3 Meaning of Two-Part Tariff The purchase of some products and services can be separated into two decisions, and therefore, two prices. Examples1) Amusement ParkPay to enterPay for rides and food within the park2) Tennis ClubPay to joinPay to playPricing decision is setting the entry fee (T) and the usage fee (P), thus choosing the trade-off between free-entry and high use prices, or high-entry and zero use prices72
4 Two-Part Tariff with a Single Consumer $/QUsage price P* is set where MC = D.Entry price T* is equal to the entireconsumer surplus. How do you findout T* ?T*DMCP*Quantity79
5 Two-Part Tariff with Two Consumers Q1Q2The price, P*, will begreater than MC. Set T*at the surplus value of D2.T*P*$/QD2 = consumer 2D1 = consumer 1Π=2T*+(P*-MC).(Q1+Q2)>ΔABCAThus there is a trade-offbetween high entry fee &high user priceMCCBQuantity83
6 The Two-Part Tariff with Many Consumers No exact way to determine P* and T*.Must consider the trade-off between the entry fee T* and the use fee P*.Low entry fee=> High sales revenue, but less entry,Low price=> More use, but falling profit with lower price.To find optimum combination, choose several combinations of P and TChoose the combination that maximizes profitRule of ThumbSimilar demand: Choose P close to MC and high TDissimilar demand: Choose high P and low T.84
7 Two-Part Tariff with Many Different Consumers (choosing T) Total profit is the sum of theprofit from the entry fee andthe profit from sales. Bothdepend on T.Profit:sales:entry feeT87
8 Two-Part Tariff with many different Consumers (choosing n, alternatively) Optimum two-part tariff that globally maximizes profits is attained atThe optimum is achieved where the vertical sum (curve not shown) of ПA and ПS reaches the maximum.
9 Two-Part Tariff With A Twist Suppose, entry price (T) entitles the buyer to a certain number of free unitsGillette razors with several bladesAmusement parks with some tokensOn-line with free time
10 BundlingBundling is packaging two or more products to gain a pricing advantage.Conditions necessary for bundlingHeterogeneous customersPrice discrimination is not possibleDemands must be negatively correlated90
11 Bundling Example With Two Consumers (theaters A-B) Reservation PriceSpiderman SpaceballsTheater A $12,000 $3,000Theater B $10,000 $4,000Renting the movies separately would result in each theater paying the lowest reservation price for each movieTotal Revenue = $26,000If the movies are bundled and if each were charged the lower of the two pricesTotal revenue will be $28,000.
12 Bundling Example With Two Consumers – Importance of Negative Correlation of Demands If the demands were positively correlated (Theater A would pay more for both films as shown), bundling would not result in an increase in revenue.Gone with the Wind Getting Gertie’s GarterTheater A $12,000 $4,000Theater B $10,000 $3,000If the movies are bundled and if each were charged the lower of the two prices, total revenue will be $26,000, the same as by selling the films, separately.
13 Bundling Example With Two Heterogeneous Goods and Many Consumers (reservationprice Good 2)$6$3.25$8.25ConsumerACBEach consumerrepresented by adot – A, B, C.Consumer A iswilling to pay up to$3.25 for good 1 andup to $6 for good 2.$10$5r1 (reservationprice Good 1)$5$1098
14 Consumption Decisions When Products are Sold Separately IIConsumers buyonly good 2P1Consumers fall intofour categories basedon their reservationprice.IConsumers buyboth goodsTwo sets of choice involved:(i) Whether to choose Pfurther up inside I orfurther down inside III –i.e., choice of intercept ofintercept of a straight line;(ii) Whether to swing the lineto capture more customersfrom one quadrant or theother – i.e., from II and IV(thus involving choice ofslope of the line)P2P (P1, P2)IIIConsumers buyneither goodIVConsumers buyonly Good 1r1100
15 Consumption Decisions When Products are Bundled r2 = PB - r1IIIConsumersbuy bundle(r > PB)Consumers donot buy bundle(r < PB)r2Consumers compare the sum of their reservation prices, r1 + r2, with the bundle price PB. They buy the bundle only if r1 + r2 is at least as large as PB.r1102
16 Consumption Decisions When Products are Bundled Depending on the prices, some of the consumers in regions II and IV might have bought one of the goods if they were sold separately. These customers are lost to the firm.However, the other customers in regions II and IV now buy both goods where they formerly bought only one.The firm then, must decide whether it can do better by bundling.Buyers of good 2 who now buy good 1 alsoBuyers who buy both the goodsBuyers of good 2 lost to the firmBuyers of good 1 who now buy good 2 alsoBuyers who buy neither goodBuyers of good 1 lost to the firm105
17 Efficiency of Bundling Depends on the Degree of Negative Correlation (Spiderman)r2Bundling pays due tonegative correlation10,0005,00012,0004,0003,000BAr15,00010,00014,000(Spaceballs)106
18 Mixed Versus Pure Bundling C1 = MC1 = 20With positive marginalcosts, mixed bundlingmay be more profitablethan pure bundling.r2100Consumer A, for example, has a reservationprice for good 1 that is below marginal cost c1.With mixed bundling, consumer A is inducedto buy only good 2, while consumer D isinduced to buy only good 1, reducing thefirm’s cost.ABDC90807060504030C2 = MC2 = 3020Is MC>0 sufficientcondition for mixedbundling to dominate?10r1102030405060708090100110
19 Mixed Bundling with Zero Marginal Costs P1P2PBProfitSell separately $80 $ $320Pure bundling $100 $400Mixed bundling $90 $90 $120 $420Is MC>0 sufficient condition for mixed bundling to dominate?118
20 Mixed Bundling with Zero Marginal Costs 120In this example, consumers B and C are willing topay $20 more for the bundle than are consumersA and D. With mixed bundling, the price of theBundle can be increased to $120. A & D can becharged $90 for a single good.C1090ABD10080604020r120406080100120117
21 Mixed Bundling in Practice Use of market surveys to determine reservation pricesDesign a pricing strategy from the survey resultsMixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.121
22 TyingPractice of requiring a customer to purchase one good in order to purchase another.Allows the seller to meter the customer and use a two-part tariff to discriminate against the heavy userExamples:Xerox machines and the paperIBM mainframe and computer cardsRenting out tractor along with driverRural moneylenders providing credit against sale of output and/or input purchase (even land leasing-in) contractIs tying necessarily ‘exploitative’?