How bundling benefits sellers and buyers

There is a widespread belief in technology circles that bundling of cable TV, newspaper, magazine and other information goods will go away now that those products can be distributed à la carte on the internet. The assumption seems to be that bundling is an artifact of another era when distribution was physical. But this reasoning misses the economic logic behind bundling: under assumptions that apply to most information-based businesses, bundling benefits buyers and sellers.

Consider the following simple model for the willingness-to-pay of two cable buyers, the “sports lover” and the “history lover”:

What price should the cable companies charge to maximize revenues? Note that optimal prices are always somewhere below the buyers’ willingness-to-pay. Otherwise the buyer wouldn’t benefit from the purchase. For simplicity, assume prices are set 10% lower than willingness-to-pay. If ESPN and the History Channel were sold individually, the revenue maximizing price would be $9 ($10 with a 10% discount). Sports lovers would buy ESPN and history lovers would buy the History Channel. The cable company would get $18 in revenue.

By bundling channels, the cable company can charge each customer $11.70 ($13 discounted 10%) for the bundle, yielding combined revenue of $23.40. The consumer surplus would be $2 in the non-bundle and $2.60 in the bundle. Thus both buyers and sellers benefit from bundling.

This model is obviously dramatically oversimplified. In real life, bundling tends to flatten the demand curve (here is some background on demand curves, and here is academic paper that presents this argument in rigorous mathematical terms). Suppose the demand curves for ESPN and the History Channel look like this:

The green boxes represent revenue for the seller. The deadweight loss areas to the right of the green boxes are transactions that would have benefited buyers and sellers but are not occurring because the revenue-maximizing prices are set too high.

Now consider what happens when you bundle channels. The key assumption is that individual buyers lie on different x-axis points of the demand curves of different channels. Sports lovers lie on the left of the ESPN demand curve but on the right side of the History Channel curve. To aggregate demand curves, you don’t stack one on top of the other. You add consumers’ willingness-to-pay separately for each channel.

Using the above simplified model, the two demand curves that go from $10 to $3 become one curve that stays flat at $13. In general, adding the individual demand curves creates a flatter demand curve:

A flatter demand curve lets sellers charge prices that capture larger areas under the curve and pass more surplus back to consumers. The only  loser is the deadweight loss area.

Some things to note about bundled pricing:

1. Bundled pricing is one reason why subscription models like Spotify should ultimately win out over à la carte models like iTunes. Subscription commerce can also be thought of as a form of bundling.

2. There are other ways to get some of the benefits of bundled pricing – for example versioning goods, and offering bulk discounts.

3. The benefits of bundled pricing are proportionate the buyers’ variance of preferences for the goods. Hence bundled pricing works best in highly “taste-based” goods like media, and wouldn’t have any benefit for fully commoditized goods (e.g. a bundle of stocks)

4. Bundled pricing can also hurt consumers if it is used by incumbents to exploit their broader catalog to “deter entry” by new competitors. This was a common complaint against Microsoft in the 90′s when they bundled applications like Internet Explorer with Windows.

66 thoughts on “How bundling benefits sellers and buyers

  1. The basic economic theory and math here are obviously spot on. But here’s where it falls short. The marginal utility of of the 50th channel is not the same as the marginal utility of the 2nd, 10th, or 20th channel. As well, different consumers have different tastes and rankings of channels, meaning that if I were to write out how much I’d be willing to pay for 50 channels independently of one another, those would not be the same prices as when I put them in rank order. I am not willing to pay the same price for that 50th channel in the bundle.

    This is a classic argument of “econs” versus “humans”. Bundling does not work for the consumer because we are not “econs”, our tastes change, and we don’t act rationally based on basic utility theory.

    Now, if I were able to choose how may channels to bundle, then we get closer to a better solution for the consumer.

  2. MogulAzam says:

    Basic Economics reminds me of international trade improves economic for both parties involved with basic 2 products. David Ricardo’s principal of Comparative Advantage applied to bundling, or The indifference curve would show the price points of bundling would be optimal in revenue generation.

  3. Hm, not sure I follow. I agree with your first paragraph but I think that is consistent with the argument in the post. Your ranking should look like a more elaborate version of the simple two-goods model I discussed.

    In general I agree that classical economics assumes people are far more rational than they are. And I’m sure lots of “irrational” psychological factors are at work for purchasing decisions. That said, the argument for bundled pricing is very strong, and I think directionally correct.

  4. From what I recall, the three criteria under which bundling makes sense for a producer are:

    1. Negative cross elasticity of demand between the bundled products. If people would buy both anyways, bundling and lowering the combined price is a money loser for the producer. This is what you’ve shown in that matrix.

    2. Relatively low marginal costs. Otherwise, you need to factor that into the matrix you show (willingness to pay minus marginal cost to provide).

    3. Inability to perfectly (or effectively) price discriminate. Otherwise the profit maximizing strategy is to just charge everyone their willingness to pay (or close to it) for each item. This might be the most interesting condition for services delivered over the internet, but, in general, it’s very difficult for companies to pull this off. How much can customers be segmented?

  5. I think your 1) is equilvant to what I call “varied user preferences” and is defined precisely in the academic paper I link to.
    Agree on 2 and 3 (I allude to some alternative price discrimination methods at the end of this post and also in my prior post)

  6. Chris – Helpful again – Thank you.

    A negative factor of bundling is if some perceived value is assumed for each channel but stand-alone options are withdrawn (very common), let us see the impact.

    Punter A would pay $10 for History and $0 for sport
    Punter B the opposite

    A bundle at $11.70 is unattractive to both parties!
    for every A-not-B Lover you require approx 6 A+B lovers to pay off and vice-versa !

    Metrics are distorted with small sample sizes and the assumption that the client base preference is dichotomous (two classes rather than a spectrum) introduces a danger, that people rather than preferences are bundled.

    This is commonplace, it creates resentment and no metrics exist in the model to track it.

  7. Hi Chris,

    I get the logic when I’d be willing to pay $3 for ESPN, but in my case I would not be willing to pay anything for ESPN. So assuming I did want to pay for the History channel, how doesn’t bundling benefit someone like me? Or are you saying that “benefits” accrue to most but not all?

    -Mike

  8. Yes, benefits are in aggregate. Some people won’t benefit. But presumably there is some other channel you’d be willing to pay for? With enough channels, the logic can still work even if you have no interest in, say, 90% of them.

  9. The assumption is with enough channels (/goods) consumer value more than 1 channel and they value that according to some curve where slope isn’t straight down. Obviously this isn’t always true but if it’s true much of the time the logic of bundling still works.

  10. Thanks for clarification,

    I wonder if it follows that eclectic mixes of goods / services will outperform tightly themed bundles.

    I read something interesting on customers preferring fewer choices on a market stand – Many varieties (ie choice ) was perceived as better, but resulted in lower sales

  11. lsternlicht says:

    You should also note that this conclusion implies a marginal cost low enough to be offset by the marginal revenue to the supplier. In the case of music bundling, you may find that the marginal cost of providing additional services outweighs the marginal revenue to the service provider.

  12. True, although in the case of, say, Spotify, the labels seem to understand that the profit maximizing strategy is to let Spotify maximize revenues and then (through renegotiation) take as much of the profits as possible.

  13. Does the math still work once one or more of the bundled services have a customer perceived negative value (e.g a cost rather than merely a value of 0)?

  14. What are the basic assumptions about consumer sentiment and preference? It seems like the underlying assumption is “more is better” and if someone its willing to pay 10 for something they really want, surely they would be willing to pay 11 for something they really want + plus something they sort of want. That likely has been true for most of the past 50-60 years, at least speaking for north america. Still, I think I sense a change of attitude. I don’t need or want 150 tv channels. In fact I’d be willing to do something sub-optimal *shudder* to have less choice. Right now today, I’d gladly pay $50/month for hbo and showtime. But I refuse to pay 70/month for those two channels and 148 that I don’t have the time or inclination to ever watch.

    (In fact, I’d pay 20/month just for a handful of shows if I could pick the shows… actually that is exactly what I do via amazon and iTunes since no a la carte option exists for hbo or showtime.)

  15. I think the key point is “enough” channels. If people vary significantly in their taste then the bundling may not make as much sense. I suspect the reality is more along the lines of a majority of people like the same channels and have a low value of the additional channels. I imagine something that may make sense in that case is you pay a bundle rate for the top channels and also get your pick of X others. Might be a bit confusing to consumers though.

  16. I guess when I replied I was thinking about information I didn’t state and that is the ESPN is far more expensive to the cable provider than any other channel [1] & [2]. So I think your (arbitrary?) choice of ESPN in your example might cause some unintended bias; your example assumes all the wholesale costs per channel to be the same? That make sense in general, but it is unfortunately not the case with ESPN.

    Fortunately though it seems that some cable providers are starting to realize they are leaving money on the table by forcing everyone to pay for ESPN[3]. Which of course doesn’t invalidate your general thesis, only your example that includes ESPN.

    [1] http://online.wsj.com/article/SB10001424052970204083204577080793289112260.html
    [2] http://www.businessweek.com/magazine/cables-espn-dilemma-wildly-popularbut-costly-09292011.html
    [3] http://www.deadline.com/2012/01/cox-scraps-espn-and-other-pricey-channels-for-new-low-cost-tier/

  17. If there was a way for cable companies to peek into your mind and determine you exact willingness to pay for each show and then price it somewhere just below that, they’d love to do that. But given that they can’t, and the wide variance in people’s willingness to pay for each show, cable companies and customers are better off bundling. I think the way you are reasoning here is common (“I’d pay $20 so why don’t they charge that”) but when you have millions of people with widely varying preferences you need to come up with pricing systems for all of them at once.

  18. Great post Chris. Any thought on why tech companies don’t bundle their devices. For instances, would it be smart for Apple or Microsoft to give you discounts if you are building a suite of their devices (eg. Apple laptop, iPad, phone). There is a real fight right now to get consumers to adopt one system for all their mobile and computer devices and I wonder if the bundling system would work for them.

    Personally, as a consumer I would be very interested if Google or Apple or even Microsoft offered discounts for those users who already own one of their devices.

  19. Most hardware companies give bulk discounts to big enterprise customers but that’s about it. I think there is lower variance in willingness-to-pay for these devices. Also might be an invitation for abuse by resellers.

  20. all valid points. Perhaps they can offer it in with a time restriction approach. For instance, you get the discount only if you use your devices for 1 or 2 year period. If you sell the devices then the warranty is void and you pay back the difference in price. FYI. I am just throwing ideas out there!!

  21. I also recall bundling being used as defense against commoditization, if the commodity good is bundled with the more differentiated good (in your example, it’s ABC/NBC/CBS etc bundled with ESPN in the “basic” cable plan). Bundling-as-commodity-defense can fall apart though when all competitors respond by bundling making the bundle, in fact, a commodity.

  22. I have a similar sentiment as @twitter-581200309:disqus ..rather pick small bundle of channels or bundle of popular shows.

    So similar question – should the cable companies be experimenting with more bundling options?

    Also – do you think cable companies are facing a price anchor problem when consumers compare $100/month for everything vs a la cart of ~$22 season (amazon tv pass) for just each show they want ?

  23. I’d agree that there is a difference between “econs” and “humans”, but in this case it favors bundling. If you assume true perfect information, then you would know exactly how many hours of every channel that you would watch a year in advance, and be able to say that TNT is worth $1.50 a month because you would watch 6.5 hours a month. Which is of course is ridiculous. You wouldn’t really know what you want to watch until you actually see what’s on.

    I would argue that in this case a real person would underestimate the utility of a channel. If there was a “sports” bundle, it probably wouldn’t include TNT (“we know drama”, or as I call it the “Law and Order” channel) or TBS (“very funny”), but you need those two channels to get the NBA and MLB playoffs. I probably wouldn’t pay for Spike but right now I’m watching “A Few Good Men”. So I prefer bundling because there are many channels that I wouldn’t buy but have shows that I “impluse watch”.

  24. Great post, Chris. Thanks for sharing. There are additional pricing-related factors that favor bundling cable TV. The affiliate fees paid to bundled content providers give them all a reliable income stream. In an a la carte world, to make up for loss in volume, cable channels would need/want to increase the per user affiliate fees. MVPDs would pass the fees along to consumers causing the price for the popular channels to greatly increase. The less popular channels could go out of business, suffering from declining advertising revenue, which was propped up by wide distribution resulting from bundling, and declining affiliate fees.

  25. Bundling has one other big, big advantage. It prevents the price going down to the marginal cost to deliver. I give you newspapers and cable as the example.

    Because News is not bundled some of the less desirable papers were willing to distribute online for free. People thought, ok, that is good enough and it was really hard for the higher end players to maintain pricing. Yes I know WSJ and Financial Times did ok, But could you imagine how many more people would pay if the choice was you got all the major papers or absolutely none?

    In cable if it was un-bundled I might be willing to take Versus, Comcast Sports, and Fox Sports for free and forgo ESPN. The other three are good enough. But nope if I want any, I will get all.

    And I’m not saying its necessarily bad for consumers either as you correctly point out. I might say, why do I want to pay Netflix for their huge library there are movies I have no desire to see, but given the fact it isn’t going to cost me extra if I rent that obscure movie I’m willing to do it and that might end up being a great choice.

  26. Great post Chris. Thanks for these examples.

    Why don’t online subscription sites bundle together their subscriptions? wsj.com/nytimes.com, economist.com/newyorker.com would make great subscription bundles. Unless online publications start working together, Apple and Amazon are the only storefronts in a position to start offering these bundles taking a margin for themselves.

  27. I agree. The economic logic for those bundles would be compelling. I don’t pay for e.g. WSJ now but would as part of a bundle of top-tier business periodicals.

  28. I think what you are saying is bundling can be anti-competitive by deterring competition? If so, I agree, and so do economists, who have lots of papers showing that to be true.

  29. Thanks, good point. As you say, the actual economics of cable are more complicated than I presented with affiliate fees etc. I think you are probably right that an a la carte world would hurt the less popular channels. Not sure if it would really help the popular channels though…

  30. I agree… Unbundled cable TV would hurt content providers of all sizes. In turn, higher prices for popular channels and the disappearance of less popular ones would hurt consumers, too.

  31. Customers might receive more content for their dollar, but that doesn’t mean they are better off.

    I think the math should include a “customer experience” term.

  32. that would be awesome. I would love to have NYtimes, WSJ, FT all in one bundle. I would even put up with one or two subscriptions that I don’t really want if the others were in the right bundle. My guess is that there is too much competition between news outlets for that to happen

  33. MJNCR says:

    This ignores the issue that at this point there are really 2-3 things worth paying for (pro sports, HBO) and 100s that are basically valueless. So you are really saying that what is “worth” $10 I am paying $30 for because it is not available for $10. There is no value to me.

    The reality is that cable bundling pivots on pro sports.

  34. This explains what annoys me in cloud hosting solutions with their claimed “pay for what you use” approach. Everything is unbundled and you have to weigh every minor technical decision against the cost it incurs.

  35. Agree sports and HBO are big, but if you poll the population people also have their favorite shows on other channels. I’d be careful extrapolating from yourself + your friends.

  36. Absolutely agreed. If I were given a NO Sports option that was reasonably priced, I’d become a cable customer. As is, I am not a cable customer because to get anything I consider worth watching I have to buy the highest price package and it’s a non-starter for me. A-la-carte would even work for me, I pay for just HBO, for example, especially if I could watch on my iPad.

  37. JamesHRH says:

    Discovery value plays a big role. How would I have learned to love storage lockers without bundling?

  38. JamesHRH says:

    Phil – there are so many positives. NFL gets potential new fans, channels get to experiment which creates potential breakout hits…..

    @cdixon:disqus full marks for a thoughtful assessment of something that is quite often considered the Death Star of the Cable Empire.

  39. JamesHRH says:

    I did this exercise once, IRL.

    The short strokes: internal company financial analysis crashes head on with the consumer’s time value of money (how much time do I want to spend choosing cable packages).

    Very few people actually care enough to make a rational decision. The just want to get what they want without getting the feeling that the have just been taken,

    Not surprisingly, the answer was three. Basic, Loaded & Choices in the middle.

    Over time, the incentivizing can tweak – I assume, I was not around for that part but I believe in the Freakonomics concept of nudges (but not a lot of the other ideas, FWIW) – the percentages between the levels, but not dramatically.

  40. Thank you, Chris for pointing me to this! I’ve probably read it back in the day, but it’s amazing how a 12 year old post explains my feelings towards “cloud” hosting pricing.

  41. JamesHRH says:

    @cdixon:disqus this really is a compelling insight. Top shelf stuff.

    It makes me recall an article about Michael Dell that, simply stated, said that his gift was to put the right components/performance together at the right price point……product design as a bundling paradigm!

  42. Good point, but I think given the choice of doing so, system 1 actually would weight for utility on a 20-30 channel basis. No one is going to do a system 2 calculation really, but I’ll bet that if they did a study, the natural reaction would be for people to value the 29th and 30th channel far less than the 10th and 11th, more so than they would if they were asked to assign a value independent of its ranking.

  43. Speaking of Kahneman, interesting to consider Peak-End rule for this ‘experience’. I think so many customers have had such poor experiences with providers, that the emotional pain factors into their (perhaps economically “irrational”) decision making process, contributing to a desire to ditch bundled cable co. packages and migrate to the internet.

    I understand the bundling vs. à la carte debate is theoretical here, but have to consider the larger context when talking about pricing, which includes service, content, and experience. Customers pay for more than content.

    And on the plus side, maybe I wouldn’t waste so much time watching other crap programming just because it came bundled :)

  44. Bundling is like the all you can eat buffet. Seems like you’re getting a good deal, til you try the fare. Honestly, all this has done is help sustain the cable monopolies and extend the monopoly to the content producers inflating the salaries of sport stars and actors. This, while we can’t pay teachers and other important producers in our society.

    I stopped getting a good deal when I had to pay more for HD and no less for SD. Huh? Cable service is pretty crappy on almost every front when you compare it to other competitive service models/applications. Builds nice skyscrapers in Philly.

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