Academic journal article Economic Inquiry

Willingness to Pay, Compensating Variation, and the Cost of Commitment

Academic journal article Economic Inquiry

Willingness to Pay, Compensating Variation, and the Cost of Commitment

Article excerpt

I. INTRODUCTION

Hicksian welfare theory, which is static in nature, forms the basis of modern welfare analysis. This theory has provided a wealth of compelling principles with direct applicability for empirical welfare analysis (see, for example, Hoehn and Randall 1987; Bockstael and McConnell 1983; Randall and Stoll 1980). The equivalence of the maximum willingness to pay (WTP) for a good with the Hicksian concept of compensating (or equivalent) variation (CV or EV) is a central precept of this theory. This specific principle has provided the necessary theoretical basis for substantial literature in several areas of applied economics, including work on valuing public goods, experimental economics, and price discriminating monopoly, to name only a few.

Thus, researchers in search of the value of a public good have designed surveys eliciting consumers' maximum WTP to obtain the public good. If the assumptions of the static Hicksian theory hold, this measure can be readily interpreted as the compensating variation, a theoretically defensible welfare measure that can be directly applied to cost-benefit analysis using stated preference methods (Mitchell and Carson 1989; Carson 1997; Smith 2000). Likewise, experimental economists elicit WTP or willingness to accept (WTA) based on actual transactions to test a variety of consumer theory hypotheses, including the empirical disparity between WTP and WTA (Horowitz and McConnell 2002; Horowitz et al. 1999; List forthcoming) and the equivalence between revealed and stated preference values (Cummings and Taylor 1999; List 2001).

However, many decisions in the real world are made in dynamic settings: Purchase decisions may be delayed while information is gathered, purchase "mistakes" can be reversed by return policies, and there are often costs associated with these transactions. In this article we explore the Hicksian concepts of compensating and equivalent variation as well as WTP (and WTA) in explicitly dynamic situations; specifically, where the agent is uncertain about the value of the good under consideration but can latter obtain more information about it. We find that, although CV and EV have natural expected value counterparts that are conceptually akin to the static CV and EV, their relationship to the WTP and WTA concepts becomes much more complicated. Specifically, in addition to CV/EV, WTP and WTA will also depend critically on a variety of factors related to the timing of the formation of these values. Even if expected CV and EV are unchanging with the acquisition of new information, WTP and WTA will generally not be. Thus, at any point in time, WTP or WTA will not be equivalent to the expected CV or EV.

The intuition behind the breakdown of the equivalence between CV/EV and WTP/WTA in an intertemporal setting has to do with the nature of the measures themselves. The Hicksian concepts of CV and EV can be thought of as measuring the intrinsic value of a good. Specifically, CV measures the amount of compensation necessary after a change in price or other attribute that holds the consumer's utility constant. Consequently, this measure depends only on the utility function itself, not on the timing of a transaction or any other characteristics of the exchange environment.

In contrast, the consumer's WTP (or WTA) for a good is a fundamentally behavioral concept. The behavior in question is that of buying (or selling) a good. How much one is willing to pay (or accept) for a good at a particular point in time will depend on a variety of factors, including, of course, the expected intrinsic value. However, also included will be the consumer's rate of time preference, the ability to reduce the risk of a bad purchase or sale by gathering more information, and the ease of later reversing the transaction if so desired. Note that all of these features are related in some way to the timing of the behavioral decision. Thus, in a static model, the behavioral concepts collapse to the intrinsic Hicksian measures. …

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