Two-part Tariffs

A two-part tariff consists of a lump sum payment plus a per-unit user charge.
Example: A seller can charge a fixed entry fee and a per unit charge.
Two customer groups of equal size with different demand curves:

Group A Group B

100
100

100 50

Consider first just the entry fee with no additional charge.

What is the highest fixed entry payment that could be charged to each group?

The total benefit for the good to Group A would be ½(100)(100) =5000. This is
simply the area under the demand curve. All consumer surplus would be
extracted. The highest entry charge to Group B would be ½(100)(50) = 2500.
Again, this charge would extract the full benefit, hence all of consumer surplus
from Group B.
Now suppose that the cost of providing the product is fixed, for either group, at
$500. What should the seller do?
Setting the entry payment at $5000, restricts the sale to just group A. And profit
would be $5000 - $500 = $4500. With an entry fee of $2500, both groups would
purchase and profit would be 2(2500-500) = $4000.
With only an entry fee, the seller sets it at $5000 and sells only to Group A. Group
B is priced out of the market.
But now consider a uniform entry fee plus a uniform price per unit.
Demand curve for Group A: P = 100-Qa so Qa = 100 -P
Demand curve for Group B: P=100 – 2Qb so Qb = 50 – P/2
Summing the demand curves yields: Qa+Qb = 150 – 3P/2

Now, if both groups are going to purchase, the entry fee must be set no higher
than consumer surplus in Group B.

100
Consumer surplus for Group B = 1/2( 100 – P) (50 - P/2)

50
50-P/2

Profit = TR – TC = 2( entry fee) + unit revenue - cost

= (100 – P)(50 – P/2) + P(150 – 3/2 P) – 1000 = 4000 +50P – P2
Take the derivative, set equal to zero and solve to get P*=25.
Consumer surplus for Group B = 1/2( 100 – P) (50 - P/2)
Now to get the entry fee, calculate consumer surplus at the unit price of 25.
Consumer surplus = 1406.25
Plugging into the profit function above yields: profit = 4625
So profit + consumer surplus = 6031.25 and has increased as a result of the two
part tariff. Social welfare has increased.

However, two part pricing does not always improve welfare. If in the absence of
the two-part tariff, both customer groups had remained in the market, then social
welfare would be reduced even with the increase in monopoly profit.
Tying and Bundling
Under a tie-in sales agreement, a customer can purchase one good only if she
agrees to purchase another good. Bundling is a tying agreement under which the
two products must be purchased in fixed proportions. Requirement tie-in agree-
ments allow for variable proportions.

In a 1958 case, (Northern Pacific Railway Co. vs. the U.S.), the court’s opinion
included the statement “Tying agreements serve hardly any purpose beyond the
suppression of competition”. But economists recognize several justifications for
tie-in arrangements:
Efficiency
Evading Price Ceilings
Quality Assurance
Secret Price Discounts
Price Discrimination
Bundling
A prime example was the renting of movies to theaters. High-quality and low-
quality films were bundled together. This was the example used in the seminal
work by George Stigler.
Maximum Price per Film Bundled Price
Theater The Chronicles of Narnia Treasure Planet
Regal $800 $250 $1050
AMC $700 $300 $1000
If the seller, Disney, could discriminate perfectly, it would charge each theater its
reservation price for each film.
TR = $800 + $250 + $700 +300 = $2050
(Stigler argued that MC for a copy of a film is close to zero so revenue
maximization coincides with profit maximization.)
If, however, Disney cannot price discriminate it can charge only $700 for Narnia
and $250 for Treasure Planet for a total revenue = 2($700) + 2($250) = $1900.

With bundling, Disney can charge $1000 per bundle for a total revenue = $2000.
Simple bundling increases revenue (and profit) because there is a difference in
the relative valuations of the two goods. That is, the ranking of reservation price
by customer varies across the bundle components. Regal is willing to pay more for
Narnia but AMC is willing to pay more for Treasure Planet.
Mixed Bundling
Consider the following three consumers with reservation prices for a Burger King
burger and fries
Burger Fries
Consumer X $1.75 $1.75
Consumer Y $2.50 $1.75
Consumer Z $3.00 $0.50
So what if the price of a burger = $2.00 and the price of the fries = $2.00?
Consumer X will buy nothing. Consumers Y and Z will each buy only a burger.
But what if the two products are bundled into a combo meal at a price of $3.50?
All three consumers are now purchasing the combo with both burgers and fries.
Now, what if consumers are able to purchase the bundled combo at $3.50 or fries
or a burger individually at $2.00 each? To maximize consumer surplus, consumers
X and Y purchase the bundle. But consumer Z purchases only the burger.
Consumer Z receives $1 in consumer surplus compared with no consumer surplus
from the combo. Consumer X receives no consumer surplus and consumer Y
receives $.75 (which is higher than the $0.50 that he would get from the burger
alone.)
Profitability with/without bundling or mixed bundling:
Without costs, the impact of bundling on social welfare cannot be determined.

Another Burger King Example with Three Types of Consumers:

Reservation Prices
burger fries
Consumer A $0.50 $3.00
Consumer B $2.00 $1.50
Consumer C $3.00 $0.50
The average total cost of producing either a burger or a serving of fries is constant
at $1.00.
Optimal Individual Prices: $2 for a burger, $3 for fries. Profit = TR-TC =$7 -$3 =$4
Consumer A purchases just fries, consumers B and C purchase just burgers
Pure Bundling: Combo Price = $3.50 Profit = $10.50 -$6 = $4.50
All three consumers purchase the bundle.
Mixed Bundling: Combo Price =$3.50, Price of a burger or order of fries = $2.99.
Consumer A will purchase only fries; Consumer B will purchase the combo,
Consumer C would purchase only a burger. Profit = $9.48 - $4.00 = $5.48.
Not only profit but social welfare improves with mixed bundling over pure
bundling. Why? With pure bundling, consumers are purchasing items with values
below production costs. This would be true of A’s burger and C’s fries.
Perhaps the most common form of tie-in is a requirement tie-in in which a
customer purchases (or leases) one good on condition that they make all
purchases of a second good from the same manufacturer. (Xerox and copy
paper).
With requirement tie-ins, the seller must be able to prevent the purchase of the
tied good from a cheaper source. If the tied product is sold by a monopoly then a
requirement tie-in may automatically occur.

Example:
Suppose a firm produces a machine that sews on buttons. The cost of sewing
them on by hand is a labor cost of $.01. A customer would be willing to pay up to
$.01 times the number of buttons attached because this is the savings over doing
it by hand. Suppose that the competitive price of buttons is $.05. If a tie-in
agreement is imposed with a button price of $.06, everyone should be willing to
agree to use the machine. Why is this price discrimination? A shirt producer that
attaches 1000 buttons per period is effectively paying 10 times as much for the
machine rental as a shirt producer that attaches only 100 buttons.
The Court’s View of Bundling and Tying:
A Landmark Case:
United States vs. United Shoe Machinery Corporation (USMC)
In the 1950’s United Shoe Machinery leased machinery. For some types of
machinery, they faced competition and for others they had substantial market
power. Their lease agreements required that the full line of machinery be used.
By tying the machines that faced competition to those for which it had market
power, it effectively foreclosed the market to competitors and extended its
monopoly power. At one point their market share exceeded 80%. USMC was
found guilty.

Brown Shoe vs. the FTC (1964)

Brown Shoe manufactured shoes and sold them through ‘franchised’ shoe stores.
Brown required that the shoe stores focus on the sale of Brown products with a
strict limit on the sale of competing manufacturers’ shoes. It was argued that
Brown shoes were tied to the sale of the shoe store franchises and effectively
foreclosed the retail market to competing manufacturers. Brown was issued a
cease and desist order that was reversed on appeal on the grounds that Brown
lacked market power.

United States vs. Microsoft Corporation 1998

The charge was that Microsoft bundled its browser, Internet Explorer, in with its
Windows Operating system in an attempt to extend its monopoly power into the
browser market. In so doing, it would adversely impact Netscape’s Navigator and
others. The Courts found that Microsoft had abused its market power in bundling
the two products.
 The Robinson Patman Act forbids tying arrangements that harm the competitive
process or competitors. In 1984, the Supreme Court attempted to articulate a
clear set of guidelines under which a tying arrangement would be per se illegal. It
stated three conditions, all of which would have to be met for a tie-in to violate
the anti-trust laws:
1. the existence of two distinct products, the tying product and the tied one.
2. the firm tying the products must have sufficient monopoly power in the tying
market to force the purchase of the tied good
3. the tying arrangement must foreclose, or have the potential to foreclose, a
substantial volume of trade.