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 multi-brand products, Chanel's creative modernity goods, Rolex watches 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.
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).
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).
Comparison With 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
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