Lecture 7: Bundling and Tying – Examples Virgin Pricing Case AEM 4160: Strategic Pricing Prof. Jura Liaukonyte

Bundling: An Example Willingness to pay Two television stations offered two old Hollywood films Casablanca and Son of Godzilla Willingness to pay Willingness to pay for Casablanca Willingness to pay for Godzilla Station A $8,000 $2,500 Station B $7,000 $3,000

Bundling: An Example Willingness to pay Willingness to pay for Casablanca Willingness to pay for Godzilla Total Willingness to pay Station A $8,000 $2,500 $10,500 Station B $7,000 $3,000 $10,000

When Bundling Increases Profit Requirement to increase profits Consumer Demand is negatively correlated: Consumers who value one good much more than other There is heterogeneity in tastes.

Bundling Extend this example to allow for Costs Mixed bundling: offering products in a bundle and separately

Setting Suppose a firm is selling two goods, 1 and 2 A consumer’s reservation prices for the two goods are given by R1 and R2 Without bundling, the firm sets the prices of the goods P1 and P2 With bundling, the firm sets a price PB per bundle containing one unit of each good

Consumption Without Bundling For any prices P1 and P2, consumers can be categorized according to whether they have higher reservation prices R1 and R2 for one of the goods, none of the goods, or both of the goods

Pure Bundling R1+ R2 =PB I II Consumers buy bundle Consumers do not buy bundle R2 R1 R1+ R2 <PB R1+ R2 >PB With pure bundling only bundles, and not separate goods, are offered Consumers will buy the good if and only if R1+ R2 ≥ PB

Bundling – Basic Idea 1 2 3 Two consumers Two goods (E,D) Valuations of consumers: (3,1), (1,3) Price goods separately: pE = pD = 3 Profits = 6 Better alternative: sell menus for $4 Profits = 8 Key idea: Make consumers more homogeneous by aggregation. Can be less extreme. Necessary condition: Negative correlation in values (Rank reversal ) 1 2 3 entree dessert

When Bundling Increases Profit Requirement to increase profits Consumer Demand is negatively correlated: Consumers who value one good much more than other There is heterogeneity in tastes.

Bundling Extend this example to allow for Mixed bundling: offering products in a bundle and separately

Example Suppose the firm produces two goods, 1, and 2, at unit cost c=0.5 There are two consumers: James has reservation prices R1J=1 and R2J=2 Karen has reservation prices R1K=2 and R2K=1

Example: No Bundling or Pure Bundling Without bundling the firm should set P1=2 and P2=2 and sell one unit of each good This would give a profit of 2•2-2•0.5=3 With pure bundling, the firm could charge PB=3 for each bundle This would give profit 2•3-4•0.5=4

Example: Mixed Bundling Suppose there are two more consumers Al has reservation prices R1A=2 and R2A=0.5 and Beth has reservation prices R1B=0.5 and R2B=2 Without bundling the optimal prices would be P1=2, P2=2 giving a profit of 4•2-4•0.5=6 With pure bundling neither Al nor Beth would buy the bundle at price PB=3

Example: Mixed Bundling However, if the goods were also sold separately at prices P1=2 and P2=2, then Al would buy good 1, Beth would buy good 2, and James and Karen would buy the bundle This would give a profit of 2•3+2•2-6•0.5=7

Bundling Again Bundling does not always work Mixed bundling is usually more profitable than pure bundling But pure bundling is not necessarily better than no bundling Requires that there are reasonably large differences in consumer valuations of the goods Bundling is a form of price discrimination May limit competition

VIRGIN PRICING CASE

Issue Problem: How should Virgin Mobile price its plans Situation Problem: How should Virgin Mobile price its plans Entering a highly saturated cell phone service industry, while targeting an unsaturated market segment Attempting to earn a profit from a limited income market Target Market Young (15-29) Trendy Different than traditional cell phone users Different spending habits Different usage Different needs Limited purchasing power “According to marketing research, target market does not trust industry pricing plans.” -Dan Schulman, CEO, Virgin Mobile USA

Objectives 1 Create value and profitability in cell phone service industry Target market ages 15-29, opportunity for growth with this market segment 1 million subscribers by year 1 and 3 million by year 4 Be different:“By focusing on the youth market from the ground up, we’re putting ourselves in a position to serve these customers in a way they have never been served before” -Dan Schulman, CEO, Virgin Mobile USA 2 3 4

Discussed Alternatives 1 Clone Industry Prices: contracts Set prices below competition: contracts A whole new plan: prepaid pricing 2 3

Clone Industry Prices Pros Cons Give customers more features for the same price Easy to promote, use current models Limited spending power on promotion may be a justifiable factor Viable with Virgin Mobile’s limited advertising budget May drive margins down if additional features are costly Reduces competitive advantage Difficult to penetrate saturated market with similar offer as competitors Competitive with other cell phone providers and packages; does not support strong market differentiation

Price Below Competition Drive sales and market share Accounts for limited spending power of target market Margins and profitability will be driven down Inconsistent with company goal of profitability Cannot compete in price wars Not a long term solution Pros Cons

A Whole New Plan: Prepaid Pricing Differentiate from competition Cater to the needs of target market Flexibility is attractive to target market Profitability is key Eliminates risk of missed payments Risk of limited returns and loyalty Churn rate may increase Pros Cons

Pricing Structure from the Carrier Perspective Contracts: Annual churn rate WITH contracts =2% * 12 months = 24% (p.8) Annual churn rate WITHOUT contracts =6% * 12 months = 72% (p.8) The difference: 72% - 24% = 48% Take AT&T example: customer base = 20.5 million If AT&T abandons the contract based plan how many new customers would it need to acquire to offset customers from an increased churn rate? Additional customers lost to churn: __________________ Acquisition cost per customer: $370 (case p.2) Total cost of offsetting higher churn rate: __________________ Not surprising that major players still continue to hold the contracts.

“Menu” Pricing: Actual Usage

Bucket/“Menu” Pricing In reality most consumers are paying more than their optimal rate = if they new exactly how much they will consume “Industry makes money from consumer confusion” Pricing menus allow carriers to advertise low per minute rates But most consumers end up choosing the wrong menu.

Hidden Fees Able to promote low per minute prices, but still collect additional revenues

Acquisition Costs Advertising per gross add: from $75 to $100 (p.5) Sales commission paid per subscriber: $100 (p.5) Handset subsidy provided to the subscriber: $100 to $200 (p.9) Total: from $275 to $405 (let’s assume somewhere in the middle = $370)

Break Even Point LTV = M 1- r+ i - AC Monthly ARPU (average revenue per unit): $52 (p.3) Monthly Cost-to-Serve: $30 (p.3) Monthly Margin: $22 Time required to break even on the acquisition cost = __________________ In the cellular industry the monthly margin is relatively fixed across periods, therefore the traditional LTV can be simplified (assuming infinite horizon): M = margin the customer generates in a year r = annual retention rate = (1-12*monthly churn rate) i = interest rate (assume 5%) AC = acquisition cost LTV = M 1- r+ i - AC

LTV With Contracts LTV = - 370 = The annual retention rate in the industry = ______________ LTV = - 370 =

LTV Without Contracts LTV = - 370 = Eliminate contracts -> churn rate increases to 6% Calculate the LTV: LTV = - 370 =

Eliminate Hidden Costs $ 29 cellular bill becomes $35 due to hidden costs Increase of 21% If these costs were eliminated, the $22 margin would be reduced to _______________ Break even would become _________= __________

What Happens to LTV? LTV = - 370 = LTV = - 370 = Without hidden costs, but with contracts Without hidden costs and without contracts Elimination of contracts drives LTV below zero Hidden costs boost the bottom line LTV = - 370 = LTV = - 370 =

Option 3: Different Pricing Approach Target audience: Youth Loathe contracts Fail credit checks Ideal plan: no contracts, no menus, no hidden fees… How to differentiate itself, and have a positive LTV Look at the factors that affect LTV

Options for Lowering Acquisition Costs Advertising costs per customer Industry=from $75 to $100 Virgin planned ad costs = 60 mil/1min= $60 (p.5) Handset subsidies: Current industry handset cost: $150 to $300 (assume $225) (p.5) Current industry handset subsidy: $100 to $200 (assume $150) (p.9) Current industry handset subsidy as a %: 67% Virgin’s handset cost: $60 to $100 (assume $80) Assume Virgin’s subsidy around 30% = $30

Acquisition Costs Then Virgin’s AC would be just ____vs. industry average $370 Sales commission: $30 Advertising per gross add: $60 Handset Subsidy $30 Total: _______

Consumer Friendly Plan: How to Achieve Profitability Break Even analysis: at what per minute price would Virgin break even: Virgin’s monthly ARPU: ______________ where p=price per minute Assume Virgin’s customers use 200 minutes per month (midpoint of estimate between 100 and 300, p.7) Monthly cost to serve: ______________ Assume monlty cost to serve is 45% of revenues (Exhibit 11) Monthly margin: _______________ p > ________ LTV = - _____ > 0

Other Price Points LTV = - ____ = _____ LTV = - _____ = ____ What if Virgin charged per minute price comparable to other industry prices, somewhere in between 10 and 25 cents: At 10 cents: At 25 cents: LTV = - ____ = _____ LTV = - _____ = ____

Virgin’s Pricing Plan: What Happened? A prepaid plan No contracts No hidden charges No peak off peak hours Very low handset subsidies No credit checks No Monthly bills Price: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest of the day No exact numbers, but churn rate lower than 6%