Monday, December 14, 2009

Bars and Cover Charges

During the Fall 2009 semester, The Daily Iowan reported that the Iowa City Council was discussing cover charges collected at local Iowa City bras. While the article focused on whether cover charges were being properly accounted and reported for tax purposes, there was a statement that cover charges at bars were supplementing "cheap" drinks.

Frankly, I am not sure what is exactly meant by "cheap" drinks, but I will go on to the assumption that it means that alcoholic beverages are sold at a lower price with a cover charge than without a cover charge. If this is the case, then from a profit-maximizing perspective this is exactly what the two-part pricing (or two-part tariff) model predicts. Let me sketch out the basic model - without the math.

Assume that the bar owner faces identical customers (the non-identical customer case is both more interesting and more complicated, which I discuss in 06E:141, 06E:177 or 06N:213). Given our assumption that each customer has the same demand curve, the owner wants to choose a cover charge and a usage price (the price of drinks in this example) such that the owner maximizes their profits. To do so, the owner sets the price of drinks equal to the marginal cost of the last drink and charges a cover charge equal to the customers consumer surplus (i.e. their economic well-being).

In this way the owner is able to transfer as much of the customers consumer surplus into sales revenue as they can. Economically, this is no different that UI charging student fees, sports teams selling personal seat licenses or country clubs charging membership fees. Each is a two-part price - one part is the right to consume and the second is the amount to consumer. According to the two-part pricing model, this is a way for a firm to pursue a profit-maximizing pricing strategy.

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