When Talk is “Free”: An Analysis of Subscriber Behavior Under Two- and Three-Part Tariffs

In many service industries, firms introduce three-part tariffs to replace or complement existing two-part tariffs. While both twoand three-part tariffs have been studied in the extant literature, to our best knowledge there have been no empirical studies of customer choice and usage when both types of tariffs are on offer. A pertinent question in that context is whether three-part tariff usage can be well predicted based on observed behavior on two-part tariffs. Given a unique data set from a mobile telephony operator, we investigate customer switching between twoand threepart tariffs as well as customers’ usage behavior under the two types of tariffs. We find empirically that customers who switched to a three-part tariff significantly “over-use” compared to their prior two-part tariff usage and attain a level of consumption that cannot be explained by a simple shift in the budget constraint or an explanation based on substitution between different types of calls. To account for this change in level of usage, we propose that the inclusive, or “free”, minutes of a three-part tariff introduces an additional attribute that is valued by the customer in her choice and usage decisions. While on the three-part tariff, the customer learns about her valuation of this attribute and adjusts her behavior accordingly. Such a valuation of an additional attribute of a three-part tariff, compared to a two-part tariff, is consistent with behavioral research that postulates that customers attach a special value to “free” products. In modeling how customers respond to this new attribute, we allow customers on a three-part tariff to have beliefs over its value and learn about it over time. Our empirical results show that the proposed model reflects significantly better the actual usage behavior relative to a model that only adjusts for a change in the budget constraint: 88.2% of switchers have a greater satiation level on a three-part than on a two-part tariff. Our results have important managerial implications for pricing and tariff design.