Question

Many retail video stores offer two alternative plans for renting films: \(\bullet\) A two-part tariff: Pay an annual membership fee (e.g., \(\$ 40\) ) and then pay a small fee for the daily rental of each film (e.g., \(\$ 2\) per film per day). \(\bullet\) A straight rental fee: Pay no membership fee, but pay a higher daily rental fee (e.g., \$4 per film per day What is the logic behind the two-part tariff in this case? Why offer the customer a choice of two plans rather than simply a two-part tariff?

Short answer

The two-part tariff pricing strategy capitalizes on frequent users by charging a membership and a smaller per-unit fee. Meanwhile, the straight rental fee caters to less frequent users who would prefer to avoid a membership fee. Offering both plans allows the video rental store to cater to customers with different consuming patterns and maximize its revenue.

Step-by-step solution

Understanding Two-Part Tariff

A two-part tariff is a pricing strategy where the price of a product or service is composed of two parts - a lump-sum fee as well as a per-unit charge. In the given example, the annual membership fee (\$40) is the lump-sum fee and the small fee for the daily rental of each film (\$2 per film per day) is the per-unit charge. This tariff thus directly relates to the consumption and rewards frequent users.

Understanding Straight Rental Fee

The straight rental fee doesn’t require any membership fee but requires a higher daily rental fee, \$4 per film per day. This tariff is more flexible and ideal for casual users who do not consume frequently enough to justify the membership fee.

Logic Behind Two-Part Tariff and the Choice

The logic behind the two-part tariff is to gain revenue from both high-demand consumers (who rent frequently and are willing to pay the membership fee for a lower per-unit cost) and low-demand consumers (who do not rent as frequently and hence prefer to avoid the membership fee but pay a higher daily rental fee). Offering a choice of plans rather than just a two-part tariff allows the store to cater to a wider range of consumers with varying consumption patterns, thereby maximizing its total revenue.

Key concepts

Microeconomics and Two-Part Tariff

Microeconomics, the branch of economics dealing with the behavior of individuals and firms in making decisions regarding the allocation of scarce resources, provides the foundational concepts for analyzing pricing strategies such as the two-part tariff. It examines how these parties interact within the market to influence the supply and demand for goods and services.

Within the microeconomic framework, a two-part tariff is an ingenious way to segment the market based on consumer usage patterns. Stores offering two-part tariffs are engaging in price discrimination, which is a way to charge different prices to different customers for essentially the same good. In the example given, customers with a high demand for movie rentals may opt for the annual membership to minimize their total costs, while low-demand customers might choose to pay per rental.

This segmentation allows the business to capture more consumer surplus, which is the difference between what consumers are willing to pay and what they actually pay. The membership fee serves as a way to ensure a base level of revenue from frequent renters, while occasional renters contribute through higher per-unit costs.

Pricing Strategies

Pricing strategies are central to a company's profitability and can include a variety of approaches, such as cost-based pricing, competition-based pricing, and value-based pricing. The two-part tariff is a clever pricing strategy that can be likened to a form of value-based pricing where customers choose the payment plan that offers them the best perceived value for their specific needs.

In the context of the video store example, the two-part tariff maximizes the store's profits by offering two distinct options. Frequent renters might value the annual membership because it reduces their average cost per movie over time. Conversely, casual renters are more likely to prefer the straight rental fee without any commitment, accepting a higher cost per movie as a trade-off for flexibility.

The strategy employed here also leverages consumer's willingness to pay, a fundamental concept in microeconomics. By providing different payment options, the video store ensures it is not excluding any potential customer based on their consumption patterns, thus optimizing its reach within the market.

Consumer Choice Theory

Consumer choice theory explores how consumers make decisions to spend their money based on preferences for certain goods and services, often facing trade-offs due to budget constraints. When presented with a two-part tariff, consumers will assess their usage patterns and evaluate which option gives them the most utility, or satisfaction, for their money.

In applying consumer choice theory to the two-part tariff, individuals are rational decision-makers who aim to maximize their utility. They will weigh the initial membership fee against their expected number of rentals. If the sum of the membership fee and the total rental fees (at the member price) is less than what they would pay under the straight rental fee option, they are likely to choose the two-part tariff.

By offering a choice, the video store acknowledges that different consumers have different utility curves and budget constraints. The goal with such a strategy is to create a win-win situation where the store increases its revenue while consumers feel they have made a choice that maximizes their individual preferences and constraints.