Chapter 8 Commodity Bundling and Tie-in Sales

Introduction Firms often bundle the goods that they offer Microsoft bundles Windows and Explorer Office bundles Word, Excel, PowerPoint, Access Bundled package is usually offered at a discount Bundling may increase market power GE merger with Honeywell Tie-in sales ties the sale of one product to the purchase of another Tying may be contractual or technological IBM computer card machines and computer cards Kodak tie service to sales of large-scale photocopiers Tie computer printers and printer cartridges Why? To make money!

Bundling: an example 1, How much can be charged for Casablanca & Godzilla? $7000 & $2500 respectively Two television stations offered two old Hollywood films Casablanca and Son of Godzilla Arbitrage is possible between the stations Willingness to pay is: 2, If the films are sold separately total revenue is $19,000 Willingness to pay for Casablanca Willingness to pay for Godzilla Station A $8,000 $2,500 Station B $7,000 $3,000

Example on next page Now suppose that the two films are bundled and sold as a package How much can be charged for the package? If the films are sold as a package total revenue is $20,000 Bundling is profitable because it exploits aggregate willingness pay

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

Now Extend this example to allow for costs , (2) mixed bundling :offering products in a bundle and separately Suppose that there are two goods and that consumers differ in their reservation prices for these goods Each consumer buys exactly one unit of a good provided that price is less than her reservation price Consumer x has reservation price px1 for good 1 and px2 for good 2 Consumer y has reservation price py1 for good 1 and py2 for good 2 Suppose that the firm sets price p1 for good 1 and price p2 for good 2

Bundling: another example 3, All consumers in region B buy only good 2 2, All consumers in region A buy both goods R2 B A y py2 py1 4, All consumers in region D buy only good 1 p2 x px2 px1 D C 1, Consumers split into four groups p1 R1 5, All consumers in region C buy neither good

Now consider pure bundling at some price pB Consumers now split into two groups 1, All consumers in region E (right of PB line) buy the bundle R2 3, Consumers in these two black regions can buy each good even though their reservation price for one of the goods is less than its marginal cost pB E F c2 c1 pB R1 2, All consumers in region F(left of PB line) do not buy the bundle

Now consider mixed bundling ( see next page) Good 1 is sold at price p1 Good 2 is sold at price p2 The bundle is sold at price PB < P1 + P2 Consumers split into four groups: buy the bundle, buy only good 1, buy only good 2 , and buy nothing

Mixed Bundling 6, This leaves two regions, 7&8 1, Consumers in this region are willing to buy both goods. They buy the bundle 5, Consumers in this region buy only good 2 8, In this region consumers buy either the bundle or product 2 R2 pB 6, This leaves two regions, 7&8 p2 3, Consumers in this region buy nothing 7, In this region consumers buy either the bundle or product 1 pB - p1 pB - p2 p1 R1 pB 2, Consumers in this region also buy the bundle 4, Consumers in this region buy only good 1

See next page Consider consumer x with reservation prices p1x for product 1 and p2x for product 2 Her aggregate willingness to pay for the bundle is p1x + p2x Consumer surplus from buying the bundle is p1x + p2x - pB

3, The consumer x will buy only product 1 Mixed Bundling (cont.) 5, Similarly, all consumers in this region buy only product 2 3, The consumer x will buy only product 1 R2 pB p2 4, All consumers in this region buy only product 1 pB - p1 x p2x 2, Consumer surplus from buying product 1 is p1x - p1 p1x pB - p2 p1 pB R1 p1x+p2x 1, Which is this measure

Mixed Bundling (cont.) What should a firm actually do? There is no simple answer mixed bundling is generally better than pure bundling but bundling is not always the best strategy Each case needs to be worked out on its merits

An Example Four consumers; two products; MC1 = $100, MC2 = $150 A $50 Reservation Price for Good 1 Reservation Price for Good 2 Sum of Reservation Prices Consumer A $50 $450 $500 B $250 $275 $525 $300 $220 $520 C $50 D $450 $500

Consider simply monopoly pricing Good 1 should be sold at $250 and Good 2 at $450. Total profit is $450 +$300 =$750. Good 1: Marginal Cost $100 Price Quantity Total revenue Profit $450 1 $450 $350 $300 2 $600 $400 $250 $250 3 $750 $450 $50 4 $200 -$200 Good 2: Marginal Cost $150 Price Quantity Total revenue Profit $450 $450 1 $450 $300 $275 2 $550 $200 $220 3 $660 $210 $50 4 $200 -$400

Now consider pure bundling 1,The highest bundle price that can be considered is $500 2, All four consumers will buy the bundle and profit is 4x$500 - 4x($150 + $100) = $1,000 Now consider pure bundling Reservation Price for Good 1 Reservation Price for Good 2 Sum of Reservation Prices Consumer A $50 $450 $500 B $250 $275 $525 $300 $220 $520 C D $450 $50 $500

Now consider mixed bundling 1, All four consumers buy something and profit is $250x2 + $150x2 = $800 Now consider mixed bundling Take the monopoly prices p1 = $250; p2 = $450 and a bundle price pB = $500 Reservation Price for Good 1 Reservation Price for Good 2 Sum of Reservation Prices Consumer A $50 $450 $500 $500 B $250 $275 $500 $525 $300 $250 $220 $520 C $50 D $450 $250 $500 2, Can the seller improve on this?

2, All four consumers buy and profit is $300 + $270x2 + $350 = $1,190 1, Try instead the prices p1 = $450; p2 = $450 and a bundle price pB = $520 3, This is actually the best that the firm can do 2, All four consumers buy and profit is $300 + $270x2 + $350 = $1,190 Reservation Price for Good 1 Reservation Price for Good 2 Sum of Reservation Prices Consumer A $50 $450 $450 $500 B $250 $275 $520 $525 $300 $220 $520 $520 C D $450 $450 $50 $500

Bundling (cont.) Bundling does not always work Requires that there are reasonably large differences in consumer valuations of the goods What about tie-in sales? “like” bundling but proportions vary allows the monopolist to make supernormal profits on the tied good different users charged different effective prices depending upon usage facilitates price discrimination by making buyers reveal their demands

Tie-in Sales Suppose that a firm offers a specialized product – a camera? – that uses highly specialized film cartridges Then it has effectively tied the sales of film cartridges to the purchase of the camera this is actually what has happened with computer printers and ink cartridges How should it price the camera and film? suppose that marginal costs of the film and of making the camera are zero (to keep things simple) suppose also that there are two types of consumer: high-demand and low-demand See example in next page Suppose that the firm leases the product for $72 per period

Tie-In Sales 3, Profit is $72 from each type of consumer So this gives profit of $144 per pair of high-and low-demand consumers Tie-In Sales Low-Demand Consumers High-Demand Consumers 4, Is this the best that the firm can do? Demand: P = 12 - Q Demand: P = 16 - Q $ $ $16 $12 2, Low-demand consumers are willing to buy 12 units $128 1,High-demand consumers buy 16 units $72 16 12 Quantity Quantity

Tie-In Sales 7, Profit is $70 from each low-demand consumer: $50 + $20 1,Suppose that the firm sets a price of $2 per unit 7, Profit is $70 from each low-demand consumer: $50 + $20 and $78 from each high-demand consumer: $50 + $28 giving $148 per pair of high-demand and low-demand Tie-In Sales 6, So the firm can set a lease charge of $50 to each type of consumer: it cannot discriminate Low-Demand Consumers Demand: P = 12 - Q Demand: P = 16 - Q $ $ $16 $12 Demand: P = 12 - Q 4, Consumer surplus for high-demand consumers is $98 5, Consumer surplus for low-demand consumers is $50 $98 $50 $2 $2 3, Low-demand consumers buy 10 units 2, High-demand consumers buy 14 units 14 16 10 12 Quantity Quantity

See example in next page 1, Suppose that the firm can bundle the two goods instead of tie them 2, Produce a bundled product of camera plus 12-shot cartridge

5, So produce a second bundle of camera plus 16-shot cartridge 7, Profit is $72 from each low-demand consumer and $80 from each high-demand consumer giving $150 per pair of high-demand and low-demand Tie-In Sales Low-Demand Consumers Demand: P = 16 - Q $ $ 4, High-demand consumers get $48 consumer surplus from buying it $16 Demand: P = 12 - Q $12 3, Low-demand consumers can be sold this bundled product for $72 $48 $72 $72 $8 6, High-demand consumers will pay $80 for this bundled camera ($128 - $48) 12 16 12 Quantity Quantity

Complementary Goods Complementary goods are goods that are consumed together nuts and bolts PC monitors and computer processors How should these goods be produced? How should they be priced? Take the example of nuts and bolts these are perfect complements: need one of each! Assume that demand for nut/bolt pairs is: Q = A - (PB + PN)

Complementary goods (cont.) This demand curve can be written individually for nuts and bolts For bolts: QB = A - (PB + PN) For nuts: QN = A - (PB + PN) These give the inverse demands: PB = (A - PN) - QB PN = (A - PB) - QN These allow us to calculate profit maximizing prices Assume that nuts and bolts are produced by independent firms Each sets MR = MC to maximize profits MRB = (A - PN) - 2QB Assume MCB = MCN = 0 MRN = (A - PB) - 2QN

Complementary goods (cont.) Therefore QB = (A - PN)/2 and PB = (A - PN) - QB = (A - PN)/2 by a symmetric argument PN = (A - PB)/2 The price set by each firm is affected by the price set by the other firm In equilibrium the price set by the two firms must be consistent

Complementary goods (cont.) 2, Pricing rule for the Nut Producer: PN = (A - PB)/2 PB = (A - PN)/2 PN = (A - PB)/2 PB  PN = A/2 - (A - PN)/4 A = A/4 + PN/4 1, Pricing rule for the Bolt Producer: PB = (A - PN)/2  3PN/4 = A/4  PN = A/3  PB = A/3 A/2  PB + PN = 2A/3 A/3  Q = A - (PB+PN) = A/3 3, Equilibrium is where these two pricing rules intersect Profit of the Bolt Producer = PBQB = A2/9 A/3 A/2 A PN Profit of the Nut Producer = PNQN = A2/9

Complementary goods (cont.) What happens if the two goods are produced by the same firm? The firm will set a price PNB for a nut/bolt pair. Demand is now QNB = A - PNB so that PNB = A - QNB $  MRNB = A - 2QNB MR = MC = 0 A  QNB = A /2  PNB = A /2 A/2 Profit of the nut/bolt producer is PNBQNB = A2/4 Demand MR A/2 A Quantity

Merger of the two firms results in consumers being charged lower prices and the firm making greater profits. Why? Because the merged firm is able to coordinate the prices of the two goods

Complementary goods Don’t necessarily need a merger to get these benefits product network ATM networks airline booking systems one of the markets is competitive price equals marginal cost in this market leads to the “merger” outcome There may also be a countervailing force network externalities value of a good to consumers increases when more consumers use the good

Network externalities Product complementarities can generate network effects Windows and software applications substantial economies of scale strong network effects leads to an applications barrier to entry new operating system will sell only if applications are written for it but… So product complementarities can lead to monopoly power being extended

Anti-trust and bundling The Microsoft case is central accusation that used power in operating system (OS) to gain control of browser market by bundling browser into the OS need\ to show monopoly power in OS OS and browser are separate products that do not need to be bundled abuse of power to maintain or extend monopoly position Microsoft argued that technology required integration further argued that it was not “acting badly” consumers would benefit from lower price because of the complementarity between OS and browser

Microsoft and Netscape Complementarity products so merge? what if Netscape refuses? then Microsoft can develop its own browser MC ≈ 0 so competition in the browser market drives price close to zero but then get the outcome of merger firm through competition So Microsoft is not “acting badly” But JAVA allows applications to be run on Internet browsers Netscape then constitutes a threat need to reduce their market share

Antitrust and tying arrangements Tying arrangements have been the subject of extensive litigation Current policy tie-in violates antitrust laws if there exists distinct products: tying product and tied one firm tying the products has sufficient monopoly power in the tying market to force purchase of the tied good tying arrangement forecloses or has the potential to foreclose a substantial volume of trade