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Pricing Services Subject to Congestion: Charge Per-Use Fees or Sell Subscriptions by Gerard Cachon and Pnena Feldman

Pricing Services Subject to Congestion: Charge Per-Use Fees or Sell Subscriptions by Gerard Cachon and Pnena Feldman

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11/09/2011

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MANUFACTURING & SERVICE OPERATIONS MANAGEMENT 
Vol. 13, No. 2, Spring 2011, pp. 244–260
issn
1523-4614
eissn
1526-5498
11
1302
0244
informs
 ® 
doi
10.1287/msom.1100.0315©2011 INFORMS
Pricing Services Subject to Congestion:Charge Per-Use Fees or Sell Subscriptions?
Gérard P. Cachon
Operations and Information Management, The Wharton School, University of Pennsylvania,Philadelphia, Pennsylvania 19104, cachon@wharton.upenn.edu
Pnina Feldman
Operations and Information Technology Management, Haas School of Business, University of California, Berkeley,Berkeley, California 94720, feldman@haas.berkeley.edu
S
hould a firm charge on a per-use basis or sell subscriptions when its service experiences congestion?Queueing-based models of pricing primarily focus on charging a fee per use for the service, in part becauseper-use pricing enables the firm to regulate congestion—raising the per-use price naturally reduces how fre-quently customers use a service. The firm has less control over usage with subscription pricing (by definition,with subscription pricing customers are not charged proportional to their actual usage), and this is a disadvan-tage when customers dislike congestion. However, we show that subscription pricing is more effective at earningrevenue. Consequently, the firm may be better off with subscription pricing, even, surprisingly, when congestionis intuitively most problematic for the firm: e.g., as congestion becomes more disliked by consumers. We showthat the absolute advantage of subscription pricing relative to per-use pricing can be substantial, whereas thepotential advantage of per-use pricing is generally modest. Subscription pricing becomes relatively more attrac-tive if consumers become more heterogeneous in their service rates (e.g., some know they are “heavy” usersand others know they are “light” users) as long as capacity is fixed, the potential utilization is high, and the twosegments have substantially different usage rates. Otherwise, heterogeneity in usage rates makes subscriptionpricing less attractive relative to per-use pricing. We conclude that subscription pricing can be effective even ifcongestion is relevant for the overall quality of a service.
Key words
: service operations; operations strategy; pricing and revenue management; game theory; queueingtheory
 History
: Received: June 18, 2008; accepted: July 28, 2010. Published online in
Articles in Advance
 January 21, 2011.
How should a firm price its service when con-gestion is an unavoidable reality? Customers dislikecongestion, so a firm has an incentive to ensure itprovides reasonably fast service. At the same time, thefirm needs to earn an economic profit, so the firm’spricing scheme must generate a sufficient amount ofrevenue. Furthermore, these issues are closely linked:the chosen pricing scheme influences how frequentlycustomers use a service, which dictates the level ofcongestion; congestion correlates with the customers’perceived value for the service, and that determinesthe amount of revenue the firm can generate.A natural option is to charge customers a per-usefee or toll: customers pay a per-transaction fee eachtime they withdraw money from the ATM; beautyshops and hair salons price on a per-use basis; andcar maintenance companies, such as Pep Boys Auto,charge each time a service is completed. Naor (1969) began this line of research, and there have been manysubsequent extensions of his basic model, but nearlyalways with a focus on per-use fees. (See Hassin andHaviv 2003 for a broad survey of this literature.)Although the emphasis in the queueing literaturehas been placed on per-use pricing, other pricingschemes are observed in practice. Most notably, somefirms sell subscriptions for the use of their service:a health club may charge an annual membershipthat allows a customer to use the facility withoutadditional charge for each visit; AOL, an Internetservice provider, initially charged customers per-useaccess fees but later switched to subscription pric-ing (a monthly access fee with no usage limitation);Netflix, a retailer that provides movie DVDs forrental, also uses subscription pricing (a monthly feefor an unlimited number of rentals); Disney chargesan entry fee for its theme park without charging perride on the attractions; et cetera.Despite the existence of subscriptions in practice,a subscription pricing strategy has a clear limitationin the presence of congestion effects: subscribers arenot charged per use, so it is intuitive that they seekservice more frequently (e.g., use the health club toooften), thereby increasing congestion and decreasing
244
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Cachon and Feldman:
Pricing Services Subject to Congestion: Charge Per-Use Fees or Sell Subscriptions?
Manufacturing & Service Operations Management 13(2), pp. 244–260, ©2011 INFORMS
245the value all subscribers receive from the service. Asa result, in a setting with clear congestion costs (e.g.,in a queueing model) one might assume that sub-scription pricing would be inferior to per-use pricing.However, in this paper we demonstrate that subscrip-tion pricing may indeed be a firm’s better pricingstrategy despite its limitations with respect to conges-tion. We do so in two different capacity managementscenarios: (i) the firm’s service capacity is exoge-nously fixed; and (ii) the firm endogenously choosesits service capacity in addition to its pricing policy.The next section reviews the extensive literature onpricing services, with an emphasis on models thataddress the issue of congestion. Section 2 details our base model. Sections 3 and 4 compare the two pricingschemes under two different assumptions for how thefirm’s capacity is determined. Section 5 extends the base model to consider the effects of heterogeneoususage rates. Section 6 summarizes our conclusions.
1. Related Literature
Our work is primarily related to three streams of liter-ature: pricing in queueing models, the theory of clubs,and advance purchase pricing.Queueing theory provides a natural framework formodeling congestion, and we adopt that frameworkas well. However, as already mentioned, the litera-ture on pricing of queues generally only considersper-use pricing (e.g., Littlechild 1974, Edelson andHilderbrand 1975, De Vany 1976, Mendelson 1985,Chen and Frank 2004). Per-use pricing is sufficientfor maximizing social welfare, but it is known that aprofit-maximizing firm does not choose the welfare-maximizing price (e.g., Naor 1969).Randhawa and Kumar (2008) and Bitran et al.(2008) do consider additional pricing schemes inqueueing models. Randhawa and Kumar (2008) com-pare per-use pricing with subscription pricing thatimposes limits on usage, e.g., Netflix has a plan inwhich a customer can view as many movies as theywant as long as they do not possess more than fourDVDs at a time. They show that this constrainedsubscription plan may be better for the firm thanthe unconstrained per-use pricing because it reducesthe volatility of the demand process the firm experi-ences. We do not consider subscription pricing withlimitations, i.e., in our model a subscription pricingplan allows for unlimited usage. Furthermore, in theirmodel the two plans have the same revenue potential,whereas in our model a key difference is that sub-scription pricing can have a higher revenue potentialthan per-use pricing. Hence, the restriction on usagewith their subscription plan is necessary to create adistinction between the two pricing schemes. Bitranet al. (2008) study a two-part tariff that combines both per-use and subscription pricing. Their focus isdifferent than ours: they do not compare per-use tosubscription pricing and instead emphasize how con-sumer uncertainty regarding service quality affectsthe dynamics of their system over time (in our modelconsumers have rational expectations, so we do notexplicitly model the learning process).There is a literature in economics on the pricing ofshared facilities (i.e., clubs) subject to congestion, suchas swimming pools and golf clubs (e.g., Berglas 1976,Scotchmer 1985). Just as in our model, customers pre-fer that the service/facility is used by fewer people,so that there is less congestion. These papers showthat a two-part tariff is optimal for the firm: a per-use fee is chosen to induce a usage level that maxi-mizes social welfare and a subscription fee is chargedto transfer all rents from customers to the firm. Theliterature on nonlinear pricing also studies the designof two-part tariffs for congestion-proned services (e.g.,Clay et al. 1992, Miravete 1996, Masuda and Whang2006). They show that when consumers have hetero-geneous needs for the service, a menu of two-parttariffs may be optimal. Like Bitran et al. (2008), thesepapers do not compare per-use pricing to subscrip-tion pricing. Strictly speaking, according to our modelthe firm always prefers the two-part tariff over eithersubscription or per-use pricing (each is a subset of theset of two-part tariffs). However, we believe a com-parison between subscription and per-use pricing iswarranted. The queueing literature focuses on per-usepricing, and both per-use pricing and subscriptionsare observed in practice. In addition, a two-part tar-iff may not be desirable for reasons that we do notmodel (nor are generally modeled); e.g., a consumermay dislike being charged twice for the same service,especially if they do not understand the motivationfor such a pricing scheme. Furthermore, firms mightprefer to forgo the additional revenues from using atwo-part tariff to save the transaction costs and theadministrative burden required for its implementa-tion. Disney, for example, initially charged consumers both to get into the park and for specific rides withinthe park, but later it abandoned per-ride charges.Barro and Romer (1987) demonstrate that per-usepricing can be equivalent to subscription pricing. Forexample, they argue that a ski slope could generatethe same revenue by charging a fee per ride or bycharging a daily lift-ticket price (which is analogousto a one-day subscription). However, in their modelthey assume that the number of ski-lift rides is fixedand fully utilized no matter which pricing scheme isused. Hence, a daily lift-ticket price can be chosensuch that usage is the same as with a per-ride price. Incontrast, in our model consumers regulate their usagedepending on the pricing scheme—subscription pric-ing leads consumers to use the facility more than any
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Cachon and Feldman:
Pricing Services Subject to Congestion: Charge Per-Use Fees or Sell Subscriptions?
246
Manufacturing & Service Operations Management 13(2), pp. 244–260, ©2011 INFORMS
positive per-use pricing scheme—resulting in differ-ent utilizations of the server. Hence, in our model thetwo schemes are not equivalent.Our subscription pricing scheme resembles ad-vance-purchase pricing (e.g., DeGraba 1995, Xie andShugan 2001). When consumers purchase in advanceof the service, such as buying a concert ticket weeks before the event, consumers are willing to pay theirexpected value for the service. In contrast, when con-sumers spot purchase, i.e., when they know theirvalue for the service, they are naturally willing topay only their realized value. When purchasing inadvance, consumers are more homogeneous relativeto the spot market, so the firm can earn more rev-enue by selling in advance than by selling just witha spot price: it can be better to sell in advance toevery customer at their expected value than to sell inthe spot market to a portion of consumers (i.e., thoseconsumers with a high realized value). In our model,subscriptions also have this ability to extract rents because consumers are more homogeneous whenthey purchase subscriptions than when they purchaseon a per-use basis. However, we consider the impactof congestion, whereas the advance-purchase modelsdo not (i.e., consumers in those models do not regu-late their usage based on the pricing policy).
2. Model Description
A single firm provides a service to a market with apotential number of
homogeneous customers. Con-sumers are assumed to be infinitesimal—i.e., everyconsumer is small relative to the size of the mar-ket. Each customer finds the service to be valuableon multiple occasions, or service opportunities. Forexample, a customer may wish to occasionally use ateller at her bank, use the Internet repeatedly, or renta movie at least a couple of times per month. Thisstream of service opportunities occurs for each cus-tomer at rate
 
. At the moment a service opportunityoccurs, a customer observes the value, or utility,
,she would receive if she were to receive the serviceto satisfy that opportunity. Service values for eachcustomer are independent and identically distributedacross opportunities, where the support of
is theinterval
0
¯
v
. Hence, we have a single market seg-ment of consumers, so differences between per-useand subscription pricing are not driven by a desireto price discriminate between segments, in contrast toEssegaier et al. (2002). We discuss multiple customersegments in §5.Although customers value receiving the service,they prefer as fast a service process as possible—eachcustomer incurs a cost
w
per unit of time to completeservice (time waiting and in service).
1
Finally, con-sumers neither receive utility nor incur disutilitywhen not in the service process and waiting for thenext service opportunity to arise.The firm offers one of two pricing schemes: a per-use fee or a subscription price. The per-use fee,
p
, is acharge for each service completion: e.g., a fee for with-drawing money from an automatic teller machine, afee for each visit to a health club, or a per-minute feefor accessing a database. A subscription price,
k
, isa fee per unit of time, which is independent of theamount of service the customer receives. (This defini-tion of a subscription is equivalent to a fixed fee,
K
,for a finite duration,
d
, with unlimited usage duringthat time, where
k
=
K/d
.) Where useful, we use “
p
and “
s
” subscripts to signify notation associated withthe per-use and subscription schemes, respectively.The server’s processing rate is
. In §3 we assume
is exogenous, whereas in §4 the firm chooses
sub- ject to a fee that is proportional to the service rate.
W
·
is the expected service time. We use the term
service time
to refer to the total time to complete theservice, i.e., it includes time waiting and in service.We assume that
WM
is sufficiently small relative to1
/ 
, where
=
is the maximum possible arrivalrate of service opportunities (i.e., the arrival rate whenevery customer seeks service at every service oppor-tunity). This implies that a customer’s informationabout the queue length during one service occasionis of little use in predicting the waiting time for thenext service encounter. It also implies that for a fixedpotential arrival rate of service,
, the potential pop-ulation of customers,
, is large, they do not seekservice too frequently (
 
is small), and capacity issufficiently large that
WM
1
/ 
. (For example,the interarrival time of services could be measuredin days, whereas service times could be measured inminutes.) Consequently, the arrival rate to the firm’squeue does not vary (approximately) with the queuelength (which is typically assumed in the queueingliterature), and there is little chance that a serviceopportunity arises while a customer is in the ser-vice process. For example, a customer does not receiveanother need to withdraw cash from an automaticteller machine while she is in the process of with-drawing cash. (See Randhawa and Kumar 2008 fora model of a closed queueing system in which thearrival rate to the queue depends on the number ofcustomers in queue.) Therefore, the expected servicetime depends only on the actual arrival rate,
. Thefunction
W
is strictly increasing (
 >
0) andconvex (


0). (Thus,
W
0
=
1
/
because 1
/
1
As in Afèche and Mendelson (2004), it is possible to allow thewaiting cost to be linear in the value of the service,
w
=
a
+
bv
.A detailed analysis is available from the authors.
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