Time Warner HowTo: extract Consumer Surplus

Consumer and Producer Surplus are one of the truly great, arbitrary fantasies of Economics. Short version: Consumer Surplus is acheived (by the consumer) when the market price of a good is less than the willingness-to-pay for that good. So (from one of my slides), imagine the purchasing of coffee:

Consumer surplus

Similarly for Producer Surplus. At each quantity sold, Producer Surplus is the difference between the market price and the Marginal Cost of production (the minimum price that the producer would have been willing to accept):

Producer Surplus

So here’s the first logical implication: Consumers and Producers would dearly like the market price to be lower and higher, respectively, because they want to get more of their own Surplus (at the cost of the other’s Surplus). Yeah?

So, given the opportunity, how would Producers pull this off? Well, look at the Consumers. See how the first Consumer (let’s assume there are 5 Consumers; you can also assume there is 1 person purchasing 5 cups of coffee) has a higher Marginal Benefit and Willingness-to-Pay than the second? And the second Consumer has a higher Marginal Benefit than the third, and so on? At the market pice of $2, the Producer is selling 5 cups of coffee, but Consumers 1 through 4 are getting positive Consumer Surplus.

How can the Producer get their hands on the Consumer Surplus? Well, suppose they could identify each Consumer, according to their Willingness-to-Pay, and charge 5 different prices. Bingo! The Producer could charge exactly each Consumer’s Willingness-to-Pay, and all the Consumer Surplus would be ‘extracted’ by the Producer – who would get all the Surplus.

And that’s the goal: find a market in which you can discriminate amongst Consumers, and get them to pay different prices. Good example: hardcover books vs. paperback. Get the impatient Consumers to pay a higher price for the earlier product (slightly differentiated) and extract some Consumer Surplus.

Here’s today’s example: Time Warner.

Time Warner Cable said it will experiment with a new pricing structure for high-speed Internet access later this year, charging customers based on how much data they download.

The company, the second-largest cable provider in the U.S., will start a trial in Beaumont, Texas, in which it will sell new Internet customers tiered levels of service based on how much data they download per month, rather than the usual fixed-price packages with unlimited downloads.

But, you say, this is wrong: Time Warner is talking about charging higher prices, as it moves out along the demand curve. Here’s the thing: they will charge Consumers a fee-for-set-of-products (like buying razor blades in packs of 4 or 8). Meaning that the low-users will pay a lower fee for their package than the high users, but the low users will pay a higher fee-per-megabyte than the high users.

Why? Because they have a higher Willingness-to-Pay. Consumers are only willing to consume more at a lower price-per-unit (this is Declining Marginal Benefit). Time Warner is moving away from a situation of charging $2 to sell all 5 cups of coffee (i.e. a price-per-month for all users, up to and including the high users) to one in which it can segregate users, such that it only needs to offer the low price-per-unit to the high users (with the lower Willingness-to-Pay-per-unit). The lower users have a higher Willingness-to-Pay-per-unit and will get a higher price-per-unit as a result.

And, at the very end, Time Warner will get its hands on some of the Consumer Surplus. It hopes. It all depends upon the reaction of the Consumer. When it comes to things like razor blades, we go along with this idea (the point of the 4-pack is that you’re paying a higher price for the 1st, then the 2nd, 3rd and 4th blade – but you just don’t realise it when you pay a since cumulative price for the box – neat trick, eh?). Sometimes, though, we don’t – and the internet is absolutely an area in which our sense of entitlement really kicks in.

If Time Warner gets greedy (sells too-low a download package, with heavy over-use penalty-rates, to try to ‘trick’ low users into incurring higher costs) it will certainly backfire. If they do it in a straightforward manner, though, there’s no reason why it shouldn’t work.

Now, readers: if you had the technological know-how, how might you engage in arbitrage? Given that Time Warner will segregate the markets, in order to charge a higher price in one than the other, can you think of the way to get between them and make some money?

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1 comment so far

  1. Jimmy Hat on

    How does the above chit chat justify the statement “Consumer and Producer Surplus are one of the truly great, arbitrary fantasies of Economics”. I read on with an open mind but encountered a total absence of evidence…


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