Lecture 8 Commodity bundling and tie-in sales

1. ECON 4100: Industrial Organization Lecture 8 Commodity bundling and tie-in sales

2. Introduction • product tie-ins and commodity bundling • commodity bundling as a way to price discriminate • complementary goods and network externalities • Before we reach oligopoly: • http://www.cbc.ca/news/canada/nova-scotia/class-action-lawsuits-manufacturing-refunds-cartels-1.4354007 4-1

3. Bundling • Firms sell goods as bundles (package-pricing) • selling two or more goods in a single package (complete stereo systems, fixed-price meals in restaurants, the whole car, not its parts) • Firms also use tie-in sales (requirements pricing): less restrictive than bundling • tie the sale of one good to the purchase of another (computer printers and printer cartridges; constraining the use of spare parts; car+financial services to pay for it) • Why? • Because it is profitable to do so!

4. Bundling: an example How much can be charged for Godzilla? How much can be charged for Casablanca? • Two television stations offered two old Hollywood films • Casablanca and Son of Godzilla • Arbitrage is possible between the stations • Willingness to pay is: If the films are sold separately total revenue is $19,000 $7,000 Willingness to pay for Casablanca Willingness to pay for Godzilla $2,500 Station A $8,000 $2,500 Station B $7,000 $3,000

5. How much can be charged for the package? Bundling is profitable because it exploits aggregate willingness pay Bundling: an example Now suppose that the two films are bundled and sold as a package If the films are sold as a package total revenue is $20,000 Willingness to pay for Casablanca Willingness to pay for Godzilla Total Willingness to pay Station A $8,000 $2,500 $10,500 Station B $7,000 $3,000 $10,000 $10,000

6. Bundling (cont.) • Extend this example to allow for • costs • mixed bundling: offering products in a bundle and separately • But see examples at Rogers We will not cover these… Go to next page (tie-in sales)

7. y py2 x px2 px1 py1 Consumer y has reservation price py1 for good 1 and py2 for good 2 Suppose that there are two goods and that consumers differ in their reservation prices for these goods Each consumer buys exactly one unit of a good provided that price is less than her reservation price Bundling: another example Suppose that the firm sets price p1 for good 1 and price p2 for good 2 All consumers in region B buy only good 2 All consumers in region A buy both goods Consumer x has reservation price px1 for good 1 and px2 for good 2 R2 B A All consumers in region C buy neither good All consumers in region D buy only good 1 Consumers split into four groups p2 D C p1 R1

8. Bundling: the example (cont.) Now consider pure bundling at some price pB R2 All consumers in region E buy the bundle Consumers in these two regions can buy each good even though their reservation price for one of the goods is less than its marginal cost pB E Consumers now split into two groups All consumers in region F do not buy the bundle F c2 c1 pB R1

9. Mixed Bundling Now consider mixed bundling In this region consumers buy either the bundle or product 2 Consumers in this region buy only good 2 Good 1 is sold at price p1 R2 Consumers in this region are willing to buy both goods. They buy the bundle Consumers in this region also buy the bundle Good 2 is sold at price p2 pB This leaves two regions Consumers split into four groups: buy the bundle buy only good 1 buy only good 2 buy nothing p2 In this region consumers buy either the bundle or product 1 Consumers in this region buy nothing Consumers in this region buy only good 1 The bundle is sold at price pB < p1 + p2 pB - p1 pB - p2 p1 pB R1

10. Mixed Bundling (cont.) Similarly, all consumers in this region buy only product 2 R2 The consumer x will buy only product 1 pB Consider consumer x with reservation prices p1x for product 1 and p2x for product 2 p2 All consumers in this region buy only product 1 Which is this measure Consumer surplus from buying product 1 is p1x - p1 Consumer surplus from buying the bundle is p1x + p2x - pB Her aggregate willingness to pay for the bundle is p1x + p2x pB - p1 x p2x pB - p2 p1 pB p1x R1 p1x+p2x

11. Mixed Bundling (cont.) • 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

12. Tie-in sales • Bundling does not always work • Requires that there are reasonably large differences in consumer valuations of the goods • It usually involves two complementary goods • What about tie-in sales? • “like” bundling but proportions vary (you do not have to buy the goods in the same proportions all the time) (also called “requirements” tie-in rather than package “tie-in”) • 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

13. Tie-in sales • What about tie-in sales? • It is sometimes for efficiency reasons, some machines work better with their usable parts • Sometimes tie-in sales are used to evade regulations like price-ceilings • It may be good to assure quality of the consuming experience • To work around problems of cartelization (you sell cheaper one of the goods to avoid detection of the discounting of the main good)

14. Tie-in Sales • Suppose that we sell a specialized product – a camera? – that uses highly specialized film • Then we effectively tie the sales of film cartridges to the purchase of the camera • It can be problematic for the regulator if it is used to affect the suppliers of film • This is what we call foreclosure

15. Tie-in Sales • How should we price the camera and film? • suppose that marginal costs of the film and of making the camera are zero (to keep things simple) • suppose also that there are two types of consumer: high-demand and low-demand • Run the example yourselves

16. Suppose that the firm leases the product for $72 per period Profit is $72 from each type of consumer So this gives profit of $144 per pair of high-and low-demand consumers Tie-In Sales: an Example High-Demand Consumers Low-Demand Consumers Is this the best that the firm can do? Demand: P = 16 - Q Demand: P = 12 - Q $ $ $16 Low-demand consumers are willing to buy 12 units $12 High-demand consumers buy 16 units $128 $72 16 12 Quantity Quantity

17. Tie-In Sales: an Example Suppose that the firm sets a price of $2 per unit Profit is $70 from each low-demand consumer: $50 + $20 and $78 from each high-demand consumer: $50 + $28 giving $148 per pair of high-demand and low-demand So the firm can set a lease charge of $50 to each type of consumer: it cannot discriminate High-Demand Consumers Low-Demand Consumers Demand: P = 16 - Q Demand: P = 12 - Q Consumer surplus for low-demand consumers is $50 $ $ Consumer surplus for high-demand consumers is $98 $16 $12 Low-demand consumers buy 10 units High-demand consumers buy 14 units $98 $50 $2 $2 14 16 10 12 Quantity Quantity

18. Suppose that the firm can bundle the two goods instead of tie them Tie-In Sales: an Example Profit is $72 from each low-demand consumer and $80 from each high-demand consumer giving $150 per pair of high-demand and low-demand High-Demand Consumers Low-Demand Consumers Produce a bundled product of camera plus 12-shot cartridge So produce a second bundle of camera plus 16-shot cartridge Demand: P = 16 - Q Demand: P = 12 - Q $ $ High-demand consumers get $48 consumer surplus from buying it $16 High-demand consumers will pay $80 for this bundled camera ($128 - $48) $12 Low-demand consumers can be sold this bundled product for $72 $48 $72 $72 $8 12 16 12 Quantity Quantity

19. Other types of price-discrimination • Quality differentiation (pay for the label) - Did you know that a Toyota Corolla and a Geo Prizm are the same car? And a Nissan Quest and a Mercury Villager?

20. Other types of price-discrimination • [We will get back to these when dealing with cartels] • Basing-point pricing: prices are quoted as “free on board” plus delivery charge from a basing. Also known as Mill base pricing. A pricing system in which prices are quoted for delivery at the point of production with the buyer to pay freight from that point. • We saw before what happens when the seller absorbs transportation costs. • With FOB manufacturers can keep peace among distributors by requiring them to use this policy, so every distributor keeps its local geographic monopoly and stops competition from other (distant) distributors. The location of the mill and the location of the basin can be different, so that there could be a complex pricing scheme by combining them.

21. Other types of price-discrimination • Basing-point pricing: prices are quoted as “free on board” plus delivery charge from a basing. Also known as Mill base pricing. A pricing system in which prices are quoted for delivery at the point of production with the buyer to pay freight from that point. • Example: “Pittsburgh Plus freight” for steel in the US • A form of spatial price discrimination based on oligopolistic collusion. The mill price at one location determines the delivered price at all locations regardless of the location of the plant from which delivery is actually made. (was used in the marketing of steel in the United States)

22. Other types of price-discrimination • Dump-the-surplus - Japanese TVs were supposed to et dumped at low prices in the US when the other markets had paid the higher prices • Time-value Those with a low opportunity cost of time will pay lower prices - coupons, rebates, vouchers (HMV), are very common • Clear-the-stock -Winners, sales floors in department stores, clearances • Loyalty schemes - Miles cards, frequent flyer programs, preferred customers inhotels etc

23. 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)

24. Complementary goods (cont.) This demand curve can be written individually for nuts and bolts: For bolts: QB = A - (PB + PN) For nuts: QN = A - (PB + PN) These give the inverse demands: PB = (A - PN) - QB PN = (A - PB) - QN

25. Complementary goods (cont.) 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 Assume MCB = MCN = 0 MRN = (A - PB) - 2QN

26. Complementary goods (cont.) 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 (there is an externality) In equilibrium the price set by the two firms must be consistent

27. Complementary goods (cont.) PB = (A - PN)/2 PN = (A - PB)/2 Pricing rule for the Nut Producer: PN = (A - PB)/2 PB PN = A/2 - (A - PN)/4 Equilibrium is where these two pricing rules intersect A = A/4 + PN/4 Pricing rule for the Bolt Producer: PB = (A - PN)/2  3PN/4 = A/4  PN = A/3  PB = A/3 A/2  PB + PN = 2A/3 A/3  Q = A - (PB+PN) = A/3 Profit of the Bolt Producer = PBQB = A2/9 A/3 A/2 A PN Profit of the Nut Producer = PNQN = A2/9

28. Complementary goods (cont.) Merger of the two firms results in consumers being charged lower prices and the firm making greater profits Why? Because the merged firm is able to coordinate the prices of the two goods (internalising the externality) What happens if the two goods are produced by the same firm? The firm will set a price PNB for a nut/bolt pair. Demand is now QNB = A - PNB so that PNB = A - QNB $  MRNB = A - 2QNB MR = MC = 0 A  QNB = A /2  PNB = A /2 A/2 Profit of the nut/bolt producer is PNBQNB = A2/4 Demand MR A/2 A Quantity

29. If one of the goods were sold competitively the price would be equal to MC (zero in this example) • The other good would be sold at the MR=MC price so at P= $A/2 • If both goods were sold competitively the price would be zero for both of course

30. Next • Game Theory • Static games and Cournot Competition • Read Ch. 9