Two part tariff is a form of pricing in which consumers are charged both an entry fee and a usage fee. It is a type of price discrimination and provides another means of extracting consumer surplus. It requires consumers to pay an upfront fee for the right to buy a product or avail a service. Consumers then pay an additional fee for each unit of the product they wish to consume.
The classic example of this strategy can be seen in amusement parks where an individual requires to pay an admission fee to enter and also need to pay a certain amount for each ride. The owner of the park must decide whether to charge a high entrance fee and a low price for the rides or alternatively to let people enter for free but charge high prices for the rides. Most telephone service is priced using a two part tariff – where they charge a monthly access fee which sometimes include some free minutes plus a per minute charge for additional minutes.
How It Works
- High-Usage Consumers pay the fixed fee and consume more, making the average cost per unit lower.
- Low-Usage Consumers may be discouraged by the fixed fee, but the firm still profits from their entry payment.
Example:
- Amazon Prime charges an annual fee (fixed) but offers free shipping (variable benefit).
- Mobile Plans often have a monthly fee + per-minute/data charges.
Why Firms Use Two-Part Tariffs
- Extracts More Profit – Captures both high- and low-demand consumers.
- Encourages Usage – Once the fixed fee is paid, consumers are incentivized to use the service more.
- Price Discrimination – Different consumer types pay different average prices.
Comparison with Other Price Discrimination Types
| Type | Definition | Example |
|---|---|---|
| First-Degree (Perfect PD) | Each consumer pays their max willingness-to-pay. | Auctions, personalized pricing. |
| Second-Degree (Usage-Based PD) | Prices vary by quantity/usage (two-part tariffs, bulk discounts). | Electricity pricing, subscription models. |
| Third-Degree (Group-Based PD) | Different prices for different segments (students, seniors). | Movie ticket discounts. |
Now let’s try to understand this concept further with two cases –
Case 1 : Two Part Tariff with a single consumer
Suppose there is only one costumer in the market or many consumers with identical demand curves. Suppose the firm knows this consumer’s demand curve. Now, since the firm wants to capture as much consumer surplus as possible it sets the usage fee ‘P’ equals to Marginal Cost and the entry fee ‘T’ equals to the total consumer surplus for each consumer. Thus, the consumer pays T* (or a bit less) to use the product and P* (which is basically equal to the marginal cost of production) for per unit consumption of the product. This way the firm is able to capture all the consumer surplus as its profit.
Case 2 : Two Part Tariff with two consumers
Now suppose that there are two different consumers (or two groups of identical consumers). The firm can set only one entry fee and one usage fee. Therefore, it would no longer want to set the usage fee equal to Marginal cost. If it did, it could make the entry fee no larger than the consumer surplus of the consumer with the smaller demand and this would not yield a maximum profit. Instead the firm should set the usage fee above marginal cost and then set the entry fee equal to the remaining consumer surplus of the consumer with smaller demand. In the diagram, with the optimal usage fee at P* which is greater than the marginal cost, the firm’s profit is 2T* + (P* -MC)*(Q1 + Q2).
Most firms, however, face a variety of consumers with different demand curves. Unfortunately, there is no simple formula to calculate the optimal two part tariff.
Conclusion
Two-part tariffs offer firms a powerful pricing strategy to maximize profits by capturing consumer surplus through a combination of fixed and variable charges. Whether applied in amusement parks, mobile plans, or subscription-based models, this approach balances access and usage fees to serve both high- and low-demand consumers. While setting the optimal tariff is relatively straightforward for a single known consumer, it becomes more complex with diverse consumer preferences. In practice, firms must make careful trade-offs between maximizing usage and maintaining profitability across different consumer types. Ultimately, two-part tariffs exemplify how pricing strategies can be fine-tuned to align firm incentives with consumer behavior, making them a central tool in modern pricing economics.