Product bundling is the practice of selling two or more products together as a package deal for a single price. A series of examples will indicate how widespread product bundling is. Computer software is often bundled with the hardware and sold as a package deal. Restaurants offer “fixed menus’’ which include soup, main course, dessert, and coffee for a single price. Automobiles offer luxury or sports packages that must be sold in conjunction with the basic vehicle. Retailers offer free parking if you buy something at their store. Gas stations offer free games when you buy gas. Professional sports teams and symphony orchestras offer season tickets that bundle together a variety of events for a single price. 19
The theory of pricing product bundles has been examined by Stigler, Adams and Yellen, and Schmalensee. 20 Put simply, the firm has a profit incentive to bundle products together when doing so allows the extraction of a greater degree of consumer surplus from the potential customers. In general, it is optimal to offer the products both separately and in the bundle, since some consumers will only want one of the products and would not be willing to pay the bundle price. Offering both the bundle and the separate products is known as “mixed” bundling, as opposed to “pure” bundling, where the products are only available as a package deal.
Consumer surplus is measured in dollars by the excess of the consumer’s reservation price over the actual price paid for an item. If the seller raises the price by a
'“See H. Leibenstein, “Bandwagon, Snob, and Veblen Effects in the Theory of Consumer Demand,” Quarterly Journal of Economics, May 1950, pp. 183-207.
''’Note that there will be implications for product-line pricing here, since the bundle of goods may be a substitute for a product, or another bundle of products, in the firm’s product line.
20 George, Stigler, “United States vs. Loew’s Inc.: A Note on Block Booking,” Supreme Court Review, 1963, pp. 153-157; William J. Adams and Janet L. Yellen, “Commodity Bundling and the Burden of Monopoly,” Quarterly Journal of Economics, 90 (May 1976), pp. 475-98; Richard Schmalensee, “Commodity Bundling by Single-Product Monopolies ," Journal of Law and Business, 25 (April 1982), pp. 67-71.
dollar, but the price remains less than or equal to the buyer’s reservation price, the buyer will still buy the product but will receive one dollar less in consumer surplus. Instead, the extra dollar will be added to the producer’s surplus, also known as profit. If the firm could treat each buyer separately, it would attempt to charge each buyer his or her reservation price, thus completely exhausting consumer surplus and maximizing producer surplus. 21
In practice the seller will be unable to determine each buyer’s reservation price and will simply assume that buyers have a range of reservation prices, such that there is a negatively sloping demand curve for both the products separately and collectively (the bundle). The seller will typically increase profit (over that available from pricing the products separately) by raising the prices of each product if sold separately and offering the bundle as a package deal at a price which is less than the sum of the prices of the components of the bundle. Thus buyers who only want one, or some subset, of the products in the bundle must pay more than they otherwise would have, and other buyers who would not have purchased all the products separately end up buying the bundle because it is the cheapest way to get the products that they do want. Raising the price of individual products will cause the firm to lose some sales, but the gain in sales resulting from the availability of the bundle typically outweighs that loss, such that the overall sales and profit are higher than if the products were priced separately. 22
Quantity Discounts. The theory of bundling explains why some firms offer a given product in several different sizes (such as small, medium, large, and jumbo bottles of Coke), and why some consumers buy only the small size and others pay more to buy larger sizes (but at a reduced price per unit, such as per ounce). The larger sizes can be viewed as bundles, or multiples, of the smallest size of the same product, and the buyer is given a discount for purchasing in quantity. Similarly, when a product is priced at, say, $3 each or two for $5, the buyer is essentially getting a discount on the second unit of the product if he or she chooses to buy that additional unit.
Why are some people induced to buy in quantity while others are not? A person will demand the extra units of the product bundled together in the larger size if the incremental cost to the consumer is less than the consumer’s reservation price for those extra units.
2l In Appendix 9A we referred to this practice as first-degree price discrimination. In fact, product bundling is a technique by which the seller can practice price discrimination, since it divides potential buyers into groups based on their willingness to buy one or other of the products separately, or the bundle of products, and allows the seller to discriminate against those willing to buy only one or a subset of the products.
22 Adams and Yellen, and Schmalensee, cited in footnote 20, determine the precise conditions under which mixed bundling will be a more profitable strategy than either pure bundling or individual prices only. The distribution of customers’ reservation prices is critical, as is the relationship of marginal costs to the prices chosen. They conclude that mixed bundling is a more profitable pricing strategy under a wide variety of circumstances.
Example: A consumer might be willing to pay a maximum of $1 for a 10 ounce bottle of cola, if she was very thirsty. The store price is, let us say, 70 cents. Since the asking price is less than the buyer’s reservation price, the seller will make the sale. But suppose the seller also has a 20 ounce bottle of the same cola for $1.15. Will the consumer buy that one instead? Suppose that her reservation price on the 20 ounce size is $1.50, indicating she expects 50 cents worth of extra utility from the additional 10 ounces. Since the additional 10 ounces will cost her only 45 cents more, she will buy the larger size. Finally, suppose the store also has a 30 ounce size, priced at $1.75. The consumer’s reservation price for the 30 ounce size is, say, $1.70, indicating her willingness to pay only another 20 cents for the additional 10 ounces. Since the additional quantity would cost her 60 cents, however, she chooses the 20 ounce size. The seller collects $1.15 from this customer, compared to only 70 cents that would have been collected if the cola had been price uniformly per ounce regardless of bottle size. Assuming that the seller’s marginal cost of the extra 10 ounces is always less than the price premium attached to the larger sizes, the seller will have increased both sales and profit. Of course, more thirsty customers, or someone buying the family groceries, is likely to buy the 30 ounce size, because their reservation prices are more likely to exceed the price asked.
In summary, the firm should consider offering its products in bundles as well as separately, because bundling may be expected to increase the firm’s profits. Bundling includes the packaging together of different products, the offering of the same product in different-sized containers, and the offering of quantity discounts for multiple units of the same product. Given the availability of bundles, the firm would then consider raising the prices of some or all of the individual products, of the smaller sizes, or of the single units, in order to extract more consumer surplus from those who want only part of the bundle. In practice, without full information on the distribution of consumers’ reservation prices, the firm would need to conduct market research to estimate this distribution, or, if the search costs of that appear to be prohibitive, the firm would experiment by introducing product bundles and by changing the prices of individual units. If profit increases as a result of these changes, the firm may wish to fine- tune its pricing structure further until maximum profits appear to be attained.
In oligopoly markets a firm may be forced into bundling as a pricing strategy by the actions of its rivals. If the rivals offer product bundles, they will be capturing those consumers with relatively high reservation prices on the additional units included in the bundle, and the firm may feel it is necessary to seek its share of these customers. Note, however, that the existence of rivals constrains the oligopolist, to some degree, if it attempts to raise the prices of its separate products, its smaller sizes, or its single units. With the availability of substitutes, and consumer awareness of those substitutes, these price increases will meet a relatively elastic demand response. Thus the greater is the degree of similarity between the rivals’ products, and the easier it is for consumers to evaluate the attributes of the products in the market, the less profitable one would expect product bundling to be.