Price Skimming

Definition
•A pricing technique designed to allow a business to charge each potential customer the most that he or she would be willing pay for a given product or service. The product or service is first offered at the highest price that customers will pay, and the price is incrementally dropped until it reaches a level designed to be viable for the long term

•Price skimming is a business technique which involves charging a high price for a product when it is released initially, and gradually lowering the price over time. The goal of this practice is to ensure that the price matches consumer willingness to pay, generating profits for the company both over time and in the short term. The “skimming” is a reference to a stage in milk processing in which the cream is repeatedly skimmed from the top, yielding milk with a steadily lower butterfat content, much as price skimming creates a steadily cheaper product.
There are a number of reasons for companies to utilize price skimming, beyond the simple desire for profits. One of the most basic motivations is the desire to recoup the investment involved in product development before competitors hit the market and make high prices unsustainable. For example, if a company develops a totally new and innovative product, it may spend a great deal of money in the process of designing and marketing the product, and it wants to recover this money quickly to make the product profitable.

Another reason involves consumer psychology. Many people attach certain values to high priced products, including luxury, exclusivity, and quality. By releasing a product with a high price, the manufacturer sends a message to prestige-conscious consumers, ensuring that they will flock to buy their product. Even as the price drops, people will continue to associate these values with the product, creating a steady demand for it.
Price skimming relies heavily on early adopters who are willing to pay a high price to be the first to have a new product. As the product spreads among these early adopters, the producer can slowly lower the price as people become less willing to pay top dollar for the product. Ideally, the producer will remain competitive with the inevitable rival products released by other companies. Supply and demand for the product will also remain stable over time.

Manipulation of pricing is a delicate business, because a company must be able to balance evidence about consumer psychology and the direction of the market when they set a price for a new product. Companies must also comply with laws which generally restrict price manipulation for reason of consumer protection. However, many nations recognize that companies have a right to attempt to recoup investments, and therefore price skimming may be tolerated as a legitimate business practice.

Limitations of Price Skimming

There are several potential problems with this strategy.
•It is effective only when the firm is facing an inelastic demand curve. If the long run demand schedule is elastic (as in the diagram to the right), market equilibrium will be achieved by quantity changes rather than price changes. Penetration pricing is a more suitable strategy in this case. Price changes by any one firm will be matched by other firms resulting in a rapid growth in industry volume. Dominant market share will typically be obtained by a low cost producer that pursues a penetration strategy.
•A price skimmer must be careful with the law. Price discrimination is illegal in many jurisdictions, but yield management is not. Price skimming can be considered either a form of price discrimination or a form of yield management. Price discrimination uses market characteristics (such as price elasticity) to adjust prices, whereas yield management uses product characteristics. Marketers see this legal distinction as quaint since in almost all cases market characteristics correlate highly with product characteristics. If using a skimming strategy, a marketer must speak and think in terms of product characteristics in order to stay on the right side of the law.
•The inventory turn rate can be very low for skimmed products. This could cause problems for the manufacturer's distribution chain. It may be necessary to give retailers higher margins to convince them to enthusiastically handle the product.
•Skimming encourages the entry of competitors. When other firms see the high margins available in the industry, they will quickly enter.
•Skimming results in a slow rate of stuff diffusion and adaptation. This results in a high level of untapped demand. This gives competitors time to either imitate the product or leap frog it with a new innovation. If competitors do this, the window of opportunity will have been lost.
•The manufacturer could develop negative publicity if they lower the price too fast and without significant product changes. Some early purchasers will feel they have been ripped-off. They will feel it would have been better to wait and purchase the product at a much lower price. This negative sentiment will be transferred to the brand and the company as a whole.
•High margins may make the firm inefficient. There will be less incentive to keep costs under control. Inefficient practices will become established making it difficult to compete on value or price.

Two- Part Tariffs

Definition of Two-Part Tariffs

A Two-Part Tariff is a pricing technique in which the price of a product or service is composed of two parts. Examples of two-part tariffs include:
1."membership discount retailers" such as shopping clubs that charge an annual fee for admission to the point of sale and also charge for your purchases
2.amusement parks where there are admission fees and also per-ride fees
3.cover charge for bars combined with per drink fees
4.credit cards which charge an annual fee plus a per-transaction fee
5.loyalty cards or clubs

The Economics of Two Part Tariffs

Economists view two part tariffs as a means to the end of price discrimination in partially or fully monopolistic markets. The way it works is the producer charges the consumer surplus as a 'cover charge' and then has a per unit charge that is the marginal cost of the unit.
For example, imagine a restaurant that can produce spaghetti for a marginal cost of $1 a plate. A customer comes in who is willing to pay $3 for the first plate, $2 for the second plate, $1 for the next plate and $0 for the fourth plate. If the restaurant charges $1 for a plate of spaghetti, then the customer will buy three plates of spaghetti for $3 and will get a consumer surplus of $3 (since they get a consumer surplus of $3-$1 = $2 for the first plate and $2-$1 = $1 for the second plate and $1-$1 = $0 for the third). If the restaurant charges $2 for a plate of spaghetti, then the customer will buy two plates at $2 for a consumer surplus of $1. The producer will get $2 of producer surplus (2*($2 - $1) or amount sold * (price - marginal cost)). That is the best the producer can do with a single price. However, if they can charge a two part tariff, then the restaurant can charge $3 to enter the restaurant and $1 per plate of spaghetti. The customer will pay the $3 to enter the restaurant (since they get $3 of consumer surplus from buying spaghetti at $1 a plate) and then buy three plates of spaghetti, for a net consumer surplus of $0. The restaurant gets $3 of producer surplus from the entrance fee, which is better than they can do with a single price.
In short, the way two-part tariff's work is the producer charges the consumer surplus as an entrance fee or cover charge, and then just charges the marginal cost for each unit of the good. This theoretically allows the producer to capture all of the consumer surplus.
In reality, the producer does not know the consumer's demand curve (a.k.a. their willingness to pay) and there is a transaction cost associated with collecting the money twice. Also, each consumer will have a different individual demand curve, so if there is just one cover charge or entrance fee, some of the customers will get some consumer surplus and some will decline to enter even though they would have been willing to pay some lesser entrance fee (since the entrance fee can be above their consumer surplus for getting the good at its marginal cost) so the producer cannot capture all of the consumer surplus.

A two-Part Tariff when Consumer Demand is Homogeneous

When consumers have homogeneous demand, any one consumer is representative of the market (the market being n identical consumers). For purposes of demonstration, consider just one consumer who interacts with one firm which experiences no fixed costs and constant costs per unit - hence the horizontal marginal cost (MC) line.
Recall that the demand curve represents our consumer’s maximum willingness to pay for any given output. Thus, as long as he receives an appropriate amount of goods, such as Qc, then he will be willing to pay his entire surplus (ABC) in addition to the cost per unit under perfect competition (Pc by Qc) - i.e. the entire area under the demand curve up to point Qc.
If the firm is perfectly competitive, it would charge price Pc and supply Qc to our consumer, making no economic profit but producing an allocatively efficient output. If the firm is a non-price discriminating monopolist, it would charge price Pm per unit and supply Qm, maximizing profit but producing below the allocatively efficient level of output Qc. This situation yields economic profit for the firm equal to the green area B, consumer surplus equal to the light blue area A, and a deadweight loss equal to the purple area C.
If the firm is a price discriminating monopolist, then it has the capacity to extract more resources from the consumer. It charges a lump sum fee, as well as a per unit cost. In order to sell the maximum number of units, the firm must charge the perfectly competitive price per unit, Pc, because this is the only price at which Qc units can be sold (note this is also the marginal cost per unit). To make up for the lower cost per unit, the firm then imposes a fee upon our consumer equal to her consumer surplus, ABC.
The lump-sum fee enables the firm to capture all the consumer surplus and deadweight loss areas, resulting in higher profit than a non-price discriminating monopolist could manage. The result is a firm which is in a sense allocatively efficient (price per unit is equal to marginal cost, but total price is not) - one of the redeeming qualities of price discrimination. If there are multiple consumers with homogeneous demand, then profit will equal n times the area ABC, where n is the number of consumers.

A two-part tariff when consumer demand is different
We now consider the case where there are two consumers, X and Y. Consumer Y's demand is exactly twice consumer X's demand, and each of these consumers is represented by a separate demand curve, and their combined demand (D market). The firm is the same as in the previous example. We assume that the firm cannot separately identify each consumer - it cannot therefore price discriminate against each of them individually.
The firm would like to follow the same logic as before and charge a per-unit price of Pc while imposing a lump-sum fee equal to area ABCD - the largest consumer surplus of the two consumers. In so doing, however, the firm will be pricing consumer X out of the market, because the lump-sum fee far exceeds his own consumer surplus of area AC.
Nevertheless, this would still yield profit equal ABCD. A solution to pricing consumer X out of the market is to thus charge a lump-sum fee equal to area AC, and continue to charge Pc per unit. Profit in this instance equals twice the area AC (two consumers): since consumer Y's demand is twice consumer X's, then 2 x AC = ABCD. As it turns out, the producer is indifferent to either of these pricing possibilities.
However, it is possible for the firm to earn even greater profits. Assume it sets the unit price equal to Pm, and imposes a lump-sum fee equal to area A. Both consumers again remain in the market, except now the firm is making a profit on each unit sold - total market profit from the sale of Qm units at price Pm is equal to area CDE. Profit from the lump-sum fee is 2 x A = AB. Total profit is therefore area ABCDE.
Thus, by charging a higher per unit price and a lower lump-sum fee, the firm has generated area E more profit than if it had charged a lower per-unit price and a higher lump-sum fee. Note that the firm is no longer producing the allocatively efficient output, and there is a deadweight loss experienced by society equal to area F - this is a result of the exercise of monopoly power.
Consumer X is left with no consumer surplus, while Consumer Y is left with area B.