Two Part Tariff: The Price Discrimination Technique In Monopoly Marketing

Have you ever been to a restaurant that charges two different levels of bills – one for reserving your table and the other for the food and beverages? Well, it may seem unfair from a customer's point of view, but this is actually a pricing technique that is quite profitable for the businesses in an imperfectly competitive market. This pricing technique is referred to as two-part tariff.

What is two-part tariff? 

Two-part tariff is a pricing technique that allows the businesses to charge the consumers an upfront fee for the product and then an additional fee based on the per unit usage. It is a price discrimination process that is generally used in clubs, amusement parks, etc.

You may have noticed, a club often charges a member a certain membership fee that offers him basic entry privileges. However, they also charge additional fee when the member chooses to avail individual services at the club. The idea behind having this pricing technique is to boost the revenues of the firm by fully capturing any consumer surplus that is available.

In order to maximize the revenues, the firm must set a price that is equal to the marginal cost. At the same time, the firm will appropriate consumer surplus by setting a fixed fee. The entrance fee is the first level of tariff. This allows the monopoly to extract all consumer surpluses. The second tariff is the price per unit, which is equal to the marginal cost. Since a firm cannot extract the surplus twice, there is no surplus in the second tariff.

How is two-part tariff determined?

For a two-part tariff to be logistically feasible in the market, a set of conditions needs to be met. First of all, the firm that is willing to implement a two-part tariff must control access to the product. This control of access is important as it keeps the consumers from buying a bunch of units of the product and then selling it to the customers who didn't pay the entry fee in the first place.

Secondly, the firm needs to have market power for the two-part tariff to be sustainable. In a competitive market, it is not feasible to have a two-part tariff. The reason is that the firms in such markets are the price takers. And they don’t have the flexibility to innovate with their pricing policies.

For the monopolists, it is easier to implement a two-part tariff since it is going to be the seller of the product only. Furthermore, it is also possible to maintain a two-part tariff in an imperfectly competitive market, especially when the competitors are using the same pricing policies. Besides, there are several other elements that influence two-part tariff determination.

• Incentives for the businesses:

It is quite obvious that when a firm has the ability to control their pricing structure, they are more likely to implement a two-part tariff as it is more profitable. Furthermore, two-part tariffs offer a firm more profit than regular monopoly since it allows the firm to sell a larger quantity and capture more consumer surplus than what it would have got under regular monopoly.

Even though it is unclear whether a two-part tariff will be more profitable than price discrimination, it is still an easier pricing technique to implement when the consumer heterogeneity, as well as imperfect information about the consumers' willingness to pay is at work.

• An edge over monopoly pricing:

The per-unit price for a certain product is generally lower under a two-part tariff than it would have been under the conventional monopoly pricing. So, when a firm comes up with such a pricing policy, this encourages the consumers to avail the product or service in greater quantities. The profit from per unit price in two-part pricing will be lower than monopoly pricing.

Interestingly, the flat fee on a per-unit basis is set high enough to get a certain amount of profit but low enough so that the consumers are still willing to avail the product/service.

• A Basic Model to determine two-part tariff:

Generally, a two tariff pricing sets the per-unit price the same as the marginal cost, which is at par with the consumers' willingness to pay. Then the firm sets the entry fee equal to the amount of consumer surplus that is generated by the consumption at the per-unit price. The challenge with this price model is that it assumes that every consumer is standing in the same position in terms of willingness to pay.

If you look at the picture above, you’ll see that in the monopoly model, the quantity is set where the marginal revenue is equal to marginal cost (Q_M). And at the quantity, the demand curve sets the price (P_M). The consumer and producer surplus is then determined by the rules for finding the consumer and producer surplus as per the graphical representation in the shaded regions.

In the case of the two-part tariff outcome, which is also described in the image above, the producer or the firm has to set the price equal to P_C and the consumer will buy Q_C units. The producer will capture the surplus of Ps (in the dark grey area) from the unit sales, while the producer surplus from the fixed up-front fee labelled as PS is in the light grey area

• How the calculation happens:

To make the concept clearer to you, let’s just work with a single consumer and a single producer in the market for the time being. The regular monopoly pricing would result in 4 units being sold at a price of $8 if we consider the willingness to pay and marginal cost number in the figure mentioned below.

You need to acknowledge the fact that a producer will only produce as long as the marginal revenue is at least as large as the marginal cost, while the demand curve represents the willingness to pay. So, when 4 units are being sold at $8, it gives the consumer surplus of $3+$2+$1+$0=$6 and product surplus of $7+$6+$5+$4=$22.

Alternatively, the producer could charge a price where the consumers’ willingness to pay matches the marginal cost, i.e. $6. In such a situation, the consumer is likely to purchase 6 units and gain consumer surplus of $5+$4+$3+$2+$1+$0=$15. The producer, on the other hand, would get from the per-unit sales the producer surplus of $5+$4+$3+$2+$1+$0=$15.

The producer could then decide to charge a $15 up-front fee by implementing a two-part tariff. From the consumer’s point of view, it would be a better decision to pay the fee and consume 6 units of the product than avoiding the market and getting $0 consumer surplus, while the producer would get producer surplus of $30 overall.

The interesting part about this model is that it educates the consumers about how the incentives will change as the price gets lower. In fact, if the consumer could not anticipate that purchasing more as a result of the lower per-unit price, he/she wouldn't be willing to pay the fixed price. The consideration becomes particularly relevant when the consumer has the choice between the conventional pricing technique and a two-part tariff.

• Efficiency:

An interesting thing about a two-part tariff is that it is economically efficient, even though some people may call it unfair. As the aforementioned picture shows, the total surplus is the same in the basic two-part tariff model as it would have been in under perfect competition. Surprisingly, the distribution of the surplus would be different.

The two-part tariff allows the producer a way to recoup the surplus that would otherwise be lost if the per-unit price was lowered below the regular monopoly price. Since total surplus is generally higher in a two-part tariff than a conventional monopoly pricing, it is possible to design a two-part tariff where both are in a comfortable position.

What type of price discrimination is a Two-Part Tariff? 

There is an on-going debate on the question of whether the two-part tariff is a form of price discrimination or not. While a group of researchers and economists argue that two-part discrimination is actually second-degree price discrimination. Others argue that two-part tariffs would not be classified as price discrimination as price discrimination involves charging different prices for different units of the same goods.

However, a two-part tariff is a price concept that is very close to price discrimination in the respect that =

         1. There is no uniform price-per-unit

         2. It allows for greater surplus capture, even for the same quantity sold, as compared to uniform pricing, and

Looking at these details, you may say it is highly-related to price discrimination, and even some textbooks also refer to the two-part tariff as price discrimination. But in reality, both are different concepts.

What is two-part pricing marketing examples? 

It will be easier to understand two-part pricing if you simply look at these following examples.

Imagine the campus bookstore has a monopoly over the supply of textbooks. Now, the bookstore hires an expert to estimate the demand curve of the market, and derives the following equation:

P = 100 – 1.5Q [where P is price and Q is quantity demanded]

In this case, the marginal revenue (MR) would be:

MR = 100 – 3Q

The bookstore buys all the books from a publisher at $40 each, which makes the bookstore’s average cost (AC) as well as marginal cost (MC) equal to $40. So, we have:

AC = 40

MC = 40

If the bookstore decides to charge uniformly for every book it sells, the demand, marginal revenue, marginal cost and average cost curves allow us to deduce that the bookstore will sell 20 books for $70 each. The economic profit will be $600.

But how do you get that? The answer is simple– two-part tariff.

Here, the students are asked to pay a cover charge, just to get the entry in the store. When they enter the store, they need to buy the books at a predetermined price. Since the textbook prices are lower, more number of customers will visit the store. Basically, the lower the price, the greater the consumer surplus. With the two-part tariff, the bookstore can recover any lost profits, which may incur due to lower prices by raising the cover charge. The bookstore can adjust their cover charge and textbook price to a certain level from where they can draw a significant amount of profit.

Now, when there is a demand for English textbooks, the bookstore decides to charge a price of $40 per book. That’s where the bookstore is selling the books at cost. To find out how many books are getting sold at this price, let’s take the demand curve and imagine the price is P while the quantity sold is Q. So, we get –

P = 100 – 1.5Q

40 = 100 – 1.5Q

Q = 40

When the cover charge is absent, it is possible for the consumers to obtain a consumer surplus of $1200. Take a look at the graph below to understand consumer surplus:

You can easily calculate the area of the triangle that signifies consumer surplus (CS), as it is bordered by the demand curve, price and vertical axis.

CS = 0.5 (base x height)

=> 0.5 (Q* x [y-intercept - P*])

=> 0.5 (40 x [100 – 40])

=> 1200

Since there is insufficient information about different consumers who make up the market (including the total number of the consumers), it is only possible to make guesses at the cover charge.

If there 30 students believe they can save money by paying the cover charge to enter the bookstore and the cover charge is set at $25 per head, the bookstore will be able to make $750 profit in such a scenario.

How does a two-part tariff differ from bundling? 

Bundling is the pricing technique where a firm decides to package two or more products or services to gain a pricing advantage. The conditions needed for bundling include:

• Heterogeneous customers

• Price discrimination not possible

• Negatively co-related demands

For instance, a restaurant charges $50 for the main course while the side dish costs $70. They can simply create a combo platter pricing $110 while reducing the amount of food compared to individual plates. This way, individual customers are more likely to buy the combo as they can save at least $10 by choosing it over solo items.

Unlike the two-part tariff, the bundling pricing does not charge any cover fee or subscription fee. It simply offers multiple products or services at a slashed price to attract more customers. Two-part tariff, on the other hand, does not offer multiple products, but they allow the consumers to get the products or services at a lower price when they are charged a cover price.

Advantages and disadvantages of a two-part tariff 

The two-part tariff is a captive-market strategy that is based on selling consumers a product or service at a lower price while charging an additional fee for essential supplies, parts or services. Interestingly, the potential for profit in this pricing technique lies in the after-sale market, not the main product.

The two-part pricing often attracts negative publicity, primarily because of the after-market margins. This is the reason why most companies are reluctant to go on record to defend their pricing. Moreover, if the firm decides to lower the after-product costs, this will inflate the price of the primary product.

Hopefully, these pieces of information have educated you enough to do your own research on the two-part tariff. If you feel you need some further assistance, help is just around the corner. Feel free to hire the experts associated with online assignment writing services.

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