The great Roman statesman and philosopher Seneca the Younger once wrote: “We no longer wonder what things are, but how much they cost”. He coined this line a little under two thousand years ago, but the words remain impressively relevant to our own modern world of commerce and consumption, where we seem to look at all things through the lens of cost and value.
Businesses can set whatever price they like for the goods and services they sell, but if that price is at odds with what their customers are prepared to pay, they are unlikely to make many sales. That is why Willingness To Pay (WTP) is one of the most important factors any business should consider when devising a pricing strategy. Put simply, it is not enough to consider your own margins when setting a price. You must also consider the perceived value of the product from the customer’s perspective, and weigh up the likely impact your pricing will have on demand – a subject we have addressed in depth in this previous blog.
If you want to go directly to the essentials of how WTP works, you can click here for the summary. Else, keep reading to get the whole picture and understand the ins and outs of WTP.
There is no magic formula every business can use to calculate WTP. It is far from an exact science. Consumers judge value in different ways for different products and services. For example, if someone is buying a new fridge-freezer or TV, there will be a different matrix of value judgements involved – different weightings given for reliability versus aesthetic appeal, quality of build versus quality of the experience and so on. When we book a hotel room, we balance practical considerations like number of beds and location against our willingness to pay extra for little luxuries, whereas for a concert ticket to see our favourite performer, it’s all about the value we put on the experience.
So there is very little consistency in how WTP works across industry verticals, or even from one product or service to the next. Cultural, social and personal factors also dictate that consumers from different countries or demographics are also likely to exhibit different WTP for the same goods. Evaluating WTP is therefore part and parcel of a business understanding its customer base and making pricing decisions that are as compatible as possible with the perceptions of their most important target demographics.
As Ibbaka puts it, “The goal is to capture as many customers as possible at as high a price as possible.” The highest possible price is that which corresponds with the WTP of enough of your customer base to make your venture most profitable. With a luxury brand like Rolex, for example, it might seem that their exceptionally high prices are well above what the majority of people are prepared to pay for a watch. However, they still find enough customers prepared to pay a premium for the quality and brand identity that Rolex represents – and the margins on their products are so high – that they are still able to make a considerable profit from a relatively low turnover.
We dig deeper into how different pricing strategies look to balance margins and demand to maximise profitability in this blog. But underpinning all pricing strategies is the ability to set prices that you know enough of your customers will be prepared to pay, and that requires understanding how value decisions are made by consumers at an individual level. That’s where we’ll focus our attention in the rest of this guide.
Willingness to Pay in Theory and Practice
The formal definition of WTP is the maximum price a customer is prepared to pay for any given product or service.
It is important to understand that an individual’s willingness to pay for a certain product or service is not fixed – the maximum they are prepared to spend can and often does vary. This is largely influenced by personal factors such as current cash flow, other outgoings, how much they have spent on the same shopping excursion, how necessary the purchase is at that present time and so on.
However, it is also widely accepted that there are ways that brands and retailers can influence WTP with the aim of encouraging customers to spend more. Several models have been developed to explain how this can be put into practice, one of them being transactional utility theory.
Transactional utility theory argues that every time a customer goes to buy a particular product or service, as well as having a maximum price they are willing to spend in their head, they also have a reference price in mind. The reference price is what they are actually expecting to spend, and might be influenced by previous experiences buying the same or similar products, research they have done ahead of the purchase, advertising and so on.
WTP and reference price might sometimes work against each other. For example, if your favourite music artist announced a concert in your town and tickets were priced at €50, you might on the one hand be happy to pay that for the experience. But on the other hand, you might, as a point of reference, consider that the last time you went to a concert you only paid €20, or that you could have a much cheaper night out at the cinema. Reference price can therefore drag down WTP.
Transactional utility theory argues that reference price and WTP can both be used by vendors to increase the likelihood that an individual will buy. In short, it is all about managing the satisfaction of the purchaser. WTP is largely based around a person’s judgement of the satisfaction they will get from a purchase after the fact. So taking the concert ticket example, if you judge that the pleasure you will get from seeing your favourite artist is worth more than €50 (and perhaps outweighs any negative financial consequences), you are likely to buy a ticket regardless of other considerations.
But consumers can also get a sense of satisfaction from the perceived value of a purchase itself, and this usually revolves around the reference price – if something is priced lower than you were expecting, the attraction of the bargain is itself a big incentive to buy. This is where special offers and discounts come into their own – you might be undecided about whether you should spend €50 on a ticket to see your favourite band, but when you see they are available for an early bird 20% discount, your mind is made up by the pleasurable feeling of getting a good deal.
The aim for businesses, then, is to know their customer base well enough to be able to price lower than their WTP. But as that can be a difficult judgement call to make, a more practical approach is to use reference price as a benchmark – either beating the prices competitors set for similar goods and services, or using special offers to increase the likelihood of a customer feeling they are getting a good deal. The payback for brands and retailers is that studies have shown a link between increased customer satisfaction and higher WTP – so, over time, the happier you can make your customers in their purchases, the more you can afford to charge them. That partly explains how luxury brands like Rolex can set prices so high – their customers get a great deal of satisfaction from buying their products, so are prepared to pay more.
Factors that Influence Willingness to Pay
Encouraging customers to increase their WTP for a product or service is clearly a very attractive idea to businesses, which is what makes the theory of transactional utility so interesting. But the conversation doesn’t stop at “Let’s make our customers feel satisfied that they are getting good value for their money.” Because the obvious question then is – how exactly do individuals decide what is and is not good value?
This is where things get tricky, because there are a lot of different factors at play in how individuals judge value. As well as characteristics of the product or service itself such as quality and general market value, personal and demographic factors such as age, gender, nationality, ethnicity, religion, income and lifestyle all influence people’s purchasing decisions.
What is more, these factors can change considerably over time – sometimes quite quickly. For example, manufacturers and vendors of plastic goods may well have seen WTP – or even willingness to buy at all – take a sharp hit amongst certain groups of consumers in just the past couple of years because of concerns over climate change and pollution.
Understanding how all of these different factors interact to determine a person’s WTP for any given product is far from easy. However, as a general rule of thumb, we can break things down into three general areas:
1. Characteristics of the product
In any given commercial sector, you can expect to find goods and services priced at a variety of different points. This is an acknowledgement of the fact that different people will have different WTPs for very similar products, and a way of the market catering for all budgets. But when you compare two such products directly, what makes some people willing to pay more for one rather than the other?
Quality is the most obvious factor – we have already mentioned Rolex a couple of times, and another good example of a brand that enjoys high WTP from its customers on the back of a reputation for quality is Apple.
Another factor that makes consumers willing to pay more for a product is what is known as the unique value effect. This is the idea that a unique selling point – something one product offers that others do not – will not only influence customers to choose that product over others, it will also make them willing to pay more for it.
To carry on the smartphone example, the big manufacturers have long been locked in a battle to add unique value to each new release in the form of clever new features in order to justify pushing up the prices. Apple, Samsung, Huawei and others focus much of their marketing around tech and specifications, whether it is a triple rear camera or 5G connectivity, because they know that successfully selling the unique value of their handsets will encourage customers to pay more.
2. Personal and social characteristics
Of course, even if you take two broadly similar products with very different credentials when it comes to quality and/or unique value propositions, there will always be people who are unwilling to pay the extra for the ‘better’ product. This is critical to how brands position themselves in the market and plays a key role in the pricing strategies they adopt. The opportunities that exist for budget and discount brands exist because there are plenty of consumers who are unable or unwilling to pay top prices.
The flipside of this is that personal values and social trends can also intersect to push up what some individuals are prepared to pay for certain products. A good example of this is ethical and sustainable consumerism, where some people are prepared to pay a premium for their organic milk or Fair Trade coffee.
3. Consumer savviness
Finally, a simple assumption that has far-reaching consequences for pricing strategy – modern consumers are well-informed and smart, arguably more so now than they have ever been, and are prepared to play the pricing game to get themselves the best possible deal. In practice, this often boils down to biding their time before making a purchase. The reference price a customer has in mind when they are considering buying a product often includes the calculation that, at some point, any given product or service will probably be put on promotion by one vendor or another. If a customer is willing to wait a while, they are likely to get themselves a better deal.
A good example of this is the way that smartphone manufacturers use a strategy known as price skimming following a new release. At first, they price handsets very high on the understanding that a certain group of early adopters will always be prepared to pay a premium for the unique value they see in the latest cutting edge gadgets. The likes of Samsung and other smartphone companies appreciate that this is a relatively small demographic, however, so after a certain period of time they will cut their recommended retail price (RRP’s) to target a different group of would-be customers. Savvy consumers have got wise to this and will hold off for the price cuts, making them something of a self-fulfilling prophecy.
Sometimes, however, vendors can flip this around and make it work for them. Ticket sellers, for example, covering everything from airline fares to concerts, have become very adept at making early bird prices work in their favour. Here, the expectation is that prices will rise, so consumers rush to buy early in a bid to get the best possible deal. Clever vendors can use this to push up WTP even for apparently ‘discounted’ tickets – by setting a high ‘door price’, they can make any kind of early bird reduction feel like good value.
Let’s recap the key points we’ve covered about WTP:
- What customers are willing to pay for a particular product or service is an essential factor to consider when adopting a pricing strategy.
- Getting a handle on what your customers are willing to pay is far from easy because there are so many influencing factors involved. But getting it wrong can have very negative consequences for your business. Price above the typical WTP of your core customer base, and you will see demand fall, with a knock-on effect on your turnover.
- Despite the difficulties, accurately evaluating what your customers are willing to pay for your goods and services will help you to maximise your profits by pricing at the optimum point on the demand curve – i.e. the point where price and turnover gives the best possible margins.
- It therefore pays to invest time, effort and money in really understanding your customers and their attitudes to pricing and value. Use your customer data to analyse the buying trends that will help you to estimate WTP more accurately.
- WTP is not fixed and it is possible to encourage your customers to raise what they are willing to pay by focusing on factors like satisfaction, quality, unique value, personal beliefs and social trends. Customers will also change what they are willing to pay over time and brands should be prepared to regularly re-evaluate their assumptions, as well as recognise the impact that changing prices and discounting can have on consumer perceptions of value.
One other important area we have not fully touched upon in this blog is how the experiences of other consumers influence WTP and the reference prices shoppers carry in their heads when they consider a purchase. This will be the subject of our next post – and in particular, how the modern trend for writing online reviews and sharing experiences on social media is influencing willingness to pay.
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