This week in my ECONS101 class, we covered pricing strategy. One pricing strategy that many firms use is two-part pricing. A firm uses two-part pricing when it splits the price into two parts (there is no mystery in why it is called two-part pricing!): (1) an up-front fee for the right to purchase; and (2) a price per unit. If the consumer wants to buy any of the product, they must first pay the up-front fee. We can think about two-part pricing first by contrasting it with a profit-maximising firm with market power that is pricing at a single price-per-unit, as in the diagram below (for simplicity, I'll use a constant-cost firm).
The firm with market power selling at a single price-per-unit selects the price that maximises profits. This occurs where marginal revenue is equal to marginal cost, i.e. at the quantity QM. To sell that quantity, they set the price at PM. The producer surplus (profit) the firm earns is the rectangular area CBDF.
However, if the firm switches to two-part pricing, then they can charge an up-front fee for consumers to access the market. The maximum that consumers are willing to pay to access the market will be equal to their consumer surplus (the difference between what the consumer is willing to pay, and the price that they actually pay). The consumer surplus is the consumer's economic rent - it is the surplus they receive from having the opportunity to buy the good or service. So, the maximum that the firm could charge as an up-front fee is the amount of consumer surplus. With the price set at P0, this is the area ABC, in which case profits (combining the original producer surplus plus the up-front fee) would now be the combined area ABDF.
The firm can do even better than that. Profitability is all about creating and capturing value. So, if the firm can create more value (by increasing the consumer surplus), they can capture more profit (by increasing the size of the up-front fee). So, by lowering the price to PS, the consumers would be willing to buy the quantity QS, and would receive consumer surplus equal to the area AEF. By setting the up-front fee equal to AEF and the per-unit price at PS, the firm then increases their profit to be all of the area AEF.
That brings me to my example, Costco, which will shortly open in New Zealand. As this article in The Conversation last week by Megan Phillips (AUT) notes:
Multiple delays and a NZ$60 entry cost have done little to quench enthusiasm for New Zealand’s first Costco, with New Zealanders lining up for more than 90 minutes recently for a chance to buy a membership to the store.
A members-only warehouse retailer, the store will sell a wide range of products including food and grocery items, clothing, electronics, furniture and more. Commentators and people familiar with the brand have claimed the store will disrupt the duopoly that currently dominates New Zealand’s grocery sector.
But to enter the warehouse you must pay a membership fee, set at $60 a year or $55 if you own a business.
Clearly, Costco is employing a two-part pricing strategy here. Notice that the $60 membership fee doesn't entitle customers to anything other than the right to purchase other goods from Costco. The membership fee is the first part of the two-part price, with the second part being the price-per-unit that customers pay when they buy goods in the store.
Now, Costco is deviating a little bit from how we described two-part pricing above, and that is Costco's attempt to overcome one of the problems with two-part pricing. The problem is that two-part pricing only works when the firm has homogeneous demand for their product (to see why, read this earlier post which explains the problem in detail). This means that all consumers have roughly the same demand for the product. This is unlikely to be the case for Costco, because they sell an enormous range of products, and their consumers likely have very different preferences from each other. When demand is heterogeneous (consumers have very different demands or preferences), then two-part pricing tends to encourage low-demand consumers to stop buying (because they don't want to pay the membership fee when they don't buy very much at all), while high-demand consumers buy more but end up spending less in total (because of the lower second part of the price, as per our earlier diagram).
However, Costco has found a way for two-part pricing to work even with heterogeneous demand. Notice that the membership fee is only $60 per year. Consumers will baulk at the membership fee only if their consumer surplus is likely to be less than $60 per year. This is unlikely to be the case for many. This is quite different from the diagram we drew earlier, where the firm increases profits by driving up the size of the up-front fee as much as possible.
So, why have a membership fee at all, if it is set so low? There are a number of reasons why Costco might implement the membership fee. First, it gives Costco customers a feeling of exclusivity. It makes them feel like they are part of a special club. As Phillips notes in that article in The Conversation:
That said, Costco has a massive following. One fanatic even tattooed the Costco’s private label brand (Kirkland Signature) on himself, and other loyal shoppers have proposed or even tied the knot in the warehouse.
The adoration seems to be building in New Zealand with 70,000 followers on a local fan page.
A loyal customer base is quite valuable and profitable for firms. Loyal customers have more inelastic demand for products, allowing prices to be slightly higher. However, Costco maintains its low prices in spite of the opportunity, because its reputation as a low cost store is important for maintaining customer loyalty.
Second, because it requires a membership to buy products from Costco, Costco knows who all of its customers are. It knows what they bought, and when, and how much they were willing to pay (or, more accurately, it knows they were probably willing to pay a bit more than they actually did pay). And Costco knows what their customers didn't buy as well, especially for products prominently on sale.
All of this customer purchase (and non-purchase) data is valuable for developing future pricing strategy. It's the main reason why supermarkets have loyalty cards (it's not out of the goodness of their hearts). And retailers have barely scratched the surface in terms of what is possible with their customer data. As I discussed in my ECONS101 class today, it may not be too long before retailers remove price stickers from their products and from the shelves, and ask customers to scan a QR code or use an in-store app to find the price. When that happens, you will know that the retailer has adopted personalised pricing (first-degree price discrimination). Costco isn't there yet either, but give it time.
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