A multiple-service firm that has economies of scale or scope cannot recover all of its costs if it prices its services at exactly their respective TSLRICs. In order to recover its legitimate total costs, a multiple-service operators must mark up its prices above TSLRIC. If the mark-ups are done right, the contributions from each service should enable the operator to fully recover its shared and common costs.
Although operators need to mark up prices above TSLRIC in order to recover their costs, such mark-ups can reduce social welfare below its theoretical maximum. Mark-ups must be set with care, to minimize this distortion. This is known as second-best optimality. Two approaches for second-best optimal pricing are value of service pricing and non-linear tariffs.
Value of Service Pricing
Value of service pricing (or “Ramsey pricing”) determines the appropriate level of contribution on a service-by-service basis, reflecting the demand characteristics of each service.
In its simplest form, value of service pricing sets the mark-up for each service as follows:
The percentage contribution of the service is set in inverse proportion to the own-price elasticity of demand for the service.
Own-price elasticity of demand measures how sensitive the demand for a service is to its price. Own-price elasticity of demand is the percent change in the quantity of the service demanded, for each percent change in the price. For example, an own-price elasticity of -3 indicates that if price were to rise by 10 percent, demand would fall by 30 percent. The negative sign signifies that demand moves in the opposite direction to price.
Thus, under a simple value of service pricing rule, if a service has an own-price elasticity of -3, the price for that service should be marked up by 33%. If a service has an elasticity of -1, the appropriate mark-up is 100%.
As the above example illustrates, under value of service pricing services with high own-price elasticities, for which demand responds strongly to changes in price, will have small percentage mark-ups. Services with low own-price elasticities will have large percentage mark-ups. In this way, value of service pricing seeks to minimize the effect on demand (and overall social welfare) from price mark-ups.
The main limitations of value of service pricing are:
- It may not be possible to reliably estimate price elasticities for the services in question, and
- Some commentators view this pricing method as unfair. This is because, under value of service pricing, “captive” customers who are dependent on a service pay the highest mark-up. For example, under this approach basic telephone services in rural areas, where customers have no other service option, would have a high mark-up. Similarly, this approach would allocate a high proportion of shared and common costs to “bottleneck” inputs.
Non-Linear Tariffs
Non-linear or multi-part tariff pricing is an extension of value of service pricing, that seeks to allow market forces themselves to determine the level each service contributes to shared and common costs.
The simplest form of nonlinear pricing is two-part pricing. Under two-part pricing, prices are made up of two components: a price for access to the service and a price for usage. (For example this might comprise a monthly rental charge and a price per minute for usage.)
Consumers are offered a choice of pricing plans, each with a different combination of access and usage charges. For example, the operator might offer two plans for a service:
- A package with an access fee and unlimited usage at zero price,
- An alternative package with lower access fee, and a per-unit charge for usage.
The idea of two-part pricing is that consumers will reveal the value they place on the service through their choice of plan. If enough different plans are offered, actual customer choices will provide sufficient demand information for the firm to price optimally.
Two- or multi-part tariffs can be designed to appeal to very diverse consumers in ways that a single, uniform price never can. In the above example, the high access fee/unlimited usage plan may appeal more to the high-volume consumer, while the low access fee/metered usage plan may appeal to the low-volume consumer. In contrast, a single price may prove too high for at least some segment of consumers and exclude them from the market.
Thus, two-part pricing can improve social welfare by broadening the appeal of a service to more consumers and encouraging greater market participation.