How Firms Try to Extract Consumer Surplus Using Two-Part Tariffs - Essay Example

Introduction A number of pricing techniques are in use to determine the best returns for a product or service. One example is ‘Premium Pricing’, where you pay an exorbitant sum for brand value or exclusivity of the product. Another, Penetration Pricing, sees market penetration by an agency by undercutting all competitors at a deliberately set low price. On achieving targeted market density, the price is raised in quick stages to prevailing or slightly higher levels to recover losses incurred and get into the black. Consumer Surplus is essentially a form of profit and market players target it, using specific pricing methods, one of which is Two-part Tariffs. Other Relevant Factors Consumer surplus may be defined as “The difference between the price that a consumer is willing to pay for a good and the amount actually paid” (Pindyk, Rubinfeld and Mehta, 107). A two-part tariff (TPT) has many interpretations, one of which is: “A form of pricing in which consumers are charged both an entry and a usage fee” (ibid, 317). There is more to two-part tariffs than described. It is essential to understand certain associated economic factors before getting at the rather complex topic. In this paper, I will explain in brief Consumer Surplus; Consumer Surplus and Demand; Monopoly and Pricing Strategies with Market Power. Two-part tariffs and consumer surplus are closely linked; I will explain what two-part tariff means in practical terms and show how firms try to extract consumer surplus using it. Consumer Surplus The public purchases goods only if there is some benefit to be had. Consumer surplus is a valuation of how much benefit individuals gain as a total on completing their purchase of the product in question. Most people have differing methods of evaluating the intrinsic value of a good. Such extraneous factors, apart from purely commercial reasons, decide for these individuals the maximum price they are willing to fork out for an item. If an individual is willing to pay £ 100 for a Liverpool vs Chelsea soccer match, but manages a ticket for £ 40; his consumer surplus is £ 60 (Refer definition of consumer surplus). Consumer Surplus and Demand According to Pindyk, Rubinfeld and Mehta, “A demand curve is the relationship between the quantity of a good consumers are willing to buy and the price of that good.” (18). They add, “It is fairly simple to calculate consumer surplus if the corresponding demand curve is known and their relationship can be examined” (ibid,107). Let us do so for an individual, as advised by the authors. In the stated example, the consumer could muster £ 100 for his first ticket. With this consumer surplus, he could manage £90 for his second ticket with a consumer surplus of £50. He kept buying tickets as they were being subsidised by consumer surpluses. He ultimately bought six tickets @ £40 each, for an overall consumer surplus of £210, all of which went back into more tickets. It is this consumer surplus that the two-part tariff attacks. (Figure 1). 100 90 80 70 C 60 50 40 c 1 2 3 4 5 6 TICKETS Figure 1 Monopoly Before we get to monopoly, it would be prudent to understand the working of a ‘perfectly competitive market’. According to Sen (159), “A perfectly competitive market is an intensely competitive market where firms sell homogenous products. The outputs of all firms are identical from the standpoint of buyers.” Moreover, “The number of buyers and sellers in the market is large; the actions of one agency will have little or no bearing on trading and all agents have perfect information” (ibid). The other extreme is where one firm rules the roost, with no competition. “Such an industry is called a monopoly” (Sen, 180). In effect, a monopolist sets all prices since he has no competition. His predatory pricing leaves little room for consumer surplus, absorbing it almost fully as additional profit. Pricing Strategies with Market Power So far we have assumed that the monopolist charges a flat rate. If he can charge different customers different rates for the same product, he gets a chance to make a greater profit. In an upscale market, he charges his customers the maximum he can extract from them. The same price will be prohibitive in a low-brow market. In this market, he charges a lower price, but still the highest he can extract from the less affluent customers. This is a simple example of price discrimination. According to Sen, “Three conditions must be met to ‘price discriminate’ successfully (202): 1. The firm has market power. A perfectly competitive firm can never ‘price discriminate’. 2. The firm must be able to separate buyers into groups which can be charged different rates. 3. The firm must be able to prevent arbitrage. Low cost buyers should not be able to sell their purchases in upscale markets.” There are various types and degrees of price discrimination. These, however, fall outside the purview of this paper. What needs to be noted is that their basic aim is the same: to extract the maximum consumer surplus. The Two-part Tariff Pindyk, Rubinfeld and Mehta state, “The two-part tariff is related to price discrimination and provides another means of extracting consumer surplus” (317). All consumers pay cash down to buy a base product. They then pay extra for each section of the good they intend to use. Discotheques charge two-part tariffs with gay abandon. Entry is at a moderate cost, conditional to buying a minimum of two drinks at the bar. Each drink costs the same, whether it is a soda or beer, and is a rip-off. “All clubs that have members charge two-part tariffs: Annual membership fee plus facility usage fee” (ibid). The two-part tariff has a few posers. “How should a firm assess entry and usage fees? Given the fact that the firm has some market power, should it go for a high entry fee coupled with low usage fees, or the other way around?” (Pindyk, Rubinfeld and Mehta, 318). The solution needs a deeper understanding of the concepts involved: 1. Case I: One Consumer. A single consumer’s demand curve can be easily traced. If some other consumers have identical demand curves, they can be clubbed into this bracket. The firm has only one aim in mind: To extract as much consumer surplus as possible. In this case, the solution is simple. Pindyk, Rubinfeld and Mehta suggest that “Usage fee (U*) should be set at the Marginal Cost (MC; cost of one addition of a good) and the entry fee (E*) equal to the total consumer surplus for that customer / group of identical consumers. The customer pays U* as usage fee and multiples of U* per extra unit used” (318). A firm operating this way will absorb all consumer surplus. 2. Case II: Two Consumers. In this case, there are two different people or two sets of different people with identical demand curves. The limitation here is that the firm can fix only one E* and one U*. This implies that setting U* equal to MC will no longer be a viable proposition. If it goes ahead and equalises the two, the entry fee will have to be related to the finances of the person/group of persons who have the lower demand. If their requirements are overlooked and they are charged what the other group (the larger demand group) is paying, they will not buy the product or simply opt out. The net result will be the realisation of a less than optimum profit. Pindyk, Rubinfeld and Mehta suggest that “The firm should set usage fee above marginal cost and then set the entry fee equal to the balance consumer surplus with the consumer having the smaller demand.” (318). There remains the question of valuation. To arrive at close to exact values of the two fees, the firm “will need to know the two demand curves, apart from its marginal cost. It can then write its profit as a function of U* and E* and select the two numerical values that maximise this function” (ibid). 3. Case III: Multiple Consumers. A large number of firms have to deal with a mixed bag of customers, with accompanying varied demands. Since the numbers of variables are too large to accommodate in a clear cut formula, an ideal two-part tariff cannot be served on a platter. A fair number of give and take experiments will become necessary. Trade-offs will appear on the solution screen. Pindyk, Rubinfeld and Mehta explain: “A lower entry fee means more entrants and increased income” (319). The risk lies in how low the entry fee is capped at. If E* is fixed below a certain value, the income no longer remains cost-effective. The problem is to derive an E* that provides the ideal number of entrants, translating into highest profit. “This can be done by setting a particular sales price, finding the optimum E* and estimating resultant profit” (ibid). The authors advise, “Change the sales price, calculate the corresponding E* and evaluate the new profit level. By iterating in this manner, the optimal two-part tariff can be arrived at” (319). Awareness of MC and the summative demand curve is insufficient data to create any sort of understandable graphic representation. “Though it is not possible to determine the demand curve of every consumer, an idea of the variance in parameters would be of help” (ibid). “If their demand curves follow some identifiable pattern, set the price close to MC and make E* large to capture the maximum possible consumer surplus,” advise Pindyk, Rubinfeld and Mehta (319). If no pattern is discernible, a less than optimum solution will have to be adopted, which is to “Set the price well above MC, charge a lower entry fee and accept the capture of a lower consumer surplus” (ibid). Conclusion In this paper, I have explained consumer surplus at length and shown that it is essentially a measure of potential profit. I have discussed pricing strategies in brief, including price discrimination, leading to the implementation of two-part tariffs. I have shown that the two-part tariff is not a cut and dried profit extraction policy, beset, as it is, by a host of variables. In each case, I have arrived at and explained the optimal method of extracting consumer surplus from the consumer, as well as its implementation by producers of a good or product. As long as there are market forces reaching out for consumer surplus, two-part tariffs are here to stay. Works Cited Pindyk, Robert. S; Rubinfeld, Daniel. L and Mehta, Prem.L. Microeconomics Sixth Edition. Delhi: Dorling Kindersley(India), 2006. Print. Sen, Anindya. Microeconomics Theory and Applications. Delhi: Oxford UP, 2006. Print. Read More