Course

Bundling

Instructor: Alex Tabarrok, George Mason University

Bundling : The requirement that products be bought together as a single bundle or unit. This is from the video “ Bundling ” in the Principles of Microeconomics

Bundling: The requirement that products be bought together as a single bundle or unit. This is from the video “Bundling” in the Principles of Microeconomics course.

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Transcript

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 20 channels, the movie pack, you might add on to your hundred with the movie pack, a bundle or package. Lexis-Nexis 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 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 1 unit or price at $40 and sell 2. Same thing for Excel. Either the firm should price at $20 and sell 2 units, both to Amanda and to Yvonne, or sell at $90 and sell just 1 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 2 units of Word at $40 each and 2 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 1 unit or sell at $120 and sell 2. Pretty obvious that what you want to do is to price the bundle at $120, sell 2 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, if 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 a 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.

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