USER CHARGES and
SALES by PUBLIC
MONOPOLIES
Know: When to Use Them
Their Advantages and Disadvantages
How Much to Charge
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License Fees are not User
Fees
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TWO KINDS of
LICENSE FEES
• Those intended primarily to generate
revenue for government - no monitoring or
inspection required, applicants rarely
denied -- e.g., business licenses
• Those based on government authority to
regulate certain activities -- usually
intended to offset, partially or completely,
the the cost of the activities involved
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USER CHARGES
Are appropriate where governments
provide private goods -- including
most public monopolies
• Make the users recognize that provision of
those service is not costless
• Promotes conservation and efficient use
• Provides signals to government as to the
level and kinds of service to provide
Automatically matches burdens to
Benefits received
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When to Use User Fees
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When to Use
• The good is both excludable and potentially
exhaustible
• Lumpy goods are usually toll goods
• Monopoly supply is appropriate where toll goods are
concerned
• Government provision may, therefore, be appropriate
for toll goods
• Publicly provided toll goods that are prone to
congestion are especially good candidates for user
fees
• Any publicly-provided, excludable good that
wouldn’t otherwise be provided might also be a good
candidate for user fees (under provision is better than
no provision)
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Advantages of Making
Users Pay
• Make the service to a degree self financing.
Transparency
• User fees register and record public demand for
service. Transparency
• Equity is enhanced when some users who
wouldn’t be liable for taxes pay. Fairness
• Citizens who don’t value services don’t have to
pay for them. Fairness
• User fees correct price/cost signals to private
users, often leading them to modify their
behavior. Efficiency
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Drawbacks to Making
Users Pay
• Not appropriate for some public or commons
type goods (lumpy public goods are toll goods).
Efficiency
• Not appropriate where public provision in
intended to promote redistribution (the fact that
some users are poor is not a good argument
against User Charges). Fairness/Efficiency
• Not appropriate where too costly to collect.
Efficiency
• Service providers and clients will usually oppose
(they normally reduce service demands). Politics
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Pricing Philosophy
“The only economic function of price is
to influence behavior … But of course
price can only have this effect on the
buyer’s side only if bills do indeed
depend on the volume [and kind] of
purchases. For this reason, economists
… are avid meterers.”
Fred Kahn
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Pricing Guidelines
• Know what drives cost -- prices should
reflect cost and its behavior
• Understand demand -- prices should reflect
demand (willingness and ability to pay)
• Use multi-part tariffs where appropriate
• Practice inverse-elasticity pricing and price
discrimination where feasible
Guidelines apply to ALL government services
that are sold to citizens
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What Price to Charge Users
The fundamental pricing rule
How to price discriminate
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The fundamental pricing
rule
Produce up to the point where MR=MC,
where MR = P[1-(1/|e|)]
For a price taker:
MR = P[1-(1/|e|)] = P, hence P=MC
For a price searcher MR = MC implies
P = MC/[1 - (1/|e|)],
hence (P- MC)/P = 1/|e|
And P/(P- MC) = |e|
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The fundamental pricing rule
P/(P- MC) = |e|
Elasticity |1.5|
Marginal
Revenue
1
Price
3
|2|
|3|
1
2
1
1
1.5 1.33
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|4|
(P-MC)/P = 1/|e|
The higher the elasticity, the
lower the markup of price over
marginal cost. The lower the
elasticity, the higher the
markup.
(Elasticity tends to be higher
when there are many
competitors and substitutes.)
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QUESTION
True or false: the
optimal price
will always be
on the elastic
portion of the
residual demand
curve?
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QUESTION
True or false: the
optimal price
will always be
on the elastic
portion of the
residual demand
curve?
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True.
If |e| is less than 1,
raising price
will both
increase
revenue, and
decrease costs.
QUESTION
When will the
optimal
price be set
where the |e|
of the
residual
demand
curve is = 1
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QUESTION
When will the If |e| is 1, MC
optimal
must equal
price be set
zero.
where the |e|
P/[P-MC] = |e|
of the
residual
P/[P- 0] = 1
demand
curve is = 1
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QUESTION: Given a linear demand curve that
intersects the Y axis at a price of $10, and a
marginal cost of $2 per unit, what is the optimal
price?
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ANSWER: P = $6. 1/|e| = (Pmax - P)/P = ($10 - P)/P.
(P - MC)/P = (P-2)/P. Equating the right side of the equation
to the left, ($10-P)/P = (P - $2)/P or ($10 - P) = (P - $2).
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Price
discrimination
Definition: A single organization price
discriminates when it charges different
prices to different consumers that are
not proportional to differences in
marginal cost, i.e., when for two
different consumers (1 & 2), p1/MC1 ≠
p2/MC2 (of course, MR1/MC1 =
MR2/MC2).
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Necessary conditions
 At least two consumer groups exist with
different elasticities, i.e., different demand
curves.
 The organization can identify consumers in
each group, and set prices differently for
consumers in the two groups.
• The organization must be able to prevent
consumers in one group from selling to
consumers in the other (no arbitrage).
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Price discrimination:
Note P1 is 3 times MC; P2 is twice MC.
Solving for |e|: (3 - 1)/3 = 1/|e| = 1.5; (2 - 1)/2 = 1/|e| = 2.
The more inelastic the demand, the higher the markup:
inverse elasticity pricing rule or, where subject to a revenue
constraint, Ramsey optimal pricing.
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Examples of price discrimination
 Senior citizen and children’s discounts
offer lower prices to those with more
elastic demands for municipal pools.
 Universities offer lower prices in the
form of financial aid (“need” based aid)
to those with higher elasticities of
demand (note: it is easier to
discriminate
where
services
are
concerned than where goods are
concerned and where consumables are
concerned than durables).
 Tying supplies to use of a durable piece
of equipment, sometimes called Barbie
Doll Marketing: give away the dolls but
charge a lot for the dresses.
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One of the most effective price-discrimination
mechanisms is the multi-part tariff.
Multi-part tariffs decompose product/services
to their fundamental attributes and charge
users for their actual consumption of each.
The best example of a multi-part tariff is your
phone bill.
Multi-part Ramsey-optimal tariffs are also
commonly used in internal transfer pricing,
initially for IT services, now more widely in
intra-net based organizations
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Lotteries, State-Run
Liquor Stores
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State Liquor Monopolies
• Voluntary and enjoyable approach to
government finance
• Can be thought of a tax on addictive
behavior
• Disproportionate quantities of alcohol are
purchased by poor and ill-educated
• Receipts tend to increase over time; they
are very stable (which tends to reduce the
volatility government income somewhat)
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LOTTERIES & VIDEO
POKER
• Voluntary and enjoyable approach to
government finance
• Can be thought of a tax on statistical
naiveté (addictive behavior)
• Disproportionate number of lottery tickets
are purchased by poor and ill-educated
• Receipts tend to decline over time; they
are also very volatile (however, their
volatility tends to reduce the volatility
government income somewhat)
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