For a business, deciding what a product’s or service’s price should be is a difficult proposition. First, the costs of production have to be considered and covered. A reasonable profit level has to be accounted for. But most important of all, the product’s value to the buyer must be entered into the price calculation. The level of the customer's willingness to pay is a significant input into making pricing decisions.

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If a business sets prices that are too low, shoppers will clear the shelves. But by asking for far less than what customers are willing to pay, the seller will miss an opportunity to make higher profits. Set the price too high, and customers won’t be interested in buying. Sales will languish.

In the olden days, before fixed prices and price tags, prices used to be fluid. They were decided by haggling until buyer and seller arrived at a price that both found acceptable. While bargaining, the buyer’s valuation surfaced, especially when the seller was experienced and skilled.

Today, unless they run a shop in a Moroccan souk or an Indian bazaar, sellers don’t have this kind of flexibility. Fixed prices are the norm, and buyers rarely negotiate. They simply buy the product at the quoted price or they walk away.

How can a seller determine a fair price for a product that reflects the customer’s willingness to pay? Let's look at three methods.

1) With a survey

When a business asks buyers how much they are willing to pay for an item, there is an inherent conflict of interest. Customers have strong incentives to provide a lowball estimate of their valuation so they can get a good deal. However, when sellers know nothing about customer willingness to pay, they may still flat out ask customers, then use the information as an initial rough estimate.

Some experts have developed structured survey methods like the price sensitivity meter to ask a series of questions to obtain the average willingness to pay of consumers. Others use indirect methods of obtaining valuations where participants have to trade-off between the price level and levels of other product attributes. The goal of every survey asking these questions is to make it harder for buyers to provide lowball estimates when giving their willingness to pay.

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2) With an auction

Economists have argued that of all methods to determine customer valuation, none is more effective or accurate than using an auction to sell the item. This method allows the buyers’ product valuation to reveal itself through how much they bid on the item. This method is what economists call “incentive compatible,” meaning that buyers can’t be strategic about their valuation. After all, if they bid lower than their real valuation, they may miss out on getting the item. This is one reason that valuable art, jewelry, vintage wine, and celebrities’ possessions are often sold through auction. But it is not feasible to determine buyers’ willingness to pay for cheap, everyday products and services. Just imagine trying to sell milk or eggs through an auction—it just wouldn't work because of the costs.

3) With a price experiment

A common method many sellers use today to find out customers’ valuation is to conduct field experiments. During the experiment, the product’s prices are changed at different time periods, and changes in sales at different price levels are tracked. Such price changes may occur in the same store for a smaller company or across different stores in the case of a large retailer. The information about levels of sales provides the seller with an understanding of how customers respond to different price levels and their valuation of the product.

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Figuring out how much buyers are willing to pay accurately is an exciting area of consumer psychology. While these three methods assume that consumers have a fixed willingness to pay for a product, the truth is that valuations change with the situation. On a hot dry day, for example, people may be willing to pay far more for a frosty can of Coke than they are in the middle of winter. But changing prices to reflect these changing valuations is often difficult to do.

I will write in greater depth in a forthcoming post about what consumers consider to be "price gouging" and what they deem a reasonable price increase.