When Talk is 'Free': The Effect of Tariff Structure on Usage under Two- and Three-Part Tariffs

Abstract

In many service industries, firms introduce three-part tariffs to replace or complement existing two-part tariffs. As opposed to two-part tariffs, three-part tariffs offer allowances, or “free” units of the service. Behavioral research suggests that the attributes of a pricing plan may affect behavior beyond their direct cost implications. There is evidence that customers value “free” units above and beyond what would be expected based on the change to their budget constraint. Nonlinear pricing research, however, has not considered such an effect.We consider a market where three-part tariffs were introduced for the first time. We analyze tariff choice and usage behavior for customers who switch from two-part to three-part tariffs. We find that switchers significantly “over-use” compared to their prior two-part tariff usage. They attain a level of consumption that cannot be explained by a shift in the budget constraint. We estimate a discrete-continuous model of tariff choice and usage that accounts for the valuation of “free” units. Our results show that 83.9% of three-part tariff users value minutes on a three-part tariff more than they would on a two-part tariff. We derive recommendations for how the provider can exploit these insights to further increase revenues.