A two-part tariff is a price discrimination technique that consists in charging consumers with a lump sum fee for the right to purchase the product and then a price per unit consumed. This practice is specially used in places such as golf clubs and amusement parks.

The firm must set the enrolment fee and the price per-unit of the product that maximises its profit. To maximise the amount of product purchased by consumers the firm must set a price that is equal to the marginal cost. Subsequently, the firm will appropriate consumer surplus by setting a fixed fee, A. The first tariff would be the entrance fee, A, which allows the monopoly to extract all consumer surplus.  The second tariff is the price per unit, p*q, being this price equal to marginal cost, which means that there is no surplus, since the surplus cannot be extracted twice.

As it can be seen in the figure below, which shows two different demand curves for two types of consumers who have different willingness to pay, there are different ways to implement a two-part tariff. Monopolies can charge different entrance fee for each consumer according to their willingness to pay, extracting all the consumer surplus (grey area). However, since this is quite the same as first-degree price discrimination, it is hard to implement. When monopolies are unable to distinguish between different types of consumers, they can charge an entrance fee high enough so only the more exclusive, more willing to pay consumers get the product (green). The monopoly will extract all the consumer surplus of the first type of consumer, but won’t sell at all to the second type. Finally, the monopoly can charge the same entrance fee to both types, but that entrance fee will be that of the less willing consumer, A₂, charging the same to the other consumer, A₁ (blue). As it can be seen, in this case the monopoly will be able to extract more total consumer surplus by increasing prices from p to p’: it will extract less from the second type of consumer (area -) but will extract even more from the first type of consumer (area +).

Third-degree price discrimination, also referred to as market segmentation of price discrimination, consists of varying prices depending on what segment of the market the consumer belongs to. Each consumer will be charged with a different price, but it will remain constant whatever the amount bought. This degree of discrimination is the most commonly used by firms and it includes examples such as students or third age discounts.

As shown in the figure above, the firm will disaggregate the global demand, and it will charge each market segment the price that will maximise its profit. Higher prices will be charged to those segments where the elasticity of demand is lower. In this case, we have

Second-degree price discrimination, or nonlinear pricing, involves setting prices subject to the amount bought, in an attempt to capture part of the consumer surplus. Revenues collected by the firm in this matter will be a nonlinear function.  A bulk sale strategy, such as quantity discounts, will be applied and consumers will choose the block that better suits them.

Consider the adjacent figure: a monopoly will be able to implement this type of  price discrimination to a certain consumer by offering discounts for buying a higher quantity. Note that d corresponds to the consumer’s demand curve, not the market’s. By offering a lower price, p2, for quantity q2, the monopoly is able to extract part of the consumer surplus. This price discrimination works similarly to a two-part tariffs. However, in this case, the monopoly won’t charge an entrance fee, but will hide this entrance fee into part of the discounted price offered to the consumer.

First-degree price discrimination, or perfect discrimination, is the highest level of price discrimination, in which each unit of production is sold at the maximum price that the consumer is willing to pay for that specific unit. The firm will gain the entire market surplus it could possibly achieve, as it will sell all the units for the maximum price at which they could be sold.

This degree of price discrimination will always have as a result a Pareto efficient level of output as marginal willingness to pay will be equal to marginal cost. For this reason and even though monopolies are associated with this strategy, the production level of output will be the same as in a competitive market, and hence, the inefficiency associated to monopolies will be eliminated. As seen in the adjacent figure, the producer surplus equals total surplus (A+B). There is not deadweight loss, even though there is not consumer surplus (A, which was extracted by the monopoly), and at the end both quantity and price are equal to those that would result from perfect competition.

First-degree price discrimination is, however, quite unrealistic. On the one hand, income elasticity of demand should be equal to zero in order for perfect discrimination to work. On the other hand, there should be imperfect information in the market, since consumers knowing that the price would drop if they showed lower willingness to buy would make them show it, thus making impossible for the monopoly to practice first-degree price discrimination. Knowing the distribution of consumers’ preferences is almost impossible to determine and it is certainly expensive to research. Therefore, in real life, the closest thing there is to perfect discrimination is bargaining reductions in prices (known as second-degree price discrimination) or offering a two-part tariff.

Price discrimination, also referred to as price differentiation, occurs when a firm sells the same product at different prices, either to the same or different consumers. The study of this strategy comes naturally when dealing with monopolies as these seek to sell additional output to consumers without lowering the price of the units that are already being sold so as to maximise their profits.  Good examples of price discrimination are transportation or storage costs. To optimise price discrimination, firms will have to control and prevent reselling, and they will also have to sort consumers depending on their willingness to pay. The former does not generally imply complications, but sorting consumers is a more complex process.

Arthur C. Pigou made a distinction between different levels of price discrimination in his book “The Economics of Welfare”, 1920. The first degree or perfect discrimination is given when the monopolist charges each unit with a price that is equal to the consumer’s maximum willingness to pay for that unit. The second degree or nonlinear price fixing is given when price depends on the amount bought by the consumer as in quantity discounts. Finally, the third degree or market segmentation of price discrimination occurs when there are several differentiated market segments to which the firm will apply different prices, e.g. student or third age discounts.