Cross subsidization definition

What is Cross Subsidization?

Cross subsidization is the practice of funding one product with the profits generated by a different product. This means that one group of customers is paying for the consumption of other customers. This situation arises when the public transit fares in densely populated areas are set somewhat higher in order to pay for artificially low transit fares in less-populated areas where the government is trying to encourage the use of public transit.

Cross-subsidization can be useful in the private sector when a business wants to use the profits from an established product line to fund its development and sale of a new product. This is especially common when it will take some time to establish the new product in the marketplace, so the company is willing to fund it at a loss for an extended period of time.

Example of Cross Subsidization

Jeff, George, and Harry order meals that cost $20, $25, and $30, respectively, and are then charged $75 for the three meals on a single bill. If each one of them pays $25, Jeff is cross subsidizing Harry for $5, since Jeff is paying $25 for a meal that cost $20, while Harry is paying $25 for a meal that cost $30.

Advantages of Cross Subsidization

Cross subsidization allows a business to use profits from high-margin products or services to support lower-margin or loss-leading offerings, which can help attract a broader customer base and increase overall market share. This strategy can promote social or strategic objectives, such as providing essential services at affordable prices or penetrating new markets. It also enables firms to maintain competitive pricing in key areas while ensuring profitability through premium segments. Additionally, cross subsidization can strengthen brand loyalty and customer retention by offering a diverse and balanced portfolio of products and services that meet varying consumer needs.

Disadvantages of Cross Subsidization

Cross subsidization can distort pricing and profitability by allowing profits from one product or customer segment to offset losses in another, which can mask inefficiencies and lead to poor decision-making. It may result in overpricing competitive offerings and underpricing noncompetitive ones, reducing market competitiveness and potentially driving away price-sensitive customers. Additionally, it can create internal conflicts as profitable units may feel penalized for supporting unprofitable areas, thereby undermining motivation and accountability. Over time, this practice can erode financial transparency, making it difficult to identify areas needing improvement and obscuring the true cost structure of operations.