1. Chapter 8
Commodity Bundling and Tie-in Sales

2. 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!

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. Now consider pure bundling
1,The highest bundle
price that can be
considered is $500
2, All four consumers will buy
the bundle and profit is
4x$ x($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

17. 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?

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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)

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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