How two-part pricing works

In the previous post we set out the basic idea behind price discrimination: your potential audience has different maximum prices they are willing to pay for what you have on offer (their “reservation prices”) and you want to find a way to get individuals to pay something close to their personal maximum, so long as it covers their marginal cost to you. Two-part pricing is a type of indirect price discrimination: everyone is offered the same deal when it comes to prices, and they choose options that reveal whether they have high or low reservation prices.

The two parts are given by something akin to an entry fee, and the prices for extras once entry has been gained. A museum sets prices for entry, and for a special exhibition. An orchestra charges for the ticket, and also for amenities once inside the concert hall. Cinemas charge for admission and for popcorn. Customers understand that they will be faced with two prices: they know there is a special exhibition, that drinks might be for sale in the concert hall, that cinemas charge a lot for popcorn. They make the decision on whether to attend and whether to plan on buying the extra based on the combination of prices.

Let’s consider two scenarios. In the first, you really don’t know much about how different customers feel about the “extras”. For example, at your museum you don’t know if it is the high reservation price customers who really want to see the special exhibit, or if it is the lower reservation price customers, who are coming to the museum principally because of that special exhibit. In this case you can’t really use two-part pricing to price discriminate, because you don’t know enough about your customers. The fallback position in this case is one we talked about in an earlier post: set the price for the extra (say, the special exhibit) at the marginal cost of that extra (the cost to you of letting one more customer in to the extra), and then set the entry fee according to what maximizes net revenue given the price you have charged for the extra.

But now let’s suppose you do know something. There are two possibilities: that it is the high reservation price customers – the ones willing to pay a lot to come to your venue – who highly value buying the extras, or that it is the low reservation price customers – the ones on the fence as to whether to come to your venue or not – who highly value the extras (while the high reservation price customers are happy with just the basic entry). Either is possible.

Suppose it is the high reservation price people who most like the extras – when they come they want to experience it all. The on-the-fence customers are just interested in the basic entry. Then you should adjust your two prices by (1) lowering the entry fee, and (2) raising the price of the extra. Why? The low reservation price customers are choosy on price, and they just want basic entry. So give them a good deal to get them in the door: have a low entry fee. But why give a low entry fee to the high reservation price people? Because they will spend on the extras: you will make your money off them there. This is exactly what cinemas do: they have found that the movie lovers, the people who want to go every weekend and are willing to pay a lot for the experience, are the ones who spend money at the concession stand. The occasional movie-goer does not tend to spend at the concession stand. So, go for low ticket prices and very high mark-up on popcorn and drinks. The Economist reports that Amazon is selling Kindles pretty much at cost of production. That suggests to me that Amazon reckons high reservation price customers are ones who will buy a lot of e-books, on-the-fence customers will not read so much. So, charge a low price for Kindles (this is like the entry fee) and a higher price for purchasing individual titles. You should be able to see why printers for home use seem to be available quite cheaply for what is, in fact, a fairly complicated piece of machinery, but ink cartridges are expensive. It also helps explain why wine has such a higher mark-up in restaurants than main courses (where the main course is the “entry fee”). To sum up: in this situation the low entry fee brings in the low reservation price customer, and you get more revenue from the high reservation price customer through what you charge for extras.

Now let’s consider the opposite situation. Suppose the customers who love to come to your venue, are willing to pay a high price for it, in fact are just interested in the basic entry, while the on-the-fence low reservation price customers are most interested in the extras. In this case, you adjust your prices by (1) raising the entry fee, and (2) lowering the price of extras. Those who love your place are fine paying the high entry fee. Those on the fence might not like the high entry fee, but are drawn in by the cheap extras. It explains why an amusement park would have high admission fees but free rides – the high fee captures revenue from those who love to go to the amusement park but actually have low interest in the rides themselves. The free rides are the draw to get the on-the-fence customers in the door.

So, high cover charge and cheap beer? Yes, if your on-the fence customer is your big beer drinker. No, if your love-your-venue customer is the big beer drinker – in that case go for low cover and expensive beer.