Applicationof Two-Part Tariff in Microeconomics
Pricedifferentiation or price discrimination has been quite a commonpractice in the contemporary human society. It refers to a pricingstrategy in which largely similar or identical goods and services aresold and bought at varying price while being offered by the sameentity in varying territories or markets. This is entirely differentfrom product differentiation in that the latter strategy incorporatesmore substantial variation in the product cost for the variedlypriced products. In essence, price differentiate is dependent on thedifferences in the willingness of customers to pay. This strategy hasgained immense use among monopolies. Indeed, monopolies that use suchnon-uniform pricing techniques have to capture a large proportion orevery other form of deadweight loss or consumer surplus that wouldresult in instances where it sets a uniform or single price. It iswell noted that monopolies that set a high uniform or single pricewould only sell its products to individuals or consumers who placethe highest value on the products, in which case the customers retaina degree of consumer surplus. This would imply that the consumerwould lose sales that would have been made to other customers whoplace a value that is less than the uniform price on the good orservice. This lost sale is referred to as deadweight loss, which isthe value of the likely or potential sales above the cost incurred inthe production of the good. Business entities that make use ofnon-uniform pricing have the capacity to capture additional consumersurplus through increasing the price at which they offer the productto consumers who place immense value on the same. Further, thebusiness entity would change what would have otherwise been adeadweight loss to profits through reduction of the price at which itoffers the product to other customers. However, some firms may nothave the capacity to practically price discriminate, in which casethey use other non-uniform pricing strategies so as to increase theirprofits. One of the most commonly used techniques involves charging atwo-part tariff in which a consumer would pay one fee so as to beentitled to purchase a good, and another price for every unit that isbought. Once it is used, the average price that is paid woulddecrease with increase in the number of units that are bought. On thesame note, it is the marginal charge rather than the fixed fee thatwould determine the number of units that are bought. In essence,two-part tariff may be used as a technique for price discrimination,as well as in the manipulation of incentives that are offered toconsumers, while also giving sellers the opportunity to capture aportion of the residual surplus via a correctly selected fixed fee.
Thereare varied examples pertaining to the two-part tariffs’ applicationin retail markets such as museums, discount shopping, bookstores andtelephone services among others. They may also be used in wholesalemarkets, where a manufacturer would levy a lump-sum charge on theretailer for the right to carry the product, as well as anotherconstant charge per every unit that the retailer orders. A largenumber of technology licensing agreements also take up a similarstructure where they specify a particular fixed fee, as well as aroyalty for every unit that is produced.
Scholarshave noted that two-part tariffs are a special type of non-linearpricing with the only differentiating factor being that the marginalprice or the charge levied for every extra unit purchased remainsconstant. In more general multi-part tariffs, it is common for thecharge levied on every additional unit to be allowed to vary in linewith the number of units that have been bought, with the marginalprice remaining constant for a particular range of units and thendecreasing or increasing once the consumer purchases a larger numberof units. In fact, the marginal price in some nonlinear pricingschemes may be persistently varying for every unit that is bought. Onthe same note, linear pricing may be seen as an extreme case or typeof two-part tariff in which the fixed fee remains at zeros.
Thereare two fundamental implications when a business uses a two-parttariff. First, there would be a reduction in the average price thatis paid with increase in the number of units. In essence, consumerswho purchase more or larger units would be required to payconsiderably lower prices per unit (average price) compared to theirsmaller counterparts. Secondly, the fixed fee is a representation ofa fixed cost for buyers who trade in line with the two-part tariffs.In essence, the fixed fee would not determine the number of unitsthat a consumer purchases rather it only determines whether he or sheget into the trading transaction. Indeed, the volume that ispurchased is dependent only on the marginal price. The twocharacteristics of a two-part tariff are the fundamental reasons whythe pricing arrangement is used. First, since the pricing strategyallows for the simultaneous utilization of the two autonomousinstruments, it would mean a trading transaction that is moreefficient than linear pricing. This is especially considering thatthe fixed fee can be utilized in transferring money from the buyer tothe seller in lump-sum thereby reducing the probability ofdistortion, while the marginal price can be set autonomously todetermine the maximized or optimal traded quantity.
Subjectto the homogeneity of demand, there are variations on the lump-sumfee that a business entity charges. Nevertheless, a rational firmsets the per-unit charge equal to or above the marginal productioncost but equal to or lower than the price that the business entitycharges or would charge in perfect monopolies.
Nevertheless,the application of two-part tariffs is based on the presence of twoconditions. First, it is imperative that the supplier has marketpower. It is well noted that the pricing strategy is a form ofmonopoly where a business entity determines who should get particularitems and or how much. This cannot be attained by business entitiesthat do not have immense market power as it would be likely thatother entities would come up and compete with the business inquestion. On the same note, it is imperative that the producer hascontrol over the access of the goods or services in question.
Roleof information in the application of Two-part tariffs
Therole of information in the application of the two-part tariff pricingstrategy cannot b gainsaid as far as creating a picture on theincentives of the technique is concerned. In instances where a sellerincurs a constant marginal cost of production and comes across abuyer who places value on units at varying levels, this would imply astandard downward sloping demand. If this seller can only employlinear price, the price would be considerably higher than themarginal cost of production but still lower than the buyer’smaximum valuation. Such a standard monopoly pricing implies that theseller suffers a deadweight loss or social welfare loss and that hefails to capture the consumer surplus. If, on the other hand, theseller has the capacity to employ a two-part tariff, he wouldmaximize his profit by setting the price per unit to equal themarginal cost of production while the fixed fee would be equal to thewhole surplus that the seller enjoys at the marginal price. Thisallows for the achievement of first degree or perfect pricediscrimination and would result in a socially efficient allocationthat not only eliminates the deadweight loss but also allows theseller to capture the entire surplus. This situation would remain thesame in instances where there exists multiple buyers each of whom hasa downward sloping demand with the assumption that the seller has thecapacity to identify each buyer’s valuation and avert thepossibility of resale among the buyers. This would allow the sellerto charge varying two-part tariffs to every buyer with the fixed feebeing equal to valuation each buyer enjoys at the price while theprice per unit remains equal to the marginal cost of production.
However,it is difficult to achieve perfect price discrimination in instanceswhere the seller does not know each specific buyer’s value or isincapable of preventing arbitrage. Such scenarios necessitate thatthe seller designs a two-part tariff’s menu and enable consumers toself-select. In this case, every buyer chooses the tariff thatoptimizes his net surplus among the set of tariffs provided whilealso selecting the amount of product that he will buy under theselected tariff. Of particular note is the fact that the design of aoptimal menu necessitates that the seller considers the applicable“participation constraints” especially with regard to ensuringthat the prices are not so high that consumers choose to do withoutthe purchase at all. Further, it is imperative that the sellerconsiders the “incentive compatibility constraints” so as toensure that high-value consumers are prevented from selecting tariffsthat target low-value consumers.
Ininstances where it is possible to rank the values of buyers by type,the tariffs’ menu that optimizes the surplus of the seller’ssurplus has varied characteristics. First, all types of customerspurchase less than their socially efficient quantities except thehigh value types who buy the efficient quantity. Further, all typesof consumers have some surplus as a result of the “informationrents” where the buyers exploit the private information that theyhave pertaining to their own values, except the lowest value buyersfrom whom the seller extracts all the surplus. Lastly, the averageprice becomes lower with increase in the quantity purchased.
However,this scenario may become a bit more complicated in instances wheretwo-part tariffs are used by rival oligopolies. Indeed, there wouldbe a reduction in the capacity of the sellers to effectivelyundertake price discrimination as a result of the competition. On thesame note, the capacity to apply the two-part tariffs would giverival sellers increased freedom to compete, in which case the profitthat they get from the sale of their goods and services in thecorresponding game’s equilibrium may be lower than the profitsthat they could make in the case of linear pricing strategies.
Two-parttariffs have also been immensely used in instances here upstreamfirms such as manufacturers are selling to downstream firms likeretailers. The fundamental insight in such scenarios is that themarginal price rather than the fixed price that every upstream firmcharges would determine the marginal cost pertaining to thecorresponding downstream firm, in which case it would have an impacton how it behaves in downstream markets. In instance where thereexists downstream and upstream monopolies, the application oftwo-part tariffs would assist trading partners to avert thepossibility of double marginalization, which could come up in thecase of linear pricing. This may come up in instances where theseller applies a tariff that sets the price per unit equal to themarginal cost of the upstream firms. In such scenarios, the verticalchain’s total profit would be equal to the profits that verticallyintegrated monopolists are likely to enjoy (Kaiserand Wright 56).Upstream firms may use two-part tariffs that involve marginal princethat is higher than upstream marginal cost so as to soften thecompetition between the downstream oligopolies in the case ofupstream monopoly and downstream oligopoly. This would allow theupstream firms to capture the residual monopoly profits downstreamand take it upstream using the fixed fee.
Ininstances where rival upstream firms have the capacity to apply thetwo-part tariffs while there is a downstream oligopolistic market,the upstream firms would have an incentive to decrease the marginalprice even lower than their marginal costs or increase it in thetwo-part tariff. This would allow them to offer their retailers alevel of commitment to either less or more aggressive behavior in thedownstream market. The upstream firms capacity to use the two-parttariffs, as a result, may cause a reduction in the equilibrium finalprices, as well as overall costs.
Applicationof Two-part Tariffs in homogenous consumer demand
Ininstances where there is a homogenous consumer demand, any consumercan represent the market. In essence, all consumers have similardemand curves in which case it is possible to capture the entireconsumer surplus through setting the price at a level equal to themarginal cost and setting the fixed fee at the same level as theindividual consumer’s surplus. In the case of heterogeneousconsumer demand, there exists two types of consumers with theconsumers that have the same group also having similar demand curves.In essence, the available consumer surplus would be captured bymaximizing the profit function with regard to the price. This isbecause there exists varied scenarios that could give the sellerprofit although he is not privy to the one that has higherprofits(Kaiserand Wright 34).First, the seller could choose to sell his products and services toonly the high-yield consumers in which case he would set the priceequal to marginal cost while the fixed fee would be equal to thehigh-yield consumers’ surplus. This is similar to the homogenousconsumer demand scenarios. Second, the seller may sell his goods andservices to the two types of consumers and set the fee to be equal tothe low-yield consumers’ surplus and then select Price to optimizethe total profit. This results in price being higher than themarginal cost.
Examplesof real-life application of Two-part tariffs
Thereare varied examples for the application of the two-part applicationsin the daily lives. For instance, operating system platforms such asBlackberry OS, Symbian and iPhone OS that allow for interactionbetween application developers and Smartphone users or even creditcard companies such as Visa and MasterCard that enable individuals tomake payments through credit cards between consumers and suppliers ina large number of two-sided markets. These platforms charge twotwo-part tariffs made up of a subscription fee, as well as aper-transaction fee. In the operating systems industries, forinstance, developers are charged a fixed fee for accessing thesystem’s source code (Kaiserand Wright 45).Additionally, they pay royalties for the applications that theyeventually sell to consumers.
Similarly,in the case of retail warehouse clubs that often bring togethervaried products suppliers and shoppers, the shoppers would pay afixed membership fee, as well as a price for every product that theypurchase. Suppliers, on the other hand, obtain a price for every goodand sometimes receive or pay an upfront payment from the retailer.
Inconclusion, Price differentiation or price discrimination has beenquite a common practice in the contemporary human society. It refersto a pricing strategy in which largely similar or identical goods andservices are sold and bought at varying price while being offered bythe same entity in varying territories or markets. However, somefirms may not have the capacity to practically price discriminate, inwhich case they use other non-uniform pricing strategies so as toincrease their profits. One of the most commonly used techniquesinvolves charging a two-part tariff in which a consumer would pay onefee so as to be entitled to purchase a good, and another price forevery unit that is bought. Subject to the homogeneity of demand,there are variations on the lump-sum fee that a business entitycharges. Nevertheless, a rational firm sets the per-unit charge equalto or above the marginal production cost but equal to or lower thanthe price that the business entity charges or would charge in perfectmonopolies. In instances where there is a homogenous consumer demand,any consumer can represent the market. In essence, all consumers havesimilar demand curves in which case it is possible to capture theentire consumer surplus through setting the price at a level equal tothe marginal cost and setting the fixed fee at the same level as theindividual consumer’s surplus. In the case of heterogeneousconsumer demand, there exists two types of consumers with theconsumers that have the same group also having similar demand curves.There are varied examples for the application of the two-partapplications in the daily lives. For instance, operating systemplatforms such as Blackberry OS, Symbian and iPhone OS that allow forinteraction between application developers and Smartphone users oreven credit card companies such as Visa and MasterCard that enableindividuals to make payments through credit cards between consumersand suppliers in a large number of two-sided markets.
Kaiser,U. and J. Wright. “Price Structure in Two-Sided Markets: Evidencefrom the Magazine Industry,” InternationalJournal of Industrial Organization, 2006., 24, 1-28