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Willingness to pay (WTP) is a measure of the maximum amount that an individual is willing to sacrifice to procure the benefits from a desired good or service or to avoid the loss from something not desired. A companion concept is willingness to accept (WTA), which denotes the amount a person is willing to receive in trade either for a possessed good or for some sort of loss. These two measures are presumed to express the maximum value (WTP) of either a good or an avoidance of harm and the minimum compensation (WTA) required to give up a good or to endure a loss. In other words, these two concepts express an individual’s “reservation price” for some change in circumstances involving personal choice, and they undergird the twin notions of supply-and-demand curves. The key difference between these measures is that an individual’s WTP is wealth or income constrained, whereas one’s WTA is not. These notions are used by private and public entities as a means of estimating the total value of benefits (or costs) associated with some change in goods or services from private suppliers, public providers, or the environment, and they underlie the notion of cost-benefit analysis.
Behind every economic choice lies some measure of value based on individuals’ preferences applied in a particular context of alternative options. The choices made in a market, such as exchanges of money for goods at some posted price, offer “revealed preferences” as to the values, where the sellers’ WTA is somewhere at or below the transacted price, while the buyers’ WTP is somewhere at or above it. The difference between a seller’s WTA and a buyer’s WTP in a given purchase is the “economic surplus” of that transaction, in which the paid price splits that surplus into its two components: producer surplus and consumer surplus, which sum to the total of mutual benefits captured in any voluntary exchange, at least as seen by its active participants as of the time it takes place. But many other choices do not transpire in market settings, such as government decisions on the provision of public goods of varied types at different levels or an assessment of the value impact of mitigation or remediation of environmental losses.
But the nature of such cost-benefit measures should be understood as well. One aspect of WTP (or WTA) involves the changing value of money across different individuals. A reasonable economic assumption about the changing value of dollars to individuals is that of “diminishing marginal utility”—that is, the more money a person has, the less each additional dollar is worth to him or her in subjective benefits. This assumption is based on the notion that dollars are spent on goods that are ranked, in which the first dollars are spent on necessities of very high value, relative to each additional dollar that is spent on goods of lesser importance, as one progresses (with rising income) from bare necessities to luxury goods. If so, then one’s WTP is as much a measure of the money’s worth as it is of the goods being valued. Think of an “appendectomy theory of value” for two individuals, one very wealthy and the other poor, each in need of this operation. The rich person is willing to pay a lot more for this procedure than the impoverished individual is, even though the appendectomy’s subjective value for each is the same (reflecting the worth to them of their lives); the difference between their WTP lies in the value of money and not in the treatment itself. So adding these dollar amounts across individuals may not yield a uniform measure of actual value, only a WTP aggregated across social groups.
It is also economic doctrine that prices reach equilibrium in a competitive market—that is, when WTP equals WTA—independent of who holds ownership rights or any other influence. A lot of experimental evidence collected by behavioral theorists show that in many cases WTA exceeds WTP, implying that “endowment effects” and other anomalies may play a role in this context, as noted by Daniel Kahneman, Jack Knetsch, and Richard Thaler and by Elizabeth Hoffman and Matthew Spitzer. This, in turn, suggests that the initial assignment of ownership rights and other psychological factors may well have important effects on the outcome of ensuing transactions.
Another key assumption of any use of WTP measures to value environmental outcomes is that they are anthropogenic, namely, that the true worth of the environment is what people believe. Many ecological economists strongly reject this approach, because of the critical nature of ecosystem services to Earth’s life-support systems. Nature’s services contribute directly and indirectly to human welfare and to the planet’s total economic output and value, in a very objective way. Ecological economists have estimated the total annual value of these services to be about double the annual level of global gross national product. Basing the value of ecosystem services on perceptions thereof, with popular levels of understanding about life-support systems so low, is not a good way to evaluate them for public policy use.
Despite these shortcomings, measures of WTP and WTA are used to value goods and services in many diverse settings. The methods employed to estimate these reservation prices are generally via complex survey instruments or laboratory purchase experiments that try—through various means—to remove any incentive for biased or untruthful answers, where responses seem more accurate when test conditions stay close to realistic choice situations, according to Miller et al. But as Hoffman and Spitzer point out, the evidence that WTA exceeds WTP may ultimately yield a more accurate understanding of how preferences are shaped by human psychology as well as initial endowments and rights and that individual value statements and choices may not always serve as an unambiguous basis for public policies involving cost-benefit analysis.
- Hoffman, Elizabeth and Matthew L. Spitzer. “Willingness to Pay vs. Willingness to Accept: Legal and Economic Implications.” Washington University Law Review, v.71/1 (1993).
- Kahneman, Daniel, Jack Knetsch, and Richard “Experimental Tests of the Endowment Effect and the Coase Theorem.” Journal of Political Economy, v.98/6 (1990).
- Miller, Klaus M., Reto Hofstetter, Harley Khromer, and Z. John Zhang. “How Should Consumers’ Willingness to Pay Be Measured? An Empirical Comparison of State-of-the-Art Approaches.” Journal of Marketing Research, v.48/1 (2011).