Understanding willingness to pay
The customer’s willingness to pay refers to the maximum that they would pay for a good or service. At this price point, they would be indifferent as to whether to buy a good or service or not – the value that they gain from the item equals to their silliness to pay, and thus if the price was above this point, they would not buy the item.
Why prices may be below customers willingness to pay
For customers, buying a product below the maximum value that they will derive from it allows the customer to capture some of the value that is being created. This must be above 0; there must be some value captured to justify the customer making the purchase, or in other words,- the price must be below the customer’s willingness to pay.
Prices may however be well below the customer’s willingness to pay. The greater the difference between the willingness to pay and the actual price that is paid, the greater the proportion of value being captured by the customer (and in turn the less captured by the companies that customers are buying from).
While firms may want to price their goods as close to a customer’s willingness to pay as they can – capturing a high proportion of the value that is created – the extent to which they are able to do this depends on industry conditions.
The first component that can push prices low is industry competition. When industry competition is high – for example, many firms producing a relatively homogenous product – competition often gravitates to price-based competitions. Companies may start undercutting one another, bringing the prices down.
Another aspect that can push prices down is that the customer has high bargaining power. For example, customers buying in large volumes may be able to squeeze the firms that they are buying from – potentially playing one firm off against another to push down the price that they pay.
A final reason that prices may be below a customer’s willingness to pay is because there are alternative substitute products that the customer could use instead. While substitute products may not identical to what the customer would opt out of preference if they are substantially cheaper, a customer may choose them instead.
Final thoughts: Increasing customers willingness to pay
A customer’s willingness to pay for a particular item is not necessarily fixed – there may be ways firms can increase the maximum a customer would pay for a particular good or service. This may, for example, involve adding new features or other benefits that the customer desires. Identifying attributes that would increase the benefit that the customer derives, in turn, increases the maximum amount that customers would be willing to pay (and may give the firm the ability in turn to increase their prices).