Lecture Note: Product Bundling

Product Bundling This is a form of price discrimination which comprises 'bundling together' several goods or services at a lower aggregate price than the total of the separate parts. Obvious illustrations are the 'luxury packs' of optional extras sold with certain new cars, and an 'all-in' price for the different facilities offered by clubs or hotels. Dorwood (1987) gives good examples of the profitable use of both 'pure bundling' and 'mixed bundling', which we have modified slightly in the discussion below. 1. Pure bundling. Film X is more valuable to exhibitor A than exhibitor B, and film Y is more valuable to exhibitor B than exhibitor A, thus: A would pay £8,000 for film X and £2,500 for film Y B would pay £7,000 for film X and £3,000 for film Y Obviously, if the two films were booked separately, X would be rented out at £7,000, so as not to exclude B, and Y at £2,500, so as not to exclude A. The distributor's revenue would be £19,000 in total. However, bundling the two films together for £10,000 (the lower of A and B's valuations for X and Y together) will increase the revenues to £20,000. The revenue gain comes from the inverse relation in the valuation of the two films by A and B, and the fact that their separate valuations are not too far apart - only £500 in our example. 2. Mixed bundling. This is more profitable than pure bundling whenever some buyers value one of the items in a bundle relatively highly, but the other (s) slightly above or below cost price, and there are further buyers who place a relatively high valuation on both or all the items in the bundle. Let us extend the number of film exhibitors to four: A values X at £8,000 and Y at £2,500. (as before) B values X at £7,000 and Y at £3,000 (as before) C values X at £5,500 and Y at £5,000 D values X at £5,000 and Y at £5,500 Under a pure bundling strategy, the same £10,000 bundle would be offered to all four. If the distributor's marginal cost of supplying each film is £4,000, then he will make a profit of £40,000 - £32,000 = £8,000. Note that, under pure bundling, A and B hire film Y, despite its marginal cost exceeding their valuations. With mixed bundling, the profit would be higher. The distributor could offer X and Y separately at £7,000 and £4,000 respectively, or the pair as a package for £10,500. The result would be A, C and D hiring the package, and B hiring film X only, as the cost of both the bundle and film Y exceed his particular valuations. The profit would now be (£10,500 x 3) + £7,000 - (£4,000 × 7) = £10,500. However, A might also prefer to hire film X for £7,000, instead of taking the package, as the extra cost of the bundle exceeds his valuation of Y by £1,000. If A did choose this option, the distributor's profit would rise to £11,000, as he does not have to supply either A or B with film Y, which has a supply cost in excess of their valuations: (£10,500 x 2) + (£7,000 x 2) - (£4,000 x 6) = £11,000. Mixed bundling is a particularly efficient means of exploiting price discrimination. Buyers are offered a pricing structure in which they are charged higher prices for buying the items separately (X + Y=£11,000) than in a package (X+Y=£10,500). Mixed bundling works as a discriminatory device by (a) using the package to extract the most from those customers who value it most (in our example C and D, who placed relatively high valuations on both films), and (b) charging a relatively high separate price for that item in the package that is valued very highly by some particular buyers (in our example film X, which was valued very highly by both A and B). It should be noted that a non-bundling policy would have resulted in a profit of only £6,500 - A, B and C would have been charged £5,500 for X with a marginal cost of £4,000 (the contribution from three sales at £5,500 is higher than four sales at £5,000, the lowest valuation placed on X by exhibitor D), and C and D £5,000 for Y (A and B having a valuation for Y below its marginal cost).