HowTo: Two-part tariffs
Proof that my students are on the ball! One of them, at least. After I gave them the Gillette 4-pack of razor blades as a pop-quiz, he discovered, and forwarded, this story:
We’ve been here before.
- Is Gillette charging $5 for the 5th razor blade? No;
- Is Reader Jordan making a rational decision, abandoning Gillette for Schick based upon this $5? No (caveat: I am aware that he may be giving the matter proper thought).
So – what’s going on, here? Two-part tariffs. Price discrimination. When Gillette charges $8.99 for a 4-pack of razor blades, are they charging you $2.25 per blade? No. Why?
Marginal utility declines, as we consume more. We get more Marginal Benefit from the first razor blade than from the second razor blade – and less from the third than the second. This is the reason why demand curves are downward-sloping, yeah? So. Ordinarily, if Gillette wanted you to buy 4 razor blades, it would need to figure out your willingness to pay at the 4th razor blade, and make that the market price – let’s call it P* = $2:
What a waste! Consumers are getting all that Consumer Surplus by paying less than our Marginal Benefit for blades 1, 2 and 3:
Now. Let’s suppose that Gillette somehow figured out a way to force us to purchase razor blades in whatever manner it chose to sell them. Say, by…making us first purchase a handle, on which only Gillette razor blades would fit. There’s your two-part tariff. “Razors” are sold in two parts! Why? Well, now Gillette can force you to purchase razor blades 4 at a time. So what is $8.99, then? Why, it is the sum of each Willingness-to-Pay, taken straight from our demand curve:
(the numbers aren’t a perfect match).
The result? No more Consumer Surplus! Perfect price discrimination. Disney, by the by, does the same thing. You pay to enter Disney World, then you pay to ride – and Disney takes all your Consumer Surplus in the process.
Back, then, to the Consumerist. Is Gillette charging $5 for the 5th razor blade? No That’d be ridiculous. What they are doing, however, is marking up the price of each of the 5 blades, taking advantage of the fact that we already have the handle.
Now, Reader Jordan. Is he acting rationally, by switching? Possibly. There’s no guarantee that his Willingness(es)-to-Pay are sufficient to pay $14 for 5 blades. And he may be considering the opportunity cost of switching, correctly – meaning he’s figured the cost also of purchasing a new handle, and buying his way into a new razor market. His switch could be optimal.
True, he’ll be pissed if he does all that and then discover Schick follows Gillette’s example. But you pay your money and you take your ride, I guess…
Thank you Nick! You better earn an A in Friday’s Mid-Term. I won’t give you one for free, but I hope to see you earn one.