Bundling

Bundling refers to when two or more goods are sold together as a package. Microsoft Office, Cable TV, Lexis-Nexis, and Spotify all provide examples of bundling. What if there were no bundling and you had to pay for Cable TV by channel rather than purchasing channels in bundles? Would you end up paying more or less? We explore this question and others in this video.

Microeconomics Course:http://mruniversity.com/courses/principles-economics-microeconomic

Ask a question about the video: http://mruniversity.com/courses/principles-economics-microeconomics/bundling-economics-examples#QandA

Next video: http://mruniversity.com/courses/principles-economics-microeconomics/labor-economics-marginal-product-labor

♪ [music] ♪

- [Alex] In our final video
on price discrimination,

we're going to be
talking about bundling.

Bundling is selling two
or more goods together as a package

so Microsoft, for example,
sells Word, Excel, PowerPoint,

a few other programs, together
in a package called Office.

You can also buy these programs
individually but the total price

then would much exceed
the Office price.

So most people buy it as Office.

Cable TV is a collection,

typically of, let's say, a hundred
channels, or you might buy

twenty channels, the movie pack --
you might add on to your hundred

with the movie pack,
a bundle or package.

LexisNexis is a collection of
thousands of different news sources.

Newspapers themselves are bundles.

They're bundles, let's say,
of sections: the sports section,

the business section.

Not everyone who reads
the business section reads

the sports section,
and vice versa.

Spotify, which we'll talk
a little bit more about later,

is a bundle of songs --
16 million songs now and growing.

It's surprising how much bundling
can increase profits.

Let's look at a simple example.

Suppose there are two products,
Word and Excel.

And let's imagine selling them
at first individually.

So for Word it's pretty clear
that there are only

two sensible prices.

Amanda values Word at $100 --
Yvonne only at $40.

So either the firm should price
at $100 and just sell one unit

or price at $40 and sell two.

Same thing for Excel.

Either the firm should price
at $20 and sell two units,

both to Amanda and to Yvonne,

or sell at $90 and sell
just one unit to Yvonne.

So let's take a look at the profits

from the high price strategy,
selling at $190.

So in this case Microsoft will sell
one unit at $100, one unit at $90

for a total profit of $190.

Notice here we're assuming
that marginal costs are zero

so revenues are the same as profits.

Now let's look
at the low price strategy.

In this case, Microsoft will sell
two units of Word at $40 each

and two units of Excel at $20 each
for a total of $120.

Now you can check
the combinations here,

but take it for granted
that the maximum profit

with the individual sale is
from selling at the high price,

and thus the profits are $190.

Now let's consider
an alternative strategy.

Suppose we combine Word

and Excel in a product
or a bundle called Office.

Amanda values Office at $120.

That is, the combination of Word
for $100 and Excel for $20,

she values for a total of $120.

Yvonne values Office at $130.

Again it's pretty clear that there
are only two sensible prices --

sell at $130 and just sell one unit
or sell at $120 and sell two.

Pretty obvious that what
you want to do is to price

the bundle at $120, sell two units,
make $240 and then notice

bundling has increased profits
by $50 or by 26%.

Pretty good deal just for combining
the products in a package.

So what's really going on here?

The problem with selling
Word and Excel individually is

that the demands for the individual
products are highly variable.

So, Amanda values Word at $100,
but Yvonne only at $40.

On the other case for Excel,
Amanda values Excel at $20,

Yvonne at $90, so there's a lot
of variability in the demands

for the two products.

That means that the firm is forced
to make a choice to sell high

but sell only a few copies
or to sell low

and to sell more copies.

On the other hand, look at what
happens when the firm bundles.

So the variability between
the bundle values is

now much, much lower.

Because the variability is lower,
the firm is able to price it closer

to the mean and grab up more
of the consumer surplus.

Now in this case, the bundling
works particularly effectively

because Amanda and Yvonne
have negative correlations --

that is Amanda has a high value
for Word and a low for Excel

while Yvonne has a high value
for Excel and a low for Word.

Negative correlation helps
here a lot, but it's

actually not necessary.

More generally what matters is
that the demand for the bundle is

less variable than the demand
for the individual products.

Zero marginal cost is
also a big help here.

And the principle here is
that it's never wise to sell

someone something if they value it
at less than the cost.

So imagine that somebody values
a product at $20,

and it costs you $30 to produce it.

While you could get them
to buy it as part of the bundle,

but that's never going
to maximize profit,

because by taking that product out
of the bundle you can cut

your costs, $30,
by more than you can cut

the willingness to pay, $20.

So you never want to sell someone

something if they value it
at less than the cost.

When marginal costs are positive,
there's always a fear that

by bundling you're going
to be selling something

that the person values
at less than the cost.

If marginal cost is zero,
we don't have that problem,

so we can bundle
to our heart's content.

So bundling is really going
to work well when we have

zero marginal cost products,
like information goods.

When marginal costs are zero,
it could make sense

to bundle hundreds or even
thousands of goods together,

information goods.

A very excellent paper on this
by Bakos and Brynjolfsson,

and their basic story is this:

Suppose that consumers have
different valuations

for different goods.

So for one good, for one consumer,
the consumer may put a high value

on that good but on the next good
they may have a low value.

Equally likely to have
a high or low value.

Now imagine that on the first good,
the consumer has a high value.

On the second good they're
likely to have a value

which is less high.

So when you combine those
two goods, you're going to get

a more intermediate result,
a result closer to the mean.

So when you add up or average
all the different goods,

maybe one here,
and one here and one here --

you add more and more goods
to the bundle -- what you get is

a demand for the bundle
which is closer to the mean.

In terms of a demand curve,
this setup means

that the demand curve is linear,
like this for an individual good,

but if you have a two-good bundle,

it increases the quantity
demanded to the mean.

Let's in fact take a look
at 20-good bundle.

So the demand for a 20-good bundle,
even though each individual good

in that bundle has
this linear demand --

the demand for the bundle itself is
much greater at the mean.

It's concentrated around the mean.

You get this big increase in
the quantity demanded at the mean

as the bundle values go to the mean.

Because the demand -- the quantity
demanded -- is concentrated

at the mean, just a small reduction
in price can increase

the quantity demanded,
and that's what the firm will do.

It'll drop the bundle price
a little bit, sell a lot more,

and eat up much more
of the total consumer surplus.

So that's why it makes
sense to bundle thousands

of goods when the goods
have zero marginal cost.

Okay, let's say a few words
about profits, consumer welfare

and total welfare efficiency.

This is a little bit tricky because
the results are not perfectly

general but the basic idea is this.

Bundling increases profits,
otherwise the firm wouldn't do it,

and we've seen why
it increases profits.

Now some of that increase comes
from reductions in consumer surplus,

a transfer from consumers.

But some of it comes
from reductions in deadweight loss,

that is it comes
from increased sales.

The increased sales add
to efficiency.

Overall consumer welfare could go
up or down, holding fixed

the number and quality of goods.

At least in one classic case,
in the big bundle zero

marginal cost case,
total welfare increases.

That is the profits and the
reduction in deadweight loss

more than make up for reductions
in consumer surplus.

Now, goods with zero marginal cost

often have very
high fixed costs, like software.

There's a lot of investment in
producing the software

in the first place,
even though it's easy to distribute.

Movies and TV, information
in general is like this.

And to the extent that increased

profits, increased investment
in the fixed cost of creation,

bundling will also tend
to increase consumer welfare,

as well as efficiency.

So on average, my belief is
that the case for bundling

is actually pretty good.

Now let's look at an application.

Cable TV is typically sold
as a package or a bundle

of hundreds of channels.

And this makes a lot of sense
because cable TV satisfies

all of our conditions
for bundling to be profitable

and also to be efficient.

For example, people who are
watching a lot of ESPN

are probably not watching
a lot of Bravo, a lot of "Top Chef."

Not only do preferences differ,
but there's only 24 hours in a day.

So if you're watching a lot
of ESPN, you can't be watching

a lot of "Top Chef" and vice versa.

But this negative correlation
among channel values creates

a bundle value, which goes closer
to the mean, which becomes

more homogeneous.

And that's exactly what we require
for bundling to be profitable.

In addition, marginal costs are zero.

So we don't have to worry
about selling someone a channel

which they value
at less than the cost.

We can give someone a channel for
free without increasing our costs.

In addition, cable TV has
got a lot of fixed costs.

First, the costs which are
extensive of laying the cable,

and also the costs of producing
the programming itself.

So for all of these reasons,
negative correlation,

zero marginal cost
and high fixed costs,

cable TV is an excellent candidate
for bundling, but this makes

a lot of people very upset.

Because of negative correlation,
people who watch football are

not watching "Top Chef"
and people watching "Top Chef" are

not watching football,
so some people feel that

they're being ripped off --
that they're being forced to pay

for something that they don't use
and there's kind of a naive theory

that if I'm paying a hundred dollars

for a hundred channels,
then under á la carte pricing --

if only I wasn't forced
to buy the package --

I'd be paying $1 per channel,
and I'd buy only the channels

that I really want.

But, of course,
that theory is wrong.

The per channel price
would increase and would likely

increase rather dramatically.

Moreover, we know
from the theory of bundling

that the firm makes the most profit
when just about everyone is

getting the same value
from the bundle.

So people shouldn't fear
that they're being ripped off.

People who will watch "Top Chef" --

they're getting a lot of value
from the bundle.

People watching football --

they're getting a lot of value
from the bundle.

There's no reason
to think that one party is

ripping the other party off.

Now maybe overall we'd be
better with more competition,

but that's sort of
a different question.

There's also in the case of cable TV,
complicated dynamics

between consumers, distributors
and content sellers.

It's unclear if you switch
to á la carte pricing who would

really grab up
that consumer surplus.

It's probably not going
to be the consumers.

It might be the distributors
who sometimes push

for á la carte pricing.

It might even be
the content sellers,

but there'd be a lot of gaming
of the system going on,

and it's not that all clear
that consumers would win that game.

There would also be some increased
costs if the cable companies had

to sell by channel and if people
could have, you know,

all the combinations and permutations
of different channels

which was possible, would likely
increase transactions costs.

Maybe in this example
only by a little bit.

Finally, if this decreased profits
for the distributors,

which it would, that is going
to have ultimate effects

on the quality and the number
of channels, the number of content

providers, and how much
they're willing to invest

in new programming,
so overall my belief is

that bundling is actually
good for consumers

and certainly not bad for consumers
or not very bad for consumers.

We don't want to follow
the naive theory.

Okay, let's make one more point.

Here's an interesting prediction
from bundling theory.

Music is currently sold
in two different ways.

iTunes sells more or less by the song,
while something like Spotify

or similar services, they sell you
a whole package or a whole bundle.

Bundling theory says that Spotify
is going to win this competition --

that the profits are much
greater for the bundler.

This is not only because
of the price discrimination reasons

which we've been talking so far,

but in this case the transactions
costs really do matter.

So when iTunes sells by the song,
and it's 99 cents per song,

the cost of the credit card
transaction can be

as much as a dollar,
or a $1.20 or 50 cents.

It can be a significant cost,

significant percentage
of the value of the song.

iTunes tries to handle this
by only charging you, you know,

for every five songs,
or every two or three days.

They try and combine
as many purchases as possible,

but still the transactions costs
of micropayments are quite large,

and that's another reason which is
pushing the music business,

in my opinion, to Spotify.

So that's a little bit
of investment advice.

Don't blame me if it doesn't work,
but I think that the bundling

is going to win out.

Here's some places
for further reading.

Adams and Yellen have a classic
on commodity bundling.

You can easily find that on the web.

A favorite of mine, the Bakos
and Brynjolfsson paper --

these authors actually wrote
two papers on the subject --

either of them is
certainly worth reading.

For a modern look at combining
bundling and bargaining theory,

you can take a look
at Crawford and Yurukoglu.

It's quite a complicated paper,
putting together the industrial

organization of these two topics.

You may also want to go
to Marginal Revolution,

my blog with Tyler,
and search for cable TV bundling.

Both Tyler and I have short
interesting posts on this topic.

Thanks.

- [Announcer] If you want to test
yourself, click "Practice questions."

Or if you're ready to move on,
just click "Next video."

♪ [music] ♪