Lecture 7: Bundling and Tying – Examples Virgin Pricing Case

1. Lecture 7: Bundling and Tying – ExamplesVirgin Pricing Case AEM 4160: Strategic Pricing Prof. Jura Liaukonyte

2. Bundling: An Example • Two television stations offered two old Hollywood films • Casablanca and Son of Godzilla • Willingness to pay is: Willingness to pay for Casablanca Willingness to pay for Godzilla Station A $8,000 $2,500 Station B $7,000 $3,000

3. Bundling: An Example 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

4. When Bundling Increases Profit • Bundling likely to increase profit if consumers' demands for bundled products are • Negatively correlated: consumers who value one good much more than other and there is heterogeneity in tastes.

5. Bundling • Extend this example to allow for • Costs • Mixed bundling: offering products in a bundle and separately

6. Setting • Suppose a firm is selling two goods, 1 and 2 • A consumer’s reservation prices for the two goods are given by R1 and R2 • Without bundling, the firm sets the prices of the goods P1 and P2 • With bundling, the firm sets a price PB per bundle containing one unit of each good

7. Consumption Without Bundling • For any prices P1 and P2, consumers can be categorized according to whether they have higher reservation prices R1 and R2 for one of the goods, none of the goods, or both of the goods

8. R2 I Consumers buy bundle R1+ R2 >PB R1+ R2 =PB II Consumers do not buy bundle R1+ R2 <PB R1 Pure Bundling • With pure bundling only bundles, and not separate goods, are offered • Consumers will buy the good if and only if R1+ R2 ≥ PB

9. Bundling – Basic Idea • Two consumers • Two goods (E,D) • Valuations of consumers: (3,1), (1,3) • Price goods separately: • pE = pD = 3 • Profits = 6 • Better alternative: • sell menus for $4 • Profits = 8 • Key idea: Make consumers more homogeneous by aggregation. • Can be less extreme. • Necessary condition: Negative correlation in values (Rank reversal ) entree 3 2 1 1 2 3 dessert

10. When Bundling Increases Profit • Bundling likely to increase profit if consumers' demands for bundled products are • Negatively correlated: consumers who value one good much more than other and there are heterogeneity in tastes.

11. Bundling • Extend this example to allow for • Mixed bundling: offering products in a bundle and separately

12. Example • Suppose the firm produces two goods, 1, and 2, at unit cost c=0.5 • There are two consumers: • James has reservation prices R1J=1 and R2J=2 • Karen has reservation prices R1K=2 and R2K=1

13. Example: No Bundling or Pure Bundling • Without bundling the firm should set P1=2 and P2=2 and sell one unit of each good • This would give a profit of 2•2-2•0.5=3 • With pure bundling, the firm could charge PB=3 for each bundle • This would give profit 2•3-4•0.5=4

14. Example: Mixed Bundling • Suppose there are two more consumers • Al has reservation prices R1A=2 and R2A=0.5 and Beth has reservation prices R1B=0.5 and R2B=2 • Without bundling the optimal prices would be P1=2, P2=2 giving a profit of 4•2-4•0.5=6 • With pure bundling neither Al nor Beth would buy the bundle at price PB=3

15. Example: Mixed Bundling • However, if the goods were also sold separately at prices P1=2 and P2=2, then Al would buy good 1, Beth would buy good 2, and James and Karen would buy the bundle • This would give a profit of 2•3+2•2-6•0.5=7

16. Bundling Again • Bundling does not always work • Mixed bundling is usually more profitable than pure 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

17. VIRGIN PRICING CASE

18. Issue • Pricing decision: • Entering a highly saturated cell phone service industry, while targeting an unsaturated market segment • Attempting to earn a profit from a limited income market • Target market is: • Young (15-29) • Trendy • Different than traditional cell phone users • Different spending habits • Different usage • Different needs • Limited purchasing power • “According to marketing research, target market does not trust industry pricing plans.” -Dan Schulman, CEO, Virgin Mobile USA

19. Objectives • Create value and profitability in cell phone service industry • Target market ages 15-29, opportunity for growth with this market segment • 1 million subscribers by year 1.3 million by year 4 • “By focusing on the youth market from the ground up, we’re putting ourselves in a position to serve these customers in a way they have never been served before” • -Dan Schulman, CEO, Virgin Mobile USA

20. Discussed Alternatives Clone Industry Prices: contracts Set prices below competition: contracts A whole new plan: prepaid pricing

21. Clone Industry Prices • Pros • Give customers more features for the same price • Easy to promote, use current models • Limited spending power on promotion may be a justifiable factor • Viable with Virgin Mobile’s limited advertising budget • Cons • May drive margins down if additional features are costly • Reduces competitive advantage • Difficult to penetrate saturated market with similar offer as competitors • Competitive with other cell phone providers and packages; does not support strong market differentiation

22. Price Below Competition • Pros • Drive sales and market share • Accounts for limited spending power of target market • Cons • Margins and profitability will be driven down • Inconsistent with company goal of profitability • Cannot compete in price wars • Not a long term solution

23. A Whole New Plan: Prepaid Pricing • Pros • Differentiate from competition • Cater to the needs of target market • Flexibility is attractive to target market • Profitability is key • Eliminates risk of missed payments • Cons • Risk of limited returns and loyalty • Churn rate may increase

24. Pricing Structure from the Carrier Perspective • Contracts: • Annual churn rate WITH contracts =2% * 12 months = 24% (p.8) • Annual churn rate WITHOUT contracts =6% * 12 months = 72% (p.8) • The difference: 72% - 24% = 48% • Take AT&T example: customer base = 20.5 million • If AT&T abandons the contract based plan how many new customers would it need to acquire to offset customers from an increased churn rate? • Additional customers lost to churn: __________________ • Acquisition cost per customer: $370 (case p.2) • Total cost of offsetting higher churn rate: __________________ • Not surprising that major players still continue to hold the contracts.

25. “Menu” Pricing: Actual Usage

26. Bucket/“Menu” Pricing In reality most consumers are paying more than their optimal rate = if they new exactly how much they will consume “Industry makes money from consumer confusion” Pricing menus allow carriers to advertise low per minute rates But most consumers end up choosing the wrong menu.

27. Hidden Fees Able to promote low per minute prices, but still collect additional revenues

28. Acquisition Costs • Advertising per gross add: from $75 to $100 (p.5) • Sales commission paid per subscriber: $100 (p.5) • Handset subsidy provided to the subscriber: $100 to $200 (p.9) • Total: from $275 to $405 • (let’s assume somewhere in the middle = $370)

29. Break Even Point M = margin the customer generates in a year r = annual retention rate = (1-12*monthly churn rate) i = interest rate (assume 5%) AC = acquisition cost - AC Monthly ARPU (average revenue per unit): $52 (p.3) Monthly Cost-to-Serve: $30 (p.3) Monthly Margin: $22 Time required to break even on the acquisition cost = __________________ In the cellular industry the monthly margin is relatively fixed across periods, therefore the traditional LTV can be simplified (assuming infinite horizon):

30. LTV With Contracts The annual retention rate in the industry = ______________

31. LTV Without Contracts Eliminate contracts -> churn rate increases to 6% Calculate the LTV:

32. Eliminate Hidden Costs $ 29 cellular bill becomes $35 due to hidden costs Increase of 21% If these costs were eliminated, the $22 margin would be reduced to _______________ Break even would become _________= __________

33. What Happens to LTV? Without hidden costs, but with contracts Without hidden costs and without contracts Elimination of contracts drives LTV below zero Hidden costs boost the bottom line

34. Option 3: Different Pricing Approach • Target audience: Youth • Loathe contracts • Fail credit checks • Ideal plan: no contracts, no menus, no hidden fees… • How to differentiate itself, and have a positive LTV • Look at the factors that affect LTV

35. Options for Lowering Acquisition Costs • Advertising costs per customer • Industry=from $75 to $100 • Virgin planned ad costs = 60 mil/1min= $60 (p.5) • Handset subsidies: • Current industry handset cost: $150 to $300 (assume $225) (p.5) • Current industry handset subsidy: $100 to $200 (assume $150) (p.9) • Current industry handset subsidy as a %: 67% • Virgin’s handset cost: $60 to $100 (assume $80) • Assume Virgin’s subsidy around 30% = $30

36. Acquisition Costs • Then Virgin’s AC would be just ____vs. industry average $370 • Sales commission: $30 • Advertising per gross add: $60 • Handset Subsidy $30 • Total: _______

37. Consumer Friendly Plan: How to Achieve Profitability • Break Even analysis: at what per minute price would Virgin break even: • Virgin’s monthly ARPU: ______________ where p=price per minute • Assume Virgin’s customers use 200 minutes per month (midpoint of estimate between 100 and 300, p.7) • Monthly cost to serve: ______________ • Assume monlty cost to serve is 45% of revenues (Exhibit 11) • Monthly margin: _______________ • p > ________

38. Other Price Points • What if Virgin charged per minute price comparable to other industry prices, somewhere in between 10 and 25 cents: • At 10 cents: • At 25 cents:

39. Virgin’s Pricing Plan: What Happened? A prepaid plan No contracts No hidden charges No peak off peak hours Very low handset subsidies No credit checks No Monthly bills Price: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest of the day No exact numbers, but churn rate lower than 6%