Two+part+pricing

Mark Duquaine


 * Two Part Pricing:**

Two-part pricing is one of many strategies used by firms that have market power. In a two-part pricing system firms charge a fixed fee for the right to use their goods and then charge a per unit fee for each unit purchased. The benefit of two part pricing for firms with market power is that it allows them to garner larger profits than they normally would at the monopoly price. Essentially firms are extracting more of the consumer surplus and turning it into direct profit. The ultimate two-part pricing scheme would charge a fixed fee equal to the total consumer surplus, thus extracting the most value out of the consumers. Source: Baye, Michael. //Managerial Economics and Business Strategy//. 2006. The chart below illustrates the two part pricing scheme:

A demonstration of a two part tariff when demand is homogeneous; the diagram applies for each consumer
 * Two Part Pricing When Consumer Demand is Homogenous**

Source: http://en.wikipedia.org/wiki/Two_part_tariff

According to Wikipedia: "When consumers have homogeneous demand, then any one consumer is representative of the market (the market being n identical consumers). For purposes of demonstration, consider just one consumer who interacts with one firm which experiences no fixed costs and constant costs per unit - hence the horizontal [|marginal cost] (MC) line."

In a monopolistic world, the firm would produce at quantity Qm and price at Pm. This would create a profit of section B. By charging a per unit price of Pc and a fixed charge of A,B,C, the firm will actually increase it's profits to A,B,C. Thus, it would extract all of the consumer surplus and increase its profits by A,C. Charging the fixed fee in this way increases income if the firm can determine the correct price to charge for the fixed fee. The risk to the firm of charging too high of a fixed fee is that the firm will be priced out of the market and will not purchase any of the products.

A two-part pricing when consumer demand is different
A demonstration of a two part tariff when demand is different Source: http://en.wikipedia.org/wiki/Two_part_tariff Another case for two part pricing is when there are two consumers and their demand is not assumed to be identical. In the case of the chart above, the demand for consumer Y is assumed to be twice that of consumer X. In other words, we are making the assumption that we cannot discriminate against the consumers individually. By charging a fixed price equal to A,B, the firm would be pricing consumer X out of the market. Therefore, one of the firm's options is to charge a fixed price of A,C and a price of Pc. In this way the firm will be able to secure a surplus of A,B,C,D. However, by pricing at Pm and selling a quantity of Qm, the firm will actually be able to garner a profit of A,B,C,D and E. Even though this will restrict output and won't be the socially efficient amount supplied, overall profits of the firm will increase by area E.


 * Real World examples where two part pricing is often used:**

1) Memberships to athletic clubs and food clubs 2) Credit cards that charge annual fees and per transaction fees 3) Amusement Parks that charge a fixed fee for entrance into the park and a fee per ride 4) Cover charges at bars 5) Golf memberships

In each of these examples the goal of the firm is to extract the largest consumer surplus possible to receive the largest profits. The firm must be careful not to charge too high of a fixed fee or it may completely alienate the consumers and receive no profit whatsoever.


 * Questions: (Answers are provided below)

1) True or False: In a two-part pricing structure a firm's optimal price is usually higher than it's marginal cost.

2) Which of the following situations is most conducive to a two-part pricing system? a. A firm in the paper industry with several competitors. This firm is a price taker. b. An athletic club with a low marginal cost that is the only athletic club in the east side of the city. c. An airline company with high fixed costs and varying demand d. A local bar in the trendy downtown district

3) Why don't firms charge above marginal costs in a two part pricing scheme?

4) True or False: A two part pricing scheme always secures the most profits for a firm.

Answers:

1) False. The optimal per unit price is usually equal to the firm's marginal cost. The reason for this is that by pricing at marginal cost and charging a fixed fee equal to the consumer's surplus the firm will be able to garner the largest profits. If the firm charges a per unit price above marginal cost it will not be able to sell the optimal amount of units.

2) B, and D. Example A reflects a firm in a competitive industry, and therefore that firm does not have market power. An airline company with varying demand is more likely to employ peak-load pricing to take advantage of the busy time periods and charge higher rates. Example B reflects the perfect opportunity for two-part pricing because the athletic club has a low marginal cost and has market power. Because of these factors the firm can extract some or all of the consumer surplus by using two-part pricing. Example D is also a favorable two-part pricing situation because the the bar has price setting power due to its monopoly position.

3) Firms don't charge per unit costs above marginal cost because if they did they would lose out on profit. By charging a higher per unit price they would incur less demand for the product and make less profit than if they charged a fixed price equal to the consumer surplus.

4) False. A two-part pricing scheme is only the most profitable if consumer surplus is adequately estimated. If a fixed price is charged that is higher than the consumer surplus than consumers will not purchase any of the product.**