Download EC 170: Industrial Organization

Commodity Bundling and Tie-In
Sales
Chapter 8: Commodity Bundling and
Tie-In Sales
1
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
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Bundling: an example
much can
• Two television stations offered two oldHow
Hollywood
films
How much can
be charged for
– Casablanca and Son of Godzilla
be charged for
If the films are sold
Godzilla?
• Arbitrage is possible between the
stations
separately total Casablanca?
• Willingness revenue
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 8: Commodity Bundling and
Tie-In Sales
$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 8: Commodity Bundling and
Tie-In Sales
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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
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Consumer y Each
has consumer
reservation
price
Bundling:
another
example
thatpy1
the
firm one
Suppose
that thereAll
areconsumers
inSupposebuys
exactly
for goodsets
1 and
py2p for in
All
consumers
price
region
B
buy
1
two goods and that
unit
of
ap good
for
good
2
region
A
buy
good
1
and
price
R2
good 2
2
x hasprovided that
consumers differ inonlyConsumer
both 2goods price
for good
price px1is less than her
their reservation
pricesreservation
B
A
for good 1 and px2
for these goods
price
for good
2 reservation
yconsumers
All
in
All
consumers
in
py2
region C buy
region D buy
p2
Consumers
x
neither good
only good 1
px2
split into
four groups
D
C
px1
p1 py1
Chapter 8: Commodity Bundling and
Tie-In Sales
R1
6
Bundling: the example (cont.)
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 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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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 8: Commodity Bundling and
Tie-In Sales
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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 8: Commodity Bundling and
Tie-In Sales
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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 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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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 8: Commodity Bundling and
Tie-In Sales
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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
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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
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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
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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
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Tie-in sales: an example 2
$
$16
Recall that the
High-Demand
Low-Demand
film sells at $2
a Consumers
ConsumersSo the firm can set
Profit
is $50 from each
per
picture
lease charge of $50
and
Demand: P = 16 - Qto each type of low-demand
Demand: P = 12
- Qhighdemand consumer. Total
consumer: it cannot
$
profit
is $100,000
Consumer surplus
Consumer
surplus
discriminate
for high-demand
for low-demand
$12
$98
consumers is
$98
consumers
Low-demand
is $50
High-demand
consumers take 10
consumers take 14
pictures
pictures
$50
$2
$2
14 16
Quantity
Chapter 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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Tie-in sales: an example 2
High-Demand Aggregate profitLow-Demand
is
now the camera at
Lease
Consumers
Consumers
$48,000 + $56,000
= Profit is $32
Profit
is $32 plus
$32.
Tying increases
the Demand:
$104,000
$24Demand:
in film Pprofits
=
plus
= 16 - Q
P =$16
12 -in
Q film
Each high-demand
firm’s profit
$56
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 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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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
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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 $40
Demand: P = 12 - Q
Low-demand
consumerSo
surplus
high-demand
consumers will pay
by leasingconsumers
the 10- can$ 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 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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Complementary goods 2
This 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 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
Chapter 8: Commodity Bundling and
Tie-In Sales
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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
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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 8: Commodity Bundling and
Tie-In Sales
29
Complementary goods 5
What happens if the two goods are produced by the same firm?
The firm will set
a price
for afirms
nut/bolt pair.
NB two
Merger
of Pthe
Demand is nowresults
QNB = A
PNB so that PNB = A - QNB
in-consumers
being charged
$
 MRNB = A - 2QNB
lower prices and the firm
Why?
Because the
MR = MC =making
0
A
greater profits
merged firm is able to
 QNB = A /2
coordinate the prices of
 PNB = A /2
the
A/2 two goods
Profit of the nut/bolt producer
is PNBQNB = A2/4
Demand
MR
A/2
Chapter 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
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 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
Chapter 8: Commodity Bundling and
Tie-In Sales
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 8: Commodity Bundling and
Tie-In Sales
34
And now…
• This view gained more force and support in Europe
– bundling of Media Player into Windows
– Competition Directorate found against Microsoft
• no on appeal
Chapter 8: Commodity Bundling and
Tie-In Sales
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
Chapter 8: Commodity Bundling and
Tie-In Sales
36