PRODUCT BUNDLING

In the movie Five Easy Pieces, actor Jack Nicholson enters a diner and asks for teaand coffee. The waitress curtly informs him that toast is not available, even thoughrestaurant has both bread and a toaster. To obtain his toast, Nicholson is forced to order a chicken salad sandwich without the chicken, mayonnaise, and lettuce.

Although little unusual, this is a form of product bundling. Bundling is the practice of selling or more products together for a single price. When the products are only available as package, the pricing strategy is referred to as pure bundling. If at least some product can also be purchased separately, then the firm is using mixed bundling.

Bundling is a common practice. College and professional sports teams offer ticket packages that include seats for popular games that are likely to be sold out, together with seats for other games that have less fan appeal. Cultural arts series are marketed in the same way. Many restaurants offer complete meals that include appetizers and dessert. Car manufacturers provide vehicles with features such as conditioning, antilock brakes, cassette decks, and airbags as standard equipment at extra price. Computer companies often include certain software, such as an operatic system and a word processor, with the machines that they sell.

Why is bundling such a common strategy? One reason is that firms can reduce then production and marketing costs by packaging goods and services in this way. For example, General Motors can customize its facilities to manufacture automobiles with a limited number of option packages. Successful college football teams such as Notre Dame can reduce their ticket sale costs because they have many season ticket holders. The waiters and waitresses at restaurants that offer only complete meals are spared much of the time required for customers to make decisions about each individual component of the meal.

But product bundling can be profitable even where there are no cost savings. Like price discrimination, bundling allows firms to increase their profits by extracting additional consumer surplus. However, in some situations, bundling may be preferable to price discrimination because it requires less information about tastes and preferences of consumers.

A simple example will be used to illustrate how bundling can increase profits. Because of their extremely high production costs, television series rarely make money to their producers when they are first seen on TV. The real payoff comes if the program lasts two or three years so that there are enough episodes produced to allow them to be sold to individual stations, which rely on reruns to meet their programming needs.

Consider a firm that has acquired the rights to 50 episodes each of two popular programs-Seinfeld and Star Trek. Suppose stations in two different cities of similar size are contemplating the distributor's offerings and that the maximum prices they will pay, often referred to as the reservation price, for a 50-episode series are as shown here:

Seinfeld Star TrekMemphis, Tenn. $500,000 $300,000Seattle, Wash. $300,000 $500,000

The numbers were set up so that preferences of the two stations would be negatively correlated. Presumably because of local tastes, the station in Memphis has a higher reservation price for Seinfeld than for Star Trek. In contrast, the Seattle station attaches more value to Star Trek. Assume that the same prices must be offered in both cities.Because preferences of the two stations are negatively correlated, the distributor can increase its profit by bundling. If the firm prices the two series separately, the maximum amount it could charge (and still sell to both stations) would be $300,000 for each, and total revenue would be $1,200,000. Now suppose the firm bundles the series and sets a price of $800,000 for the two. Each station will buy the package because the price does not exceed the sum of the reservation prices of the stations for the two series. But total revenue to the distributor will be $1,600,000. By bundling, the firm earns an additional $400,000.

If demands for the series had not been negatively correlated, bundling would not have been advantageous. For example, assume that the reservation prices for the two stations were as follows:

Seinfeld Star TrekMemphis, Tenn. $300,000 $400,000Seattle, Wash. $400,000 $500,000

In this case, the firm could charge a maximum of $300,000 for Seinfeld and $400,000 for Star Trek and earn a total of $1,400,000. But the highest package price that could be charged is $700,000 per station, and this would generate the same amount of revenue. For bundling to be profitable, there must be at least some consumers whose preferences are negatively correlated with others. If there are consumers who have a high reservation price for one good but place a low value on the second, there must be other consumers whose reservation price for the second good is higher than for the first.

Key Concepts• Pure bundling involves selling two or more products together for the same price.• If reservation prices are negatively correlated, bundling can increase profits by capturing part of the consumer surplus.