Commentary: Are Flat Rates Good Business?

Last December, America Online Inc. decreed that there is a free lunch. For $19.95 a month, it promised to turn off the meter and let customers spend unlimited time online, no questions asked. Perhaps predictably, some subscribers stayed connected for hours, even days. The network was quickly overwhelmed. Frustrated at being unable to log on, customers have since filed at least eight lawsuits.

Executives at AOL insist that flat-rate pricing works. They say they can eliminate the congestion by spending $350 million on equipment. And they predict that in the long run, the increased traffic will pay off in higher revenue from advertising and transactions. For now, though, they're losing a battle with their own customers. CEO Stephen M. Case has been reduced to pleading with them to curtail their usage during peak hours "during this transitional period."

AOL isn't the only company that has flirted with flat rates (table). Under the right circumstances, flat-rate pricing can please customers and plump profits. The trick, though, is to figure out what those circumstances are.

ROUND THE CLOCK. Principle No.1 is to save flat rates for products or services for which there's a natural limit to demand--like all-you-can-eat salad. Or bus trips. With a three-week advance purchase, Greyhound Lines Inc. charges $59 for a one-way trip anywhere in the lower 48 states. It can get away with this because few people have the fortitude for a cross-country journey by bus. In contrast, demand for keeping an online connection "nailed up" is close to inexhaustible, at least for those customers who have a phone line dedicated to the computer and aren't paying their local phone company a per-minute charge for it.

Like Greyhound, Walt Disney Co. and other amusement-park operators have figured out how to make flat-rate pricing work. They charge once for admission instead of selling tickets per ride. That causes long lines for popular rides, but in this case congestion is accepted. One theory is that parents would rather stand in line than have their kids tugging on them every five minutes, wanting to spend more money on rides.

Surprisingly, flat rates can even work for electricity and natural gas. It would seem that a fixed price per month based on the previous year's consumption would encourage people to crank up the thermostat. In fact, demand is fairly inelastic--that is, people don't increase consumption much even though doing so wouldn't cost more, says Frederick H. Abrew, president and CEO of Equitable Resources Inc. in Pittsburgh. Equitable isn't a flat-rate purist: It charges extra if usage is 20% or more above the previous year and gives a rebate if it drops 20% or more.

CANNIBALIZING? Pricing theory says: Don't give a price cut to people who willingly pay higher prices. Yet AT&T, another flat-rate pricer, seems to have done just that with its One Rate plan. It charges 15 cents a minute, anytime, anywhere in the U.S. Who would that appeal to? People who avoided other discount plans because they seemed confusing--and thus had been paying higher rates. AT&T won't discuss the plan's financial success.

Parcel carriers are moving in the opposite direction. After years of charging uniform rates for delivery anywhere in the country, United Parcel Service Inc. and Federal Express Corp. recently began to offer prices that vary based on distance. For the first time, customers can save money by shipping products from regional depots instead of from one central location--and many are jumping at the chance. "I pass along the discount to my customers," says UPS customer Eitan Spiegel, chief operating officer of Amana Tool Corp. in Farmingdale, N.Y., a maker of woodcutting gear and accessories. "Now, they will want to call me more."

Flat rates fare best when they attract customers who don't make a cold calculation of how to save money. For instance, AOL is counting on lots of light users to underwrite its network upgrade by paying $19.95 a month even though they would spend less if they paid by the hour. In the end, though, customers figure out what's in their own best interest. That's why some of today's flat-rate forays fall flat.

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