Question

What is the significance of the concept of a reservation price in the supply and demand model?

Answer 1

Reservation price for consumer is the maximum price that the consumer is willing to pay for a product to be able to enter the transaction. For a producer, it is the minimum price at which the producer is willing to sell its product and engage in the market transaction. Reservation prices are very important in supply and demand model because they indicates the maximum and minimum willingness to pay for a product in the market by consumers and producers respectively. This helps in determining the range in which the price can vary to settle the market to an equilibrium level.

It also helps in marginalizing the market because if the price level goes beyond any of these reservation prices, market participants I will leave the market. For example, if the market price is greater than the maximum reservation price for consumers, there will be no transaction. Similarly in the market price falls below the minimum reservation price again there will be no transaction. In this way reservation price impose a limit on the market price in a range in which it can vary.