Download EC 170: Industrial Organization

Bundling and Tying
Chapter 6: Bundling and Tying
1
Bundling: 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 6: Price Discrimination,
Product Variety, Bundling, and Tying
2
Bundling: an example
How
much canfilms
• Two television stations offered two old
Hollywood
How much can
be charged for
– Casablanca and Son of Godzilla
be charged for
If the films are sold
Godzilla?
• Arbitrage is possible betweenCasablanca?
the stations
separately total
• Willingnessrevenue
to pay is:
is $19,000
$7,000
Willingness to Willingness to
pay for
pay for
Casablanca
Godzilla
Station A
$8,000
$2,500
Station B
$7,000
$3,000
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
$2,500
3
Bundling:
How much can
an
example
2
beBundling
charged
forprofitable
is
thebecause
package?
it exploits
Now suppose
aggregate willingness
that the two films are
If and
the films
Willingness
to sold
Willingness
Total
payto
bundled
sold are
as pay
a package
total pay for
for
Willingness
as a package
revenue
is $20,000Godzilla
Casablanca
to pay
Station A
$8,000
$2,500
$10,500
Station B
$7,000
$3,000
$10,000
$10,000
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
4
Bundling
• Extend this example to allow for
– costs
– mixed bundling: offering products in a bundle and
separately
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
5
Suppose that there are
Consumer y Each
has consumer
reservation
price
two goods
and that
Bundling:
another
thatpy1
the
firm one
All
consumersexample
inSupposebuys
exactly
for goodsets
1 and
py2p for in
All
consumers
price
consumers differ inregion B buy
1
unit
of
ap good
for
good
2
region
A
buy
good
1
and
price
R
only Consumer
good 2
2
their
reservation prices
2
x hasprovided that
both 2goods price
for
good
for these
reservation price px1is less than her
B goods
A
for good 1 and px2
for good 2 reservation price
y
py2
p2
px2
x
All consumers in
region C buy
neither good
All consumers in
region D buy
Consumers
only good 1
split into
four groups
D
C
px1
p1 py1
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
R1
6
Bundling: another example 2
Now consider pure
bundling
at some
All consumers in
pB E buy
Consumers in theseprice
two
regions
region
R2
can buy each good eventhe
though
bundle
their reservation price for one of
Ethe goods is less than its
Consumers
cost
All marginal
consumers
in
pB
c2
F
c1
now split into
two groups
region F do not
buy the bundle
pB
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
R1
7
R2
pB
p2
pB - p1
Mixed
bundling
In
this region
Now consider mixed
consumers
buy
Consumers
in Good
this
bundling
1 is sold
either
theonly
bundle
region
buy
at price p1
or product
2
in this
good
2 Consumers
inGood
this 2Consumers
is sold
region
are willing to
region also at price
p
2
This
leaves
both
goods. They
buy the bundle buy
two
regions
buy
the bundle
Consumers
In this regionsplit
consumers
buy
Consumers in this
into
four groups:
either the bundle
region buy
nothing in this
Consumers
The
bundle is sold buy the bundle
or product 1
region
at price
pBbuy
< p1only
+ pbuy
only good 1
2
good 1
pB - p2
p1
pB
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
R1
buy only good 2
buy nothing
8
Mixed
bundling
2
Similarly,
all
consumers in
this region buy
only product 2
R2
The consumer
x will buy only
product 1
Consider consumer x with
consumers
reservationAll
prices
p1x for in
Which
is
this
Consumer
surplus
from
Consumer
surplus
region
from
buy
product
1 this
and
p2x for
measure
Her
aggregate
willingness
buyingbuying
product
1 isbundle
the
only
is 1
product
2product
to
pay
for
the
bundle
is
p1x -pp1 + p - p
1x
p1x2x+ p2xB
x
pB
p2
pB - p1
p2x
pB - p2
p1
pB p1x
R1
p1x+p2x
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
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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 6: Price Discrimination,
Product Variety, Bundling, and Tying
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An Example
Four consumers; two products; MC1 = $100, MC2 = $150
Consumer
Reservation
Price for
Good 1
Reservation
Price for
Good 2
Sum of
Reservation
Prices
A
$50
$450
$500
B
$250
$275
$525
C
$300
$220
$520
D
$450
$50
$500
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
11
The example 2
Price
$450
$300
$250
$50
Price
$450
$275
$220
$50
Good 1: Marginal Cost $100
Quantity
TotalConsider
revenue simple
Profit
monopoly
pricing
1
$450
$350
2
$400
$600
Good 1 should be sold
3
$750
$450
at $250 and good 2 at
4
$200
-$200
$450. Total profit
Good 2: Marginal
Cost +
$150
is $450
$300
Quantity
= Total
$750revenue
1
2
3
4
$450
$550
$660
$200
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
Profit
$300
$200
$210
-$400
12
The example
3 consider pure
Now
bundling
Consumer
A
B
C
D
Reservation
Reservation
Price forThe highest
Price for
bundle
Good 1 price that
Good
2 be
can
considered
isbuy
$500
All four
consumers
will
$50
$450
the bundle and profit is
4x$500
$100)
$250- 4x($150 +
$275
= $1,000
$300
$220
$450
$50
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
Sum of
Reservation
Prices
$500
$525
$520
$500
13
The example
Now4 consider mixed
Take the monopoly prices p1 = $250; p2 = $450 and
a bundle price pB = $500
bundling
All four consumers buy
something
and profit
is
Reservation
Reservation
Consumer
Price +
for$150x2 Price for
Can the$250x2
seller
improve
Good
1
Good 2
=
$800
on this?
Sum of
Reservation
Prices
A
$50
$450
$500
B
$250
$275
$525
$500
C
$300
$250
$220
$520
D
$450
$250
$50
$500
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
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The example 5
Try instead the prices p1 = $450; p2 = $450 and a bundle price pB = $520
This is actually
the best Reservation
that the
Reservation
All four consumers
buy
Consumer
do for
Price+forfirm can
Price
and profit is $300
Good 1
$270x2 + $350
= $1,190
A
$50
Good 2
Sum of
Reservation
Prices
$450
$450
$500
B
$250
$275
$525
$520
C
$300
$220
$520
D
$450
$450
$50
$500
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
15
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
16
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
17
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, highdemand 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 6: Price Discrimination,
Product Variety, Bundling, and Tying
18
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
19
Tie-in
sales:
an
example
2
So the firm can set a
$
$16
Recall
theof $50
lease that
charge
High-Demand
Low-Demand
film sells at $2
Consumers to each type of Profit
Consumers
is $50 from each
per
picture
consumer:
it cannotlow-demand and highHigh-demand
Demand: P = 16 - Q
Demand: P = 12 - Q
discriminate
consumers take 14
demand consumer. Total
pictures$
profit is $100,000
Consumer surplus
Consumer
surplus
for high-demand
$12
consumers is $98
$98
for low-demand
consumers
Low-demand
is $50
consumers take 10
pictures
$50
$2
$2
14 16
Quantity
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
10 12
Quantity
20
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
21
Tie-in sales: an example 2
High-Demand Aggregate profit
Low-Demand
is
now the camera at
Lease
Profit
is $32 plus
Consumers
Consumers
$48,000 + $56,000
= Profit is $32
$32.
$24 in film profits =
Tying increases
theDemand:
$104,000
plusP =$16
Demand: P = 16 - Q
12 -in
Qfilm
Each
$56 high-demandfirm’s profit
profits
= $48
Consumer
surplus
consumer will lease
$
$
the camera at $32
High-demand
$12
consumers take 12
pictures
$16
$32
$4
$2
for low-demand
consumers
Low-demand
is $32
consumers take 8
pictures
$32
$4
$2
$24
12
Quantity
$16
16
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
8
12
Quantity
22
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
23
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
24
Tie-in sales:
High-Demand
Consumers
$
$16
12
Aggregate profit is now
an $50,000
example
2
+ $58,000 =
$108,000
Low-Demand
Consumers
High-demand
Demand:consumers
P = 16 - Q get $40
Demand: P = 12 - Q
Low-demand
high-demand
consumerSo
surplus
consumers will pay
by leasingconsumers
the 10- can$ be
up to $70 to lease
picurecharged
camera $86 to lease
the 10-picure
$12
the 14-picture
camera
camera
$40
$70
$2
$70
$2
$16
10 14 16
Quantity
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
10 12
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)
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
26
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
MRN = (A - PB) - 2QN
Assume MCB = MCN = 0
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
27
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
28
Complementary goods 4
PB
A
A/2
Pricing rule for
the Nut
Equilibrium
is for
Producer:
Pricing rule
two
PN where
= (A - these
Pthe
B)/2Bolt
pricing
rules
Producer:
Pintersect
B = (A - PN)/2
A/3
A/3 A/2
A
PN
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
 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
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
29
Complementary goods 5
What happens if the two goods are produced by the same firm?
of the
The firm willMerger
set a price
PNBtwo
forfirms
a nut/bolt pair.
results in consumers
Demand is now QNB = A - PNB so that PNB = A - QNB
being charged
$
lower
prices
and
the
firm
 MRNB = A - 2QNB
Why? Because the
making greater profits
MR = MC = 0
A
merged firm is able to
 QNB = A /2
coordinate the prices of
 PNB = A /2
the two goods
Profit of the nut/bolt producer
is PNBQNB = A2/4
A/2
Demand
MR
A/2
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
A
Quantity
30
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
31
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
32
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
33
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
34
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
35
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
36
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 6: Price Discrimination,
Product Variety, Bundling, and Tying
37
Competitive Bundling/Tying 3
Product
$8.50 is lowest
Pain Relieffeasible
Decongestant
price and isBundle
Demand
Costs
Fixed Cost
Marginal Cost
Moral:100
competitive
50 by only
achieve
pressure may be the
offering the bundled
underlying reason for
product
$300
$300
$300
much bundling
$4
$4
$7
50
Feasible Prices
Separate Goods
Pure Bundling
Mixed Bundling
Bundle + Good 1
Bundle + Good 2
$6
---$10
$10
----
$6
---$10
---$10
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
----$8.50
$10
$9
$9
38
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-ofreason standard with increasing recognition that
whether price discrimination or competitive pressure is
the reason, bundling/tying is often welfare-improving
Chapter 6: Price Discrimination,
Product Variety, Bundling, and Tying
39