equal to their WTP. [1, 2, 7]

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A product's demand curve, also known as a demand function, illustrates the relationship between the quantity of items consumers will purchase and every possible price point. [4, 7] A key feature of demand curves is their downward slope, which signifies that as a product's price increases, the quantity consumers demand for it falls. This inverse relationship also means that when a product's available quantity is low, it can be sold at a high price. The curve itself is derived from the willingness to pay (WTP) of each consumer, showing the number of consumers whose WTP is at or above any given price.

Demand Curve

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Microeconomics Open access e-text https://core-econ.org/the-economy/.

To cite a unit, use The CORE Econ Team 2023 The Economy 2.0: Microeconomics Open access e-text https://core-econ.org/the-economy/ Unit [unit number] (url).

CORE Econ - The Economy 2.0: Microeconomics

Willingness to Pay (WTP)

Gregory King was a 17th-century English official who compiled extensive statistical data on the population and wealth of England. This data became the empirical basis for the Davenant-King Law of Demand.

Gregory King (1648–1712)

Charles Davenant, an English politician from the 17th century, is credited with publishing the Davenant-King Law of Demand in 1699. He utilized the data compiled by Gregory King to articulate the relationship between the supply of a commodity and its price.

Charles Davenant (1656–1714)

Published in 1699 by Charles Davenant based on data from Gregory King, this law articulated the relationship between a crop's harvest size and its market price. It specifically analyzed the price of corn, calculating, for example, that a 10% shortfall in the harvest would result in a 30% price increase.

The Davenant–King Law of Demand

The Law of Demand states that there is an inverse relationship between the price of a product and the quantity that consumers demand. When the price is lower, more consumers are willing to purchase the product, resulting in higher demand. Conversely, as the price rises, the quantity demanded falls. This principle is the reason demand curves are expected to slope downward.

Law of Demand

This diagram illustrates two distinct, parallel demand curves, labeled D and D'. The vertical axis represents the price in pounds, from 0 to 12,000, while the horizontal axis indicates the quantity of consumers, from 0 to 100. The lower demand curve, D, is a downward-sloping line that connects the points (0, 6000) and (60, 0). The upper demand curve, D', is also a downward-sloping line, linking the points (0, 10000) and (100, 0).

A Graph Showing Two Alternative Demand Curves (D and D')

A firm's pricing decision is significantly influenced by the slope of the demand curve, which indicates how sensitive consumer demand is to price changes. If the demand curve is steep, it signifies that a price increase will not cause a substantial decrease in sales. This allows the firm greater power to raise its price without losing many customers.

Impact of Demand Curve Steepness on Pricing Power

The price elasticity of demand, symbolized by epsilon (ε), is a measure of the sensitivity of the quantity demanded of a product to changes in its price. [1, 10, 13] It is calculated as the percentage change in quantity demanded that occurs along the demand curve in response to a 1% increase in price. [1] Because quantity demanded generally falls as prices rise, this value is typically negative. For ease of interpretation, it is often expressed as a positive number. If the elasticity value exceeds one, demand is considered 'elastic,' meaning a 1% price increase results in a quantity demanded decrease of more than 1%. [2] If the value is less than one, demand is termed 'inelastic.' [2]

Price Elasticity of Demand

A consumer survey is a method for estimating product demand, which is especially valuable for new products like cereals or space flights where historical sales data is unavailable. The technique involves asking a large sample of consumers about their willingness to pay at different price points. By analyzing the proportion of respondents willing to purchase at each price, it's possible to construct the entire demand curve for the product.

Estimating a Demand Curve via Consumer Surveys

The data for the Apple Cinnamon Cheerios demand curve originates from a 1996 study by economist Jerry A. Hausman. [7] The study, titled 'Valuation of New Goods Under Perfect and Imperfect Competition,' was included in the book 'The Economics of New Goods,' published by the University of Chicago Press on pages 207-248. [7]

Source of Demand Curve Data for Apple Cinnamon Cheerios (Hausman, 1996)

For simplicity in economic models, both supply and demand curves are frequently depicted as straight lines. In reality, they are more likely to be non-linear. The precise shape of these curves depends on the distribution of valuations among market participants—that is, how willingness to pay (for demand) or willingness to accept (for supply) varies from person to person.

Linearity of Supply and Demand Curves as a Simplification

Figure 8.7 shows the market demand curve for bread, representing the total quantity demanded by all consumers at various prices. Fundamentally, this curve also illustrates the willingness to pay (WTP) of the consumers for each unit of the good. The curve has a downward slope, indicating that as the price falls, more consumers are willing to purchase the product.

The Market Demand Curve for Bread (Figure 8.7) and Consumer Willingness to Pay

This activity presents a scenario involving a hat shop to analyze the consequences of a price adjustment. Initially, the shop sells 20 hats weekly for \$10 per hat. After raising the price to \$12, weekly sales decrease to 15 hats. The task is to use this data to evaluate a series of statements and identify the correct ones.

Activity: Analyzing a Hat Shop's Price Change

The inverse demand function, written as $P = f(Q)$, defines price as a function of quantity. [3] This representation aligns with the standard graphical display of a demand curve, with price on the vertical axis and quantity on the horizontal axis. [1] It specifies the maximum price a firm can set to sell a given quantity of its product. While the direct demand function is used to express price elasticity in terms of price, the inverse demand function is useful for expressing elasticity entirely in terms of quantity.

Inverse Demand Function: Price as a Function of Quantity

The direct demand function, denoted as $Q = D(P)$, expresses the quantity demanded (Q) as a function of price (P). Consistent with the downward-sloping nature of the demand curve, this is a strictly decreasing function. It is derived by rearranging the inverse demand function, $P = f(Q)$, to solve for Q. Thus, the function $D(P)$ is the mathematical inverse of the inverse demand function $f(Q)$. This direct functional form is necessary for the mathematical determination of the market equilibrium price by equating it with the direct supply function.

Direct Demand Function: Quantity as a Function of Price (Q = D(P))

Aggregate demand represents the total expenditure on all goods and services produced within an economy at a given time. [1] It is a macroeconomic concept that sums up the demand from all sectors of the economy. [2, 5]

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