Question

Question 1.a. Applying appropriate microeconomic theory, proceed as follows:
(a) Introduce assumptions for a two-tariff model.
(b) Explain the rationale for setting the optimal tariff and price per unit.
(c) Discuss the economic efficiency of this pricing method, and the impact on consumers and suppliers.
(d) Provide a hypothetical real-world example, explaining how this pricing approach may be advantageous for a company.

Answer 1

(a) Assumptions for a two-tariff model:

A two-part tariff is a type of price discrimination policy taken by a monopolist. The price of the good or service is divided into two parts, such as lump sum charge and a per unit fee. Assumptions for this model:

· Consumers are identical, that is demand is homogeneous

· Goods or services offered by the firm are identical to all consumers

· Supplier should have a market power

(b) Rationale for setting the optimal tariff and price per unit:

The rationale is to extract more consumer surplus by using a two-part tariff having a fixed fee and a price per-unit of a product purchased by the consumers.

By extracting consumer surplus, the monopolist can increase the profit level through this pricing policy. In figure, the shaded area T* is the lump sum fees that a consumer has to pay to use the service or to buy the product and P* is the price that has to be paid as additional fees for each unit the consumer wish to consume.

(c) Economic efficiency of this pricing method

If the firm is perfectly competitive, the equilibrium price should be at the point where the marginal cost curve cuts the demand curve. This is the point of allocative efficiency. However, at Q1 level of output, the monopolist charges price p* and produces below allocative efficiency. Firm earns positive profit represented by the area P*AHF. The area of the triangle FHG is the deadweight loss arises due to not producing at point G. Economic efficiency is reduced due to two – part tariff policy.

(d) In real world, an example of two- part tariff policy is

Amusement parks, which charges an entry fees and later the consumers have to pay per unit fee for each ride.

Therefore, even if the consumer does not use any ride, the company earns positive profit. This is possible, if no such amusement park is there in the locality so that an willing consumer who wish to visit an amusement park has no other option.