Estimating willingness to pay by risk adjustment mechanism

Abstract

Measuring consumers’ Willingness To Pay (WTP) without considering the level of uncertainty in valuation and the consequent risk premiums will result in estimates that are biased toward lower values. This research proposes a model and method for correctly assessing WTP in cases involving valuation uncertainty. The new method, called Risk Adjustment Mechanism (RAM), is presented theoretically and demonstrated empirically. It is shown that the RAM outperforms the traditional method for assessing WTP, especially in a context of a nonmarket good such as a totally new product.

Keywords:

• purchase decisions
• willingness to pay
• contigent valuation method
• adjustment mechanism

JEL Classification:

• D12
• D81
• M31

Notes

¹ One would face uncertainty over how much gains could be obtained from a nonmarket good that has never before existed. Such uncertainty would not be removed until the good is actually consumed. For example, the value of improved environment is not realized until it is actually provided and consumed.

² Cameron and Quiggin (1994) said ‘Respondents seem not to hold in their heads a single immutable ‘true’ point valuation … . At best, they may hold a distribution of values-amounts they would be willing to pay with some associated probability density. This might be interpreted as ‘uncertainty’. Whenever they are asked to produce value for the resource, they make a draw from this distribution and use it as a basis for their response to the current discrete-choice CV question’.

³ Although the ex post WTP is a more accurate indicator of the true value of a good and it would be desirable to know that value when doing a cost benefit analysis and developing public policy, only the ex ante WTP is typically known or knowable at that decision point.

⁴ According to Carson and Mitchell (1994), up to 1994 there had been about 1600 CVM studies and papers from over 40 countries on many topics including transportation, sanitation, health, the arts and education as well as the environment.

⁵ The open-ended format asks how much a respondent is willing to pay for the product while the close-ended format asks whether the respondent is willing to pay a bid price for the product.