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Chapter 8

• Commodity Bundling and Tie-in Sales

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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!

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Bundling: an example• Two television stations offered two old

Hollywood films– Casablanca and Son of Godzilla

• Arbitrage is possible between the stations• Willingness to pay is:

Station A

Station B

Willingness to pay for

Casablanca

Willingness to pay for Godzilla

$8,000

$7,000

$2,500

$3,000

1, How much canbe charged forCasablanca &

Godzilla? $7000 & $2500 respectively

1, How much canbe charged forCasablanca &

Godzilla? $7000 & $2500 respectively

2, If the films are

soldseparately

totalrevenue is $19,000

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Example on next page

Now suppose that the two films are bundled and sold as a package

If the films are sold as a package total revenue is $20,000

How much can be charged for the package?

Bundling is profitable because it exploits aggregate willingness pay

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Bundling: an example

Station A

Station B

Willingness to pay for

Casablanca

Willingness to pay for

Godzilla

$8,000

$7,000

$2,500

$3,000

Total Willingness

to pay

$10,500

$10,000

$10,000

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Now Extend this example to allow for

(1) costs ,

(2) mixed bundling :offering products in a bundle and separately

Suppose that there are two goods and that consumers differ intheir 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

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2, All consumers inregion A buyboth goods

2, All consumers inregion A buyboth goods

Bundling: another example

R2

R1

xpx2

px1

ypy2

py1p1

p2

AB

DC

1, Consumerssplit into

four groups

1, Consumerssplit into

four groups

3, All consumers inregion B buyonly good 2

3, All consumers inregion B buyonly good 2

5, All consumers inregion C buyneither good

5, All consumers inregion C buyneither good

4, All consumers inregion D buyonly good 1

4, All consumers inregion D buyonly good 1

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Now consider pure bundling at some price pB

Consumers now split into two groups

R2

R1c1

c2

pB

pB

E

1, All consumers inregion E (right of PB

line) buythe bundle

1, All consumers inregion E (right of PB

line) buythe bundle

F

2, All consumers inregion F(left of PB

line) do notbuy the bundle

2, All consumers inregion F(left of PB

line) do notbuy the bundle

3, Consumers in these two

black regions can buy each

good even thoughtheir

reservation price for one

ofthe goods is less than its

marginal cost

3, Consumers in these two

black regions can buy each

good even thoughtheir

reservation price for one

ofthe goods is less than its

marginal cost

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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

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Mixed Bundling

R2

R1p1

p2

pB

pB

pB - p1

pB - p2

1, Consumers in thisregion are willing to

buy both goods. They

buy the bundle

1, Consumers in thisregion are willing to

buy both goods. They

buy the bundle

2, Consumers in this

region alsobuy the bundle

2, Consumers in this

region alsobuy the bundle

3, Consumers in

thisregion

buy nothing

3, Consumers in

thisregion

buy nothing

4, Consumers in thisregion buy only

good 1

4, Consumers in thisregion buy only

good 1

5, Consumers in thisregion

buy onlygood 2

5, Consumers in thisregion

buy onlygood 2

6, This leavestwo regions, 7&8

6, This leavestwo regions, 7&8

7, In this regionconsumers buy

either the bundle

or product 1

7, In this regionconsumers buy

either the bundle

or product 1

8, In this regionconsumers buy

either the bundleor product 2

8, In this regionconsumers buy

either the bundleor product 2

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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

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Mixed Bundling (cont.)

R2

R1p1

p2

pB

pB

pB - p1

pB - p2

x

p1x

p2x

p1x+p2x

1, Which is thismeasure

1, Which is thismeasure

2, Consumer surplus from

buying product 1 is

p1x - p1

2, Consumer surplus from

buying product 1 is

p1x - p1

3, The consumer x will buy only

product 1

3, The consumer x will buy only

product 1

4, All consumers inthis region buyonly product 1

4, All consumers inthis region buyonly product 1

5, Similarly, all consumers in

this region buyonly product 2

5, Similarly, all consumers in

this region buyonly product 2

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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

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An ExampleFour consumers; two products; MC1 = $100, MC2 = $150

ConsumerReservation

Price for Good 1

Reservation Price for Good 2

Sum of Reservation

Prices

A

B

C

D

$50 $450 $500

$250 $275 $525

$300 $220 $520

$450 $50 $500

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Consider simply monopoly pricingGood 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$300

$250

$50

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3

4

$450$600

$750

$200

$350$400

$450

-$200

$250

Good 2: Marginal Cost $150

Price Quantity Total revenue Profit

$450$275

$220

$50

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3

4

$450$550

$660

$200

$300$200

$210

-$400

$450

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Now consider purebundling

ConsumerReservation

Price for Good 1

Reservation Price for Good 2

Sum of Reservation

Prices

A

B

C

D

$50 $450 $500

$250 $275 $525

$300 $220 $520

$450 $50 $500

1,The highest bundle

price that can beconsidered is $500

1,The highest bundle

price that can beconsidered is $500

2, All four consumers will buythe bundle and profit is

4x$500 - 4x($150 + $100)= $1,000

2, All four consumers will buythe bundle and profit is

4x$500 - 4x($150 + $100)= $1,000

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Now consider mixed bundling

ConsumerReservation

Price for Good 1

Reservation Price for Good 2

Sum of Reservation

Prices

A

B

C

D

$50 $450 $500

$250 $275 $525

$300 $220 $520

$450 $50 $500

Take the monopoly prices p1 = $250;

p2 = $450 and a bundle price pB = $500

$500

$500

$250

$250

1, All four consumers buysomething and profit is

$250x2 + $150x2= $800

1, All four consumers buysomething and profit is

$250x2 + $150x2= $800

2, Can the seller

improveon this?

2, Can the seller

improveon this?

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1, Try instead the prices p1 = $450; p2 = $450 and a bundle price pB = $520

ConsumerReservation

Price for Good 1

Reservation Price for Good 2

Sum of Reservation

Prices

A

B

C

D

$50 $450 $500

$250 $275 $525

$300 $220 $520

$450 $50 $500

$450

$520

$520

$450

2, All four consumers buy and profit is $300 + $270x2 + $350 =

$1,190

2, All four consumers buy and profit is $300 + $270x2 + $350 =

$1,190

3, This is actuallythe best that the

firm can do

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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

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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 pageSuppose that the firm leases the product for $72 per period

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Tie-In SalesHigh-Demand

Consumers

Low-DemandConsumers

Demand: P = 16 - QDemand: P = 16 - Q Demand: P = 12 - QDemand: P = 12 - Q

$

Quantity Quantity

$16

16

$12

$

12

2, Low-demand consumers are

willing to buy 12 units

2, Low-demand consumers are

willing to buy 12 units

$721,High-demand

consumers buy 16

units

1,High-demand

consumers buy 16

units

$128

3, Profit is $72 from each type of consumer

So this gives profit of $144 per pair of high-

and low-demand consumers

3, Profit is $72 from each type of consumer

So this gives profit of $144 per pair of high-

and low-demand consumers

4, Is this the best

thatthe firm can do?

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Tie-In Sales

Low-DemandConsumers

Demand: P = 16 - QDemand: P = 16 - Q Demand: P = 12 - QDemand: P = 12 - Q

$

Quantity Quantity

$16

16

$12

$

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1,Suppose that the firm sets a price of

$2 per unit

1,Suppose that the firm sets a price of

$2 per unit

$2 $2

14 3, Low-demand

consumers buy 10 units

3, Low-demand

consumers buy 10 units

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5, Consumer surplus for low-

demand consumers is $50

5, Consumer surplus for low-

demand consumers is $50

$50

4, Consumer surplus for high-

demand consumers is $98

4, Consumer surplus for high-

demand consumers is $98

$98

2, High-demand

consumers buy 14 units

2, High-demand

consumers buy 14 units

6, So the firm can set a lease charge of $50

to each type of consumer: it cannot

discriminate

6, So the firm can set a lease charge of $50

to each type of consumer: it cannot

discriminate

7, Profit is $70 from each low-demand

consumer: $50 + $20and $78 from each

high-demand consumer: $50 + $28giving $148 per pair of high-demand and

low-demand

7, Profit is $70 from each low-demand

consumer: $50 + $20and $78 from each

high-demand consumer: $50 + $28giving $148 per pair of high-demand and

low-demand

Demand: P = 12 - Q

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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

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Tie-In Sales

Low-DemandConsumers

Demand: P = 16 - QDemand: P = 16 - Q

Demand: P = 12 - QDemand: P = 12 - Q

$

Quantity Quantity

$16

16

$12

$

12

3, Low-demand

consumers can be sold this

bundled product for

$72

3, Low-demand

consumers can be sold this

bundled product for

$72

$72

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

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

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$72

$48

4, High-demand consumers get $48 consumer surplus

from buying it

4, High-demand consumers get $48 consumer surplus

from buying it

5, So produce a second bundle of camera plus 16-shot cartridge

5, So produce a second bundle of camera plus 16-shot cartridge

6, High-demand consumers will pay $80 for this bundled

camera ($128 - $48)

6, High-demand consumers will pay $80 for this bundled

camera ($128 - $48)

$8

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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)

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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

MRN = (A - PB) - 2QN

Assume MCB = MCN = 0

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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

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

In equilibrium the price set by the two firms must be consistent

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Complementary goods (cont.)

PB

PN

1, Pricing rule for the Bolt Producer:

PB = (A - PN)/2

1, Pricing rule for the Bolt Producer:

PB = (A - PN)/2A/2

A

2, Pricing rule for the Nut Producer:PN = (A - PB)/2

2, Pricing rule for the Nut Producer:PN = (A - PB)/2

A/2

A

3, Equilibrium is

where these twopricing rules

intersect

3, Equilibrium is

where these twopricing rules

intersect

PB = (A - PN)/2

PN = (A - PB)/2

PN = A/2 - (A - PN)/4

= A/4 + PN/4

3PN/4 = A/4

PN = A/3

PB = A/3

A/3

A/3

PB + PN = 2A/3

Q = A - (PB+PN) = A/3

Profit of the Bolt Producer = PBQB = A2/9

Profit of the Nut Producer = PNQN = A2/9

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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

$

Quantity

MRNB = A - 2QNB

A

A

DemandMR

MR = MC = 0 QNB = A /2

A/2

PNB = A /2A/2

Profit of the nut/bolt producer is PNBQNB = A2/4

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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

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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

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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

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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

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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

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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