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Commodity Bundling and Tie-In Sales

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

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Commodity Bundling and Tie-In Sales

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  1. Commodity Bundling and Tie-In Sales 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! Chapter 8: Commodity Bundling and Tie-In Sales

  3. Bundling: an example How much can be charged for Godzilla? How much can be charged for Casablanca? If the films are sold separately total revenue is $19,000 • Two television stations offered two old Hollywood films • Casablanca and Son of Godzilla • Arbitrage is possible between the stations • Willingness to pay is: $7,000 Willingness to pay for Casablanca Willingness to pay for Godzilla $2,500 Station A $8,000 $2,500 Station B $7,000 $3,000 Chapter 8: Commodity Bundling and Tie-In Sales

  4. How much can be charged for the package? Bundling is profitable because it exploits aggregate willingness pay Bundling: an example 2 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 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 $10,000 Chapter 8: Commodity Bundling and Tie-In Sales

  5. Bundling • Extend this example to allow for • costs • mixed bundling: offering products in a bundle and separately Chapter 8: Commodity Bundling and Tie-In Sales

  6. Suppose that there are two goods and that consumers differ in their reservation prices for these goods y py2 x px2 px1 py1 Consumer y has reservation price py1 for good 1 and py2 for good 2 Each consumer buys exactly one unit of a good provided that price is less than her reservation price Bundling: another example Suppose that the firm sets price p1 for good 1 and price p2 for good 2 All consumers in region B buy only good 2 All consumers in region A buy both goods Consumer x has reservation price px1 for good 1 and px2 for good 2 R2 B A All consumers in region C buy neither good All consumers in region D buy only good 1 Consumers split into four groups p2 D C p1 R1 Chapter 8: Commodity Bundling and Tie-In Sales

  7. Bundling: another example 2 Now consider pure bundling at some price pB R2 All consumers in region E buy the bundle Consumers in these two regions can buy each good even though their reservation price for one of the goods is less than its marginal cost pB E Consumers now split into two groups All consumers in region F do not buy the bundle F c2 c1 pB R1 Chapter 8: Commodity Bundling and Tie-In Sales

  8. Mixed bundling Now consider mixed bundling In this region consumers buy either the bundle or product 2 Consumers in this region buy only good 2 Good 1 is sold at price p1 R2 Consumers in this region are willing to buy both goods. They buy the bundle Consumers in this region also buy the bundle Good 2 is sold at price p2 pB This leaves two regions Consumers split into four groups: buy the bundle buy only good 1 buy only good 2 buy nothing p2 In this region consumers buy either the bundle or product 1 Consumers in this region buy nothing Consumers in this region buy only good 1 The bundle is sold at price pB < p1 + p2 pB - p1 pB - p2 p1 pB R1 Chapter 8: Commodity Bundling and Tie-In Sales

  9. Mixed bundling 2 Similarly, all consumers in this region buy only product 2 R2 The consumer x will buy only product 1 pB Consider consumer x with reservation prices p1x for product 1 and p2x for product 2 p2 All consumers in this region buy only product 1 Which is this measure Consumer surplus from buying product 1 is p1x - p1 Consumer surplus from buying the bundle is p1x + p2x - pB Her aggregate willingness to pay for the bundle is p1x + p2x pB - p1 x p2x pB - p2 p1 pB p1x R1 p1x+p2x Chapter 8: Commodity Bundling and Tie-In Sales

  10. Mixed bundling 3 • 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 Chapter 8: Commodity Bundling and Tie-In Sales

  11. An Example Four consumers; two products; MC1 = $100, MC2 = $150 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 Chapter 8: Commodity Bundling and Tie-In Sales

  12. The example 2 Good 1: Marginal Cost $100 Consider simple monopoly pricing Price Quantity Total revenue Profit $450 1 $450 $350 $300 2 $400 $600 Good 1 should be sold at $250 and good 2 at $450. Total profit is $450 + $300 = $750 $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 $200 $550 $220 3 $660 $210 $50 4 $200 -$400 Chapter 8: Commodity Bundling and Tie-In Sales

  13. The example 3 Now consider pure bundling Reservation Price for Good 1 Reservation Price for Good 2 Sum of Reservation Prices Consumer The highest bundle price that can be considered is $500 All four consumers will buy the bundle and profit is 4x$500 - 4x($150 + $100) = $1,000 A $50 $450 $500 B $250 $275 $525 $300 $220 $520 C D $450 $50 $500 Chapter 8: Commodity Bundling and Tie-In Sales

  14. The example 4 Now consider mixed bundling Take the monopoly prices p1 = $250; p2 = $450 and a bundle price pB = $500 All four consumers buy something and profit is $250x2 + $150x2 = $800 Reservation Price for Good 1 Reservation Price for Good 2 Sum of Reservation Prices Consumer Can the seller improve on this? A $50 $450 $500 $500 B $250 $275 $525 $500 $250 $300 $220 $520 C D $450 $250 $50 $500 Chapter 8: Commodity Bundling and Tie-In Sales

  15. The example 5 This is actually the best that the firm can do Try instead the prices p1 = $450; p2 = $450 and a bundle price pB = $520 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 Chapter 8: Commodity Bundling and Tie-In Sales

  16. Bundling again • Bundling does not always work • Mixed bundling is always more profitable than pure bundling • Mixed bundling is always better than no 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 Chapter 8: Commodity Bundling and Tie-In Sales

  17. Tie-in sales • 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 Chapter 8: Commodity Bundling and Tie-In Sales

  18. Tie-in sales 2 • 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 also that there are two types of consumer, high-demand and low-demand, with one-thousand of each type • high demand P = 16 – Qh; low demand P = 12 - Ql • the company does not know which type is which Chapter 8: Commodity Bundling and Tie-In Sales

  19. Tie-in sales 3 • Film is produced competitively at $2 per picture • so film is priced at $2 per picture • Suppose that the company leases its cameras • if priced so that all consumers lease then we can ignore production costs of the camera • these are fixed at 2000c • Now consider the lease terms Chapter 8: Commodity Bundling and Tie-In Sales

  20. So the firm can set a lease charge of $50 to each type of consumer: it cannot discriminate Tie-in sales: an example 2 Recall that the film sells at $2 per picture High-Demand Consumers Low-Demand Consumers Profit is $50 from each low-demand and high-demand consumer. Total profit is $100,000 High-demand consumers take 14 pictures Demand: P = 16 - Q Demand: P = 12 - Q $ $ Consumer surplus for high-demand consumers is $98 Consumer surplus for low-demand consumers is $50 $16 $12 Low-demand consumers take 10 pictures $98 $50 $2 $2 14 16 10 12 Quantity Quantity Chapter 8: Commodity Bundling and Tie-In Sales

  21. Tie-in sales example 3 • This is okay but there may be room for improvement • Redesign the camera to tie the camera and the film • technological change that makes the camera work only with the firm’s film cartridge • Suppose that the firm can produce film at a cost of $2 per picture • Implement a tying strategy that makes it impossible to use the camera without this film Chapter 8: Commodity Bundling and Tie-In Sales

  22. High-Demand Consumers Low-Demand Consumers Demand: P = 16 - Q Demand: P = 12 - Q $ $ $16 $12 $2 $2 16 12 Quantity Quantity Tie-in sales: an example 2 Tying increases the firm’s profit Aggregate profit is now $48,000 + $56,000 = $104,000 Lease the camera at $32. Profit is $32 plus $16 in film profits = $48 Profit is $32 plus $24 in film profits = $56 Each high-demand consumer will lease the camera at $32 Consumer surplus for low-demand consumers is $32 Low-demand consumers take 8 pictures High-demand consumers take 12 pictures $32 $32 $4 $4 $16 $24 12 8 Chapter 8: Commodity Bundling and Tie-In Sales

  23. Tie-in sales example 3 • Why does tying increase profits? • high-demand consumers are offered a quantity discount under both the original and the tied lease arrangement • but tying solves the identification and arbitrage problems • film exploits its monopoly in film supply • high-demand consumers are revealed by their film purchases • quantity discount is then used to increase profit • arbitrage is not an issue: both types of consumers pay the same lease and the same unit price for film Chapter 8: Commodity Bundling and Tie-In Sales

  24. Tie-in sales example 4 • Can the firm do even better? • Redesign the camera so that the film cartridge is integral • offer two types of integrated camera/film package: high capacity and low capacity • what capacities? • This is similar to second-degree price discrimination • design two cameras with socially efficient capacities: 10 picture and 14 picture • lease these as integrated packages Chapter 8: Commodity Bundling and Tie-In Sales

  25. High-Demand Consumers Low-Demand Consumers Demand: P = 16 - Q Demand: P = 12 - Q $ $ $16 $12 12 $2 $2 14 16 10 12 10 Quantity Quantity Aggregate profit is now $50,000 + $58,000 = $108,000 Tie-in sales: an example 2 High-demand consumers get $40 consumer surplus by leasing the 10-picure camera Low-demand consumers will pay up to $70 to lease the 10-picure camera So high-demand consumers can be charged $86 to lease the 14-picture camera $40 $70 $70 $16 Chapter 8: Commodity Bundling and Tie-In Sales

  26. 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) Chapter 8: Commodity Bundling and Tie-In Sales

  27. Complementary goods 2 Demand curve can be written individually for nuts and bolts For bolts: QB = A - (PB + PN) For nuts: QN = A - (PB + PN) This gives the inverse demands: PB = (A - PN) - QB PN = (A - PB) - QN These allow us to calculate profit maximizing prices Assume 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 Chapter 8: Commodity Bundling and Tie-In Sales

  28. Complementary goods 3 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 Chapter 8: Commodity Bundling and Tie-In Sales

  29. Complementary goods 4 PB = (A - PN)/2 PN = (A - PB)/2 Pricing rule for the Nut Producer: PN = (A - PB)/2 PB  PN = A/2 - (A - PN)/4 Equilibrium is where these two pricing rules intersect A = A/4 + PN/4 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 Profit of the Bolt Producer = PBQB = A2/9 A/3 A/2 A PN Profit of the Nut Producer = PNQN = A2/9 Chapter 8: Commodity Bundling and Tie-In Sales

  30. Complementary goods 5 Merger of the two firms results in consumers being charged lower prices and the firm making greater profits 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 Why? Because the merged firm is able to coordinate the prices of the two goods $  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 Chapter 8: Commodity Bundling and Tie-In Sales

  31. Complementary goods 6 • 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 Chapter 8: Commodity Bundling and Tie-In Sales

  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 Chapter 8: Commodity Bundling and Tie-In Sales

  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 with no 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 Chapter 8: Commodity Bundling and Tie-In Sales

  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 Chapter 8: Commodity Bundling and Tie-In Sales

  35. And now… • This view gained more force & support in Europe • bundling of Media Player into Windows • Competition Directorate found against Microsoft • Microsoft Appealed • Microsoft finally lost its appeal in September, 2007 • Result: Microsoft ordered to stop bundling and forced to pay fine of €497 (finally settled in October, 2007) • Some economists upset by this decision arguing that as price discrimination, bundling often expands the market, AND also that bundling/tying can reflect competition and not just market power Chapter 8: Commodity Bundling and Tie-In Sales

  36. Competitive Bundling/Tying • Bundling and tying are very commonly observed phenomena • Perhaps too commonly observed to be just the outcome of monopoly power • Is there a way to understand competitive bundling? • Yes! Salinger and Evans (2005) and Evans (2006) • It may well be the case that the structure of demand and the nature of scope and scale economies force competitive firms to bundle tie their goods Chapter 8: Commodity Bundling and Tie-In Sales

  37. Competitive Bundling/Tying 2 • Consider the table on the next slide and assume consumer willingness to pay is $20 for most preferred option • Competitive firm can’t offer pain reliever & decongestant separately, To do so incurs • total fixed cost of $600 • Marginal cost of $4 • Breakeven price = $6 • 50 by pain relief alone and pay $6 per unit • 50 by decongestant alone and pay $6 per unit • 100 buy both and pay $12 per combined unit • Total Revenue = $1800; Total cost = $600 + $4x150 + $4x150 = $1800 • Rival could sell bundled product for $10 and steal all 100 customers interested in joint goods who now pay $12 Chapter 8: Commodity Bundling and Tie-In Sales

  38. Competitive Bundling/Tying 3 $8.50 is lowest feasible price and is achieve by only offering the bundled product Moral: competitive pressure may be the underlying reason for much bundling Chapter 8: Commodity Bundling and Tie-In Sales

  39. 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 & tied one • firm tying the products has sufficient market 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 • As time passes, approach is more and more of a rule-of-reason standard with increasing recognition that whether price discrimination or competitive pressure is the reason, bundling/tying is often welfare-improving Chapter 8: Commodity Bundling and Tie-In Sales

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