Reservation (or reserve) price is a limit on the price of a good or a service. On the demand side, it is the highest price that a buyer is willing to pay; on the supply side, it is the lowest price at which a seller is willing to sell a good or service. Reservation prices are commonly used in auctions, but the concept is extended beyond.
In microeconomics, consumers set their reservation price as the highest price that they are willing to pay for goods or a service, while seller set the smallest price at which they would sell. Similarly, in finance, the reservation price--also called the indifference price--is the value at which an investor would be willing to buy (or sell) a financial security given his or her particular utility function.
Reservation prices are commonly used in auctions, where the seller may or may not make it known what the lowest acceptable price is. Buyers--especially if by proxy--may have their own reservation price at which they are unwilling to further bid. This can be seen as the "walk away" point for either party, in negotiation where the reservation price is the point beyond which a negotiator is ready to walk away from a negotiated agreement. A seller may produce a reservation demand, which is a schedule of reservation prices at which a seller would be willing to sell different quantities of a particular good.
Reservation prices vary for the buyers and sellers according to their disposable income, their desire for--or to sell--the good, and knowledge of information about substitute goods. A reservation price can be used to help calculate the consumer surplus or the producer surplus with reference to the equilibrium price.
In the basic model of optimal auction design developed by Roger Myerson (1981), the optimal reservation price (i.e., the smallest admissible bid) is independent of the number of bidders. Myerson assumes that the bidders have private independent values (i.e., each bidder's valuation of the object to be auctioned off is a realization of a random variable observed only by the bidder, and the random variables are stochastically independent). For example, if every bidder's valuation is drawn independently from a uniform distribution on the interval [0,100], then the optimal reservation price is 50. According to traditional economic theory, the optimal reservation price results from balancing two opposing effects. First, a higher reservation price is desirable for the seller since it deters bidders from falsely claiming that they have only a small valuation. Second, a higher reservation price is undesirable for the seller since it deters bidders with truly small valuations from participating in the auction. According to behavioral economic theory, a reservation price may also have additional effects. In particular, Rosenkranz and Schmitz (2007) have argued that a reservation price can serve as a reference point when bidders have preferences as studied in prospect theory.