Bundling and Tying Chapter 6 Bundling and Tying

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, Power. Point, 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 between. Casablanca? the stations separately total • Willingnessrevenue to pay is: is $19, 000 $7, 000 Willingness to 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 be. Bundling 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 Willingness as a package revenue is $20, 000 Godzilla Casablanca to pay Station A $8, 000 $2, 500 $10, 500 Station B $7, 000 $3, 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 thatpy 1 the firm one All consumersexample in. Supposebuys exactly for goodsets 1 and py 2 p for in All consumers price consumers differ inregion B buy 1 unit of abuy good for good 2 region A good 1 and price p R only Consumer good 2 2 their reservation prices 2 x hasprovided that both 2 goods price for good for these reservation price px 1 is less than her B goods A for good 1 and px 2 for good 2 reservation price y py 2 px 2 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 px 1 py 1 Chapter 6: Price Discrimination, Product Variety, Bundling, and Tying R 1 6

Bundling: another example 2 Now consider pure bundling at some All consumers in p. B E buy Consumers in theseprice two regions region R 2 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 p. B c 2 F c 1 now split into two groups region F do not buy the bundle p. B Chapter 6: Price Discrimination, Product Variety, Bundling, and Tying R 1 7

Mixed bundling R 2 p. B p 2 p. B - p 1 In this region Now consider mixed consumers buy Consumers in Good this bundling 1 is sold either theonly bundle region buy at price p 1 or product 2 in this good 2 Consumers in. Good this 2 Consumers 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 p. Bbuy < p 1 only + pbuy only good 1 2 good 1 p. B - p 2 p 1 p. B Chapter 6: Price Discrimination, Product Variety, Bundling, and Tying R 1 buy only good 2 buy nothing 8

Mixed bundling 2 Similarly, all consumers in this region buy only product 2 R 2 The consumer x will buy only product 1 Consider consumer x with consumers reservation. All prices p 1 x for in Which is this Consumer surplus from Consumer surplus region from buy product 1 this and p 2 x for measure Her aggregate willingness buying product 1 isbundle the only is 1 product 2 product to pay for the bundle is p 1 x -pp 1 + p - p 1 x 2 x+ p 2 x. B x p. B p 2 p. B - p 1 p 2 x p. B - p 2 p 1 p. B p 1 x R 1 p 1 x+p 2 x Chapter 6: Price Discrimination, Product Variety, Bundling, and Tying 9

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 10

An Example Four consumers; two products; MC 1 = $100, MC 2 = $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 $500 Chapter 6: Price Discrimination, Product Variety, Bundling, and Tying 11

The example 2 Good 1: Marginal Cost $100 Price $450 $300 $250 $50 Price $450 $275 $220 $50 Quantity Total. Consider 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 $750 revenue 1 2 3 4 $450 $550 $660 $200 Chapter 6: Price Discrimination, Product Variety, Bundling, and Tying Profit $300 $210 -$400 12

The example 3 consider pure Now bundling Consumer A B C D Reservation Price for. The 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 4 x$500 $100) $250 - 4 x($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 Now 4 consider mixed Take the monopoly prices p 1 = $250; p 2 = $450 and a bundle price p. B = $500 bundling All four consumers buy something and profit is Reservation Consumer Price + for$150 x 2 Price for Can the$250 x 2 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 $500 Chapter 6: Price Discrimination, Product Variety, Bundling, and Tying 14

The example 5 Try instead the prices p 1 = $450; p 2 = $450 and a bundle price p. B = $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 $270 x 2 + $350 = $1, 190 A $50 Good 2 Sum of Reservation Prices $450 $500 B $250 $275 $520 C $300 $220 $520 D $450 $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 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 2000 c • 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 $50 from each low per picture consumer: it cannot High-demand high-demand Demand: P = 16 - Q Demand: and P = 12 -Q discriminate consumers take 14 consumer. Total profit is pictures$ $100, 000 Consumer surplus for high-demand $12 consumers is $98 for low-demand consumers Low-demand is $50 consumers take 10 pictures $50 $2 $2 Quantity 14 16 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 $48, 000 + $56, 000 = Profit is $32. $24 in film profits Tying = increases the. Demand: $104, 000 plus. P =$16 Demand: P = 16 - Q 12 -in. Qfilm Each firm’s profit $56 high-demand 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 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 $40 Demand: P = 12 - Q Low-demand So high-demand consumer surplus by consumers will pay can$ be leasing consumers the 10 up to $70 to lease picurecharged camera $86 to lease the 10 -picure $12 the 14 -picture camera $40 $70 $2 $16 $2 $70 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) - 2 QB MRN = (A - PB) - 2 QN 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 )/2 Bolt B pricing rules Producer: Pintersect B = (A - PN)/2 A/3 A/2 A PN PB = (A - PN)/2 PN = (A - PB)/2 PN = A/2 - (A - PN)/4 = A/4 + PN/4 3 PN/4 = A/4 PN = A/3 PB + PN = 2 A/3 Q = A - (PB+PN) = A/3 Profit of the Bolt Producer = PBQB = A 2/9 Profit of the Nut Producer = PNQN = A 2/9 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 will. Merger 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 - 2 QNB making greater profits Why? MR = MC = 0 A Because the merged QNB = A /2 firm is able to coordinate the prices of the two goods PNB = A /2 Profit of the nut/bolt producer is PNBQNB = A 2/4 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

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 36

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 37

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 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