What Is a Two-Part Tariff, and Why Does Costco Charge an Annual Membership Fee?

• Under a two-part tariff, customers pay an “entry fee” and a price per unit consumed
• A two-part tariff is used by credit card companies, phone carriers, and wholesale clubs
• Deutsche Bahn used two-part pricing to make more people buy train tickets

Have you ever shopped at Costco, BJs, or Sam’s Club? If yes, you probably paid a fee to become a club member and accrued additional expenses throughout your membership for each product you purchased. Different organizations, such as credit card companies, amusement parks, and wholesale clubs, use two-part tariffs to capture more profits.

A two-part tariff is a form of price discrimination that assumes charging consumers a fixed fee for the right to purchase a product and a set price for each unit consumed. An example of a two-part tariff is StraighTalk’s basic phone plan, which costs $30/month and provides 100MB of data monthly. Whenever customers want to buy additional data, they can get it for $5 per 1GB. Likewise, consumers who want to shop at Costco must pay $60 in an annual fee and pay additionally for any products they wish to purchase at Costco.

As I discussed in one of my articles on price discrimination, companies segment customers by their willingness to pay and charge different prices to different customer groups. A two-part tariff allows companies to charge an entry fee and an additional price per unit, based on each customer’s consumption level. As a result, different consumers benefit from a product/service proportionally to what they pay.

How Does a Two-Part Tariff Affect Profits?

Take a look at the graph. This graph represents the price-setting under monopolistic competition, the most common type of competition (e.g., McDonald’s vs. Burger King).

If a company sets its price at the optimal level (p), then the benefit that consumers get from the deal, also called consumer surplus, would be equal to “A.”

Meanwhile, the contribution margin that a supplier receives from the trade, also called the producer surplus, would be equal to “B.” The area “C” would be considered a loss, or deadweight loss, which exists due to market inefficiency in a monopolistic competition. On the other hand, a company may use a two-part tariff by setting an entry fee at “c” and charging an additional price for each unit consumed. Under the two-part tariff strategy, the total surplus (consumer surplus + producer surplus) is equal to A+B+C compared to A+B. However, 100% of this surplus goes to the producer. As a result, the producer captures the maximum level of profits, but consumers gain no extra benefits from the trade.

How Did Deutsche Bahn Increase Ticket Sales Using a Two-Part Tariff?

Hermann Simon, a founder of Simon-Kucher & Partners, describes a great example of an effective two-part tariff strategy in his book “Confessions of the Pricing Man: How Price Affects Everything”.

At the beginning of the 1990s, a German railway company Deutsche Bahn was losing money. Deutsche Bahn’s tickets were more expensive than the price that car owners paid for gas. As a result, Germans preferred to travel on a car rather than on a train.

The real issue, however, was that consumers only considered variable costs such as the cost of gas but did not take into account fixed costs such as car insurance, amortization, and parking. To solve the problem, Deutsche Bahn decided to split the price of its ticket into two components — fixed and variable costs. The first BahnCard was released in 1992. The new ticket cost was $140 per year and $0.08 per kilometer, which was $0.02 less on average than the gas price.

BahnCard was a tremendous success, which helped Deutsche Bahn’s customers understand that railway tickets were not as expensive. The number of BahnCards sold during the first several months reached one million, and more than five million cards were in use as of 2018.