MGEC 621

PROFESSOR WHITE
AUTUMN 2008 / Q1

TwoPartPricing

This note examines a form of sophisticated pricing called twopart pricing.

Priortoclass,pleaseprepareyouranswerstotheproblemonpage6.Youdonot
needtohandinyourworkonthisproblem;however,pleasebepreparedtostate
youranswersandexplainhowyoudiditduringclass.

Twopart pricing is a clever way to implement a price discrimination strategy. This

strategy seeks to extract all of a consumers surplus from his or her participation in the
market. This strategy is widely used, as it can increase a firms profits even beyond
monopolypricingthatyoustudiedin603.

Howisthispossible?Twopartpricingusesanupfrontfee(manytimescalledanentry,
access, or membership fee), and an additional price for each unit of product
consumed(apriceperuse).Examplesincluderazorsandrazorblades,camerasandfilm,
healthclubmemberships,amusement/themeparkpricing,andcellularphonepricing.

The problem that arises in implementing twopart pricing is to set the most profitable
combinationoftheupfrontfee(entryfee)andtheadditionalpriceforeachunitpurchased.
Figure1showsthesituationwithoneconsumer(oragroupofidenticalconsumers).The
optimal strategy issimple: set the entry feeatT (the consumer surplus) and theprice
peruse(P)atmarginalcost(MC).Theprofitinthiscaseis:

Totalrevenuetotalcost=(TREntry+TRUse)(variablecost+fixedcost)
=(T+F)(F+fixedcost)

sincetherevenuefromchargingapriceperuseisthesameasthetotalvariablecostin
thisexample.Thetotalprofit=Tfixedcost.

Notethatthisyieldsthesameresultasfirstdegreepricediscrimination.

SessionNote01TwoPartPricing.doc

Page1of7


Price/unit

AT=areaABC=consumersurplus

PBCMC=AVC

DemandCurve

0QCQuantity

FIGURE1.TwoPartPricingwithaSingleConsumer

Notethat,withasingleconsumer(orsetofidenticalconsumers),theoptimalpriceper
useequalsmarginalcostregardlessoftheshapeofthemarginalcostcurve.Theentry
feestillequalsconsumersurplus.Figure2showsthis,witharisingmarginalcostcurve.
The only difference from Figure 1 is that the firm now makes some additional profit
becauseitsmarginalcostislowerthanthepriceperuseforeachunitlessthanQC.The
additionalprofitisareaBCE.

Price/unit
AT=areaABC=consumersurplus

MC

PBC

DemandCurve
E

0QCQuantity

FIGURE2.TwoPartPricingwithIncreasingMCandaSingleConsumer

The twopart pricing strategy is most effective when consumers have similar demand
characteristics.Weillustratethestrategywithanexampleproblem.

SessionNote01TwoPartPricing.doc

Page2of7


Example:TennisClubMemberships

Youmanageatennisclubandwishtorestrictmembershiptothoseconsumerswithahigh
demand (serious players). You estimate there are about 1,000 such players, and that the
relevantdemandfunctionforeachplayeris

Q=6P

whereQisthecourthoursperweekandPistheperhourcourtuseprice.Fixedcosts
are$5,000perweekandthemarginalcostis$0(therearelotsofcourts).

(a) At what price should you set the annual membership fee to maximize profits, and
whatwillyouraverageweeklyprofitsbe?

(b)Comparethetotalprofitwiththistwopartpricetotheprofittheclubwouldearnif
you used standard monopoly pricing. This means having an upfront fee of zero, and
choosingtheusagepricetomaximizeprofit.

(c)Howwouldyouranswerto(a)changeifthemarginalcostofprovidinganhourof
tenniswasMC=$1,insteadofzero?

Analysisfor(a)

Step1:Calculatethetotalconsumersurplusforeachconsumer.

Since marginal cost is $0, you can maximize the membership fee (and still cover your
marginalcosts)bysettingausagepriceof$0andsettingthefeeatconsumersurplus:

6Consumersurplus=(6*6)=$18

P=0
6Quantity

So:Themanagershouldchargeeachconsumer(justunder)$18perweekasthemem
bershipfee,andallowallplayerswhopaythemembershipfeetousethecourtsforfree.

SessionNote01TwoPartPricing.doc

Page3of7

Step2.Nowcalculatetheweeklytotalprofit:

Week=TRTC=(1,000*$18)$5,000=$18,000$5,000=$13,000

Step3.Calculatetheannualprofitandannualmembershipfee:

Year=($13,000/week)*(52weeks/year)=$676,000/year

Theannualmembershipfee=($18/customerperweek)*52
=$936/personperyear.

Notethatthereisnousagefeebecausethemarginalcostis$0.Youshouldbeclearabout
whysettingtheusagepricefeeequaltoMCmaximizesprofitshere.

Analysisfor(b)

Thisisthesametypeofmonopolypricingquestionyouencountered(towardtheendof)
MGEC603duringpreterm.Ifthefixedfeeiszero,thenprofitis

Week =totalrevenuetotalcost

=P*totaldemandvariablecostfixedcost
=P*(1,000*Q(P))fixedcost(sincemc=0)
=P*(1,000*(6P))$5,000

Marginal revenue is MR = 1,000 * (6 2P), so setting MR = MC (which is zero) and

solving for price gives the answer: The monopoly price is PM = $3. Profit under
standardmonopolypricingisthen$4,000/week,or$208Kperyear.

TheKeyPoint. Afirmusingtwopartpricescanmakeatleastasmuchprofitasit
couldusinguniformpricingevenmonopolypricing.Often,itcanmakemuchmore.

Remark.Wedistinguishbetweentheusagepricewhentwopartpricingisused,versus
theoptimalpricewhennoupfrontfeeisused(thatis,standardmonopolypricing,PM).
Todoso,thestandardmonopolypriceissometimescalledthebestuniformprice.

Analysisfor(c)

Ifthemarginalcostis$1,thenconsumersurplusis$12.50.Seethegraphbelow:

SessionNote01TwoPartPricing.doc

Page4of7


6Consumersurplus=(5*5)=$12.50

P=1MC

56Quantity

Step1:SetthemembershipfeeatCS=$12.5;theusagepriceatP=$1.

Step2:Weeklyprofitisnow:

Week=TRTC=TREntry+TRUsevariablecostfixedcost
=(1,000*$12.5)+(1,000*5*$1)(1,000*5*$1)$5,000

=$7,500

Step3:Yearlyprofitandannualmembershipfee:

Year=($7,500/week)*52=$390,000/year

Theannualmembershipfee=($12.5/customerperweek)*52weeks/year
=$650/customerperyear.

TwoPartPricingwithNonIdenticalConsumers

When demand across consumers is not identical, the optimal strategy is more compli
cated. In this case, the usage fee cannot be set at marginal cost if you are to serve
multipleconsumertypes.Often,theusagefeeissetgreaterthanmarginalcost.

Thekeytradeofffacingmanagersisthatalowerentryfeemeansmoreconsumerswill
initiallypurchasetheproductorservice,andreturnsfromsubsequentusewillincrease.
However, as the entry fee is lowered, the profitability derived from the entry fee is
reduced.

Most managers solve the pricing problem with a trial and error approach. If the
demand curves for consumers are known, however, the problem can be solved
analytically. The optimal strategy is best illustrated through a problem. The problem
belowwillbethebasisforourdiscussionoftwopartpricinginclass.

SessionNote01TwoPartPricing.doc

Page5of7

ProblemtoPrepareforClass

Note:YoumayuseExcelinansweringthisquestion.Thisproblemwillbethebasisforourdis
cussioninclass;youdonotneedtohandinyoursolution.Forclass,pleasebepreparedtostate
youranswersandhowyousolvedit(or,atleast,explainasfarasyouwereabletoget).

Suppose again that you manage a tennis club. However, you know that there are two
differenttypesofpotentialclubmembers:Highdemandtypes(seriousplayers),andlow
demandtypes(casualplayers).Thedemandforcourttimeofaseriousplayeris

QS=6P

whereQisthecourthoursperweekandPistheperhourcourtuseprice.Thedemand
forcourttimeofacasualplayerislower:

QC=4P.

Supposethatthereare1,000seriousplayersandanother1,000casualplayersinthelocal
market.Fixedcostsare$5,000perweek,andmarginalcostis$0.

(a)Supposefirstthatyoudonotusetwopartpricing.Whatistheoptimalmonopoly
pricetochargeperhourofcourtuse,ifyoucannotchargeanupfrontmembershipfee?
(Youmustchargethesamepriceperhourtobothtypesofplayers).Howmuchprofit
willthismake?

(b)Findtheprofitmaximizingtwopartpricingstrategy.Whatistheoptimalmember
shipfee(perweek)andtheoptimalusageprice?Note:Youmustofferthesamemember
shipfeeandusagepricetoallpotentialcustomers(youcanttellthemapartexante).

(c)Supposethatyoucouldacquiretheclubfromitscurrentownerfor$10,000perweek,
andthensetanewmembershipfeeandcourtusepriceasyouseebest.Isbuyingthe
clubaprofitableinvestment?(Assumeallfinancingcostsareincludedinthe$10k/week
price.Thatmeansyoumayignorediscountinghere.)

ManagerialImplications

1. The Key Point. Generally speaking, twopart pricing works well when consumers
desire to make repeat purchases (or visits) from the same seller, for the same type of
goodorservice.Whenitisfeasible,twopartpricingwilltypicallyyieldhigherprofits
thaneventhebestuniformpricingstrategy(monopolypricing).

SessionNote01TwoPartPricing.doc

Page6of7


2.Practicallimitations.Therearetwo.Oneistheneedtobeabletoidentifywhether
eachparticularcustomerhaspaidthefixedfeeornotwhenhe/shemakespurchases(or
usesaservice)later.ThisiswhyCostcohasmembershipcards,amusementparksstamp
yourhand(ordontletyouout),andsoon.Thesecondpracticallimitationisthattwo
part prices have little value if the consumer is buying at most one unit of the good.
ThereisnotmuchpointinchargingatwopartpriceforanewcarifyourunaHonda
dealership,forexample,orifyouarerunningarestaurantfortouristswhoareunlikely
toreturn.

3.Costconsiderations.Thekeylongruntradeoffmanagersmustconsiderisbetweena
high entry fee (lower number of consumers demanding service but greater profit per
consumer)andalowerentryfee(highernumber ofconsumersdemandingservice but
lower profit per consumer). In thinking about this tradeoff, the cost of serving each
customershouldcomeintoplay(seetheAOLarticle,below).

4.Thepricemenustrategy.Oneextensionmanagersuse(rememberthisisoftenatrial
anderrorprocess)istoofferconsumersamenuofseveraltwopartpriceoptions,and
letconsumersrevealtheirreservationprices.Thisiswhatmobilephonecompaniesdo
inofferingachoicebetweenpackageswithalowmonthlyfeeandasmallallowanceof
free minutes, or packages with a high monthly fee and a large allowance of free
minutes. Nonprofit museums and other organizations do much the same thing,
offering consumers the choice between a membership that allows free unlimited
visits,orahigherpervisitadmissionpriceifavisitordoesnotpaythemembershipfee.

Application:ISPPricing

AOLintroducedthetwopartpricingstrategy(withazerousageprice)intotheinternet
access service industry back in 1997. Is has proven a big success, and is the now the
dominant(almostexclusive)formofpricingbyinternetserviceproviderstoresidential
consumers in the U.S. Consider the attached article from The Economist, Making a
BusinessoftheBuffet.WhatdidAOLdowrongatthestart?Whatshouldtheyhave
donedifferently?

SessionNote01TwoPartPricing.doc

Page7of7