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. Consumer Surplus is thus the utility for consumers able to purchase a product for a price that is less than the highest price 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 an exorbitant sum is charged for brand value
or exclusivity of the product, like LVMH, Rolex watches, Gucci shoes or Rolls Royce cars.
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, Netflix and Costco.
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 the repayment of the cost in instalments, at some fixed rate of interest. International giants, like Amazon, have internal arrangements with select Banks which often do not charge any interest for repayment in instalments or offer dicounts if the buyer uses/switches to their Credit/Debit Card. 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, Producer Surplus, Market Equilibrium, 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).
Figure 1 : Consumer Surplus
In the figure above,
Consumer Surplus is the area shaded red, under the demand curve & above the
price.
Producer Surplus
Producer surplus is the
difference between what the producer receives for the good and the amount
he/she must receive to be willing to provide the good. It is the area above the
supply curve & below the price. In Figure 2 below, Consumer Surplus is the
area shaded green.
Figure 2: Producer Surplus
Market Equilibrium
Total social welfare is
the sum of consumer surplus and producer surplus. Both the consumers and the
producers want to maximise their surplus leading to efficient allocation of
resources to produce the product which maximises the total benefit to the
society. This happens when Market Equilibrium prevails.
Figure 3: Market
Equilibrium
At any other point other than the equilibrium, caused by a variation in surplus at either end will lead to the total surplus reducing below the optimal as depicted.
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 4
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.
The four basic laws of
supply and demand are:
- 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.
The demand curve for all
consumers is projected by simply consolidating individual demands at each
price. Demand curves are used to estimate behaviours in competitive markets, and
are combined with supply curves to assess the equilibrium price, or market
clearing price, where the demand is equal to the supply, depicted as the point
where the demand and supply curves meet. Profit margins are optimal at this 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.
The producer continues to
makes his profit at any point on the curve, since he works on volume
distributed to multiple retailers and the profit margin he has added for the
product. His cut-off point is at a much lower price, as seen on Figure 1. Note
that the supply curve is close to being a straight line, while the demand curve
does actually curve.
Consumer Surplus and
Demand
According to Pindyk et al.,
“A demand curve is the relationship between the quantity
of a good consumers are willing to buy and the price of that good” (ibid, 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 pair of Reebok shoes. Let us assume he has
four family members and a close friend who would also like to buy those shoes.
Utilising his consumer surplus of $60, he could get them, who have available
resources of $75-$80, to also buy the said shoes (refer Figure 2). With each
buy, the consumer surplus keeps increasing, till at one stage it reaches a
total of say, $100. Assume that his friend can afford only $20. He can now give
$20 to his friend and then buy two more pairs as gifts for other friends. In
effect, he and his coterie kept buying shoes as they were being subsidised by
consumer surpluses. They ultimately bought eight pairs of shoes @ $40 each, at
one time having an overall consumer surplus of $100, all of which went back
into more shoes. Note that they wanted to buy the shoes. If the buyer was
satisfied with only two pairs, he would retain some surplus funds. It is this
consumer surplus that the two-part tariff attacks.
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 was one example. Current
examples in the half-witted US market are frozen shrimp and steel nails shipped
from India and lemon juice from South Korea.
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 et al., 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.
Technically speaking, "two-part tariff" is somewhat of a misnomer, since tariffs are taxes on imported goods. for most purposes, you can just think of "two-part tariff" as a synonym for "two-part pricing," which makes sense since the fixed fee and the per-unit price do in fact constitute two parts.
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 et al., 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 et al., 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 et al., 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 et al., (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).
Compared to Monopoly
Pricing
In general, the per-unit
price for a good will be lower under a two-part tariff than it would be under
traditional monopoly pricing. This encourages consumers to consume more units under
the two-part tariff than they would under monopoly pricing. The profit from the
per-unit price, however, will be lower than it would have been under monopoly
pricing since otherwise, the producer would have offered a lower price under
regular monopoly pricing. The flat fee is set high enough to at least make up
for the difference but low enough that consumers are still willing to
participate in the market.
A Basic Model
Figure 5
As stated, a two-part
tariff will see per-unit price equal to marginal cost (or the price at which
marginal cost meets the consumers' willingness to pay) and then set the entry
fee equal to the amount of consumer surplus that consuming at the per-unit
price generates. (Note that this entry fee is the maximum amount that could be
charged before the consumer walks away from the market entirely). Jodi Beggs, writing for ThoughtCo in 2019 believes that the
difficulty with this model is that it implicitly assumes that all consumers are
the same in terms of willingness to pay, but it is still a helpful starting
point.
Such a model is depicted
above. On the left is the monopoly outcome for comparison - quantity is set
where marginal revenue is equal to marginal cost (Qm), and the price is set by
the demand curve at that quantity (Pm). Consumer and producer surplus (common
measures of well being or value for consumers and producers) are then
determined by the rules for finding consumer and producer surplus graphically,
as shown by the shaded regions.
On the right is the
two-part tariff outcome as described above. The producer will set price equal
to Pc (named as such for a reason that will become clear) and the consumer will
buy Qc units. The producer will capture the producer surplus labeled as PS in
dark grey from the unit sales, and the producer will capture the producer surplus
labelled as PS in light grey from the fixed up-front fee.
Example:
Figure 6
It's also helpful to think
through the logic of how a two-part tariff impacts consumers and producers, so
let's work through a simple example with only one consumer and one producer in
the market. If we consider the willingness to pay and marginal cost numbers in
the figure above, we will see that regular monopoly pricing would result in 4
units being sold at a price of $8. (Remember that a producer will only produce
as long as marginal revenue is at least as large as marginal cost, and the
demand curve represents a willingness to pay.) This gives consumer surplus of
$3+$2+$1+$0=$6 of consumer surplus and $7+$6+$5+$4=$22 of producer surplus.
Alternatively, the
producer could charge the price where the consumer's willingness to pay equals
marginal cost, or $6. In this case, the consumer would purchase 6 units and
gain consumer surplus of $5+$4+$3+$2+$1+$0=$15. The producer would gain
$5+$4+$3+$2+$1+$0=$15 in producer surplus from per-unit sales. The producer
could then implement a two-part tariff by charging a $15 up-front fee. The
consumer would look at the situation and decide that it's at least as good to
pay the fee and consume 6 units of the good than it would be to avoid the
market, leaving the consumer with $0 of consumer surplus and the producer with
$30 of producer surplus overall. (Technically, the consumer would be
indifferent between participating and not participating, but this uncertainty
could be resolved with no significant change to the outcome by making the flat
fee $14.99 rather than $15.)
One thing that is
interesting about this model is that it requires the consumer to be aware of
how her incentives will change as a result of a lower price: if she didn't
anticipate purchasing more as a result of the lower per-unit price, she would
not be willing to pay the fixed fee. This consideration becomes particularly
relevant when consumers have a choice between traditional pricing and a
two-part tariff since consumers' estimates of purchasing behavior have direct
effects on their willingness to pay the up-front fee.
Cost Effectiveness
Figure 7
One thing to note about a
two-part tariff is that, like some forms of price discrimination, it is
economically efficient (despite fitting many people's definitions of unfair, of
course). You may have noticed earlier
that the quantity sold and per-unit price in the two-part tariff diagram were labeled
as Qc and Pc, respectively- this is not random, it is instead meant to
highlight that these values are the same as what would exist in a competitive
market. As the above diagram shows,
total surplus (i.e. the sum of consumer surplus and producer surplus) is the
same in our basic two-part tariff model as it is under perfect competition, it
is only the distribution of surplus that is different. This is possible because the two-part tariff
gives the producer a way to recoup (via the fixed fee) the surplus that would
be lost by lowering the per-unit price below the regular monopoly price.
Because total surplus is
generally greater with a two-part tariff than with regular monopoly pricing, it
is possible to design a two-part tariff such that both consumers and producers
are better off than they would be under monopoly pricing. This concept is particularly relevant in
situations where, for various reasons, it is prudent or necessary to offer
consumers the choice of regular pricing or a two-part tariff.
Conclusion
In this paper, I have
explained consumer surplus 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
Jodi Beggs; https://www.thoughtco.com/overview-of-the-two-part-tariff-4050243
