Consumer Surplus and How it is Extracted Using Two-Part Tariffs
Abstract
Consumer Surplus is the difference between the price that a consumer is willing to pay for a good and the amount he actually pays. From another angle, Consumer Surplus is the utility for consumers by being able to purchase a product for a price that is less than the highest price that they would be willing to pay. Conversely, Producer Surplus is the amount that producers benefit by selling at a market price mechanism that is higher than the least that they would be willing to sell for. At some point, no producer surplus accrues to the seller. Economic profit is driven to zero and that item is either taken off the shelf and / or disposed off in ‘Sales Season’. Consumer Surplus is of singular importance in understanding the Microeconomic term “Two-part Tariff’.
Introduction
A number of pricing techniques are used 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, like LMVH, DKNY or Armani dresses.
Another, Penetration Pricing, sees market penetration by an agency by undercutting all competitors at a deliberately set low price, a painful reminder of Chinese dominance of the global apparel market during the ATC (quota) phase and even subsequently.
Barring China, once targeted market density is achieved, the price may be raised in
quick stages to prevailing or slightly higher levels to recover losses incurred and get into the black. Many sellers allow you to repay the cost in installments, at some fixed rate of interest. Consumer Surplus is essentially a form of profit and marketers target it, by using specific pricing methods, one of which is Two-part Tariffs.
Consumer Surplus is the difference between the price that a consumer is willing to pay for a good and the amount he actually pays. From another angle, Consumer Surplus is the utility for consumers by being able to purchase a product for a price that is less than the highest price that they would be willing to pay. Conversely, Producer Surplus is the amount that producers benefit by selling at a market price mechanism that is higher than the least that they would be willing to sell for. At some point, no producer surplus accrues to the seller. Economic profit is driven to zero and that item is either taken off the shelf and / or disposed off in ‘Sales Season’. Consumer Surplus is of singular importance in understanding the Microeconomic term “Two-part Tariff’.
Other Relevant Factors
Pindyk, Rubinfeld and Mehta, in their book: Microeconomics Sixth Edition, define Consumer Surplus as “the difference between the price that a consumer is willing to pay for a good and the amount actually paid” (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 article, I will explain in brief Consumer Surplus, Demand Curve, 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. It is a measure of the welfare that people gain from the consumption of goods and services, or a measure of the benefits they derive from the exchange of goods. 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 US$ 100 for a pair of Reebok shoes but manages a marked down version for $ 40; his consumer surplus is $60 (Refer definition of consumer surplus).
Demand Curve
The demand curve is a graph depicting the relationship between the price of a
certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule. (O'Sullivan and Sheffrin 2003).
Figure 1
The point at which the demand and supply curves intersect is called the Point of Economic Equilibrium. This is the price at which seller gains optimal profit in a competitive market. Variations can take place in the market.
The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.
- If demand increases and supply remains unchanged, then it leads to higher equilibrium price and higher quantity.
- If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and lower quantity.
- If supply increases and demand remains unchanged, then it leads to lower equilibrium price and higher quantity.
- If supply decreases and demand remains unchanged, then it leads to higher equilibrium price and lower quantity.
point and retailers are free to manipulate prices according to endemic conditions. The
same item can be bought at steep costs in up-market areas and at far more reasonable prices at normal stores. The graph shows how demand tails off rapidly above this price.
Consumer Surplus and Demand
Figure 2
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” (ibid 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. The Polaroid camera is one example.
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). These are:
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 Dutch firm Makros is an example where apparel is considered. The stores are open only to paid registered members to gain entry to the store. Unit costs inside are very low, when compared to ruling market prices. A number of online stores also come into this category, like the Malaysian Lelong.
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:
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.
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 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).
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 (ibid). 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