EXPLAIN HOW FIRMS TRY TO EXTRACT CONSUMER SURPLUS USING TWO-PART TARIFFS By Instructor Institution Location Date Introduction Two part pricing is a popular strategy that is used by firms who possess significant market power. The two part pricing system by firms is executed in such a way that firms charge fixed fee in exchange for the use of their commodity besides setting a aside a per unit fee for each unit of the commodity purchased…
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Consumer Surplus and two part tariffs Monopolist firms are always associated to price discrimination and two-part pricing. Monopoly market structure is a form of market structure in which there is only one consumer and several producers. The monopolists are able to effect two part tariffs because they have the market power and because the consumers have inelastic demand curve. Market power, on the other hand, refers to the firm’s ability to raise the price of a commodity in the market over the marginal cost of producing the good in order to increase profit. The monopolists who act as price makers in the market without losing their customers or decreasing their sales majorly enjoys market power. The goods produced in these markets are very essential to people and that is why they still purchase the goods when their prices increase (Perloff, 2012). Market power is majorly brought about by barriers to entry to the new firms by monopolists. Elasticity is an important factor when one wants to determine market power and this depends on the shape of the demand curve where the price is raised above the marginal cost curve by the firm. It is given by the equation below: Price/Marginal cost= price elasticity of demand/ (1 + price elasticity of demand) Elasticity is affected greatly by availability of substitutes in that the more substitutes a good has, the more elastic the commodity is likely to be. Lastly, time affects elasticity as it takes time for consumers to react to the changes in price of goods. It has been observed that the demand for goods may be inelastic in the short run but elastic in the end due to price increase (Goolsbee & Syverson, 2013). Two critical conditions should be satisfied for the two-part tariff to hold. The first condition is that the supplier must have market power and the other is that the producer should be able to control access to the market. According to Pindyck & Rubinfeld (2009) in case where there is only one type of consumers who have the same demand curve then firms captures the concept of consumer prices through setting the price that is equal to marginal cost. Moreover, the fixed fee is set at point where it is equal to the consumer surplus of individual consumer price. Ordinarily, the consumer would charge price Pm and produce quantity Qm which accords the firm a profit shown by region B. However, due to two part pricing the firm will charge price Pc and a fixed charge of ABC making the firm to increase its profit to ABC. By charging price Pc the firm will extract all the surplus and realize increase in profits by AC. Figure 1: the figure shows how consumer surplus is obtained when demand is homogeneous; the diagram applies for each consumer In case there are two types of consumers and all the consumers within the same group possess the same demand curve then the only way to capture consumer surplus is through maximizing the profit function with respect to the price. The firms can attain the consumer surplus in two ways with two kinds of consumers. The first way to attain consumer surplus is through selling to high yield customers (Goolsbee & Syverson, 2013). High yield customers are charged a price, which is equal to marginal cost, and the fee is set equal to the price of the high yield custom
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