Bundling

Surely you've gone shopping and noticed that two goods are being sold together as a package deal. Typically, the two goods are related and make sense to buy together, like laundry detergent and fabric softener. Sometimes, one good is a necessity, and the other is just a perk or luxury that sweetens up the deal. If you are buying a car, you can get the base model and add a sunroof as an add-on, or you can purchase the next model up that already includes a sunroof and heated seats for a comparable price of adding a sunroof to the base model. This pricing strategy is called bundling, and it is done very purposefully by companies to maximize revenue. But just how do they do that? Well, suppose you'll have to stick around...

Bundling Definition

First thing first, the bundling definition is when companies package two or more items together so that they can advertise and sell them as a package deal. A company will group goods or services together under one price so that the buyer is either encouraged or forced to buy both of the goods that make up the bundle, even if they initially only wanted one of the goods.

The purpose of bundling is to increase the number of goods sold while reducing the cost of advertising and distribution of the goods. If a firm bundles two goods and the consumer is only looking to buy one of the bundled goods, they are enticed to buy the other goods as well. By having consumers buy two goods together, the firm reduces its overall costs.

It is also important to note that bundling is only effective when the two goods have negatively correlated demands. This means that the reservation price for one good is higher in one area and lower in another, while the reservation price for the other good is lower in the first area and higher in the second area. If demand was positively correlated, it would mean that one area would be willing to pay more for both goods. This would cause the firm to miss out on revenue since they set the bundle price at the lowest reservation price.

Monopolies will also use bundling as a way to capture more of the consumer base and increase their market power. They can do this by lowering the price of the good over which they have monopoly power while bundling it with a good that they do not have a monopoly over. Not only will consumers still have to buy the monopoly good, but the monopolist will reward the consumer for buying the competitive good from them by bundling it with the monopolized good at a reduced price.

Product Bundling Characteristics and Types

There are two types of product bundling characteristics. There is pure bundling and mixed bundling. The use of each method is determined by the type of goods and whether they are complements or substitutes for each other. Pure bundling occurs when a company decides to sell products only as a bundled package. They are not available to buy separately. Mixed bundling is when a company sells goods both as a bundle and separately.

Product Bundling: Pure Bundling

Pure bundling increases a firm's revenue because it relies on the consumer's desire to buy one portion of the bundle. If the consumer values one part of the bundle, they will have to purchase the other half. This concept is known as tying. Pure bundling is a form of tying because tying is when a firm requires the consumer to purchase one good so that they can buy another good. A firm will choose pure bundling when they have zero to low marginal production costs.

Pure bundling is useful to firms when they cannot price discriminate or tailor their prices to generate maximum revenue. For example, the demand for a good is higher in one area than it is in another area. To even out demand, maximize revenue and make it more predictable, the firm would bundle the first good with a second good. The demand for the second good must be higher in the area where the other good's demand was lower. This way, both goods are sold in both areas.

The drawback of pure bundling is that if the bundle price is out of the consumer's budget and the consumer does not have the choice of individually buying the goods, the firm loses out on the sale of both the bundle and the individual product. Economically, we would say that by using pure bundling, the company forfeits the consumer surplus they could have captured had they allowed consumers to purchase just one or the other good.

Product Bundling: Mixed Bundling

Mixed bundling works to increase profits because it offers the consumer an option to buy two goods separately for their individual prices or to buy them as a bundle. This works as long as the price of the bundle is lower than the combined price of both goods included in the bundle. Typically, mixed bundling is the best option to bring in the most revenue since it encourages the consumer to purchase the bundle of goods but still allows them to only buy one if they want to. This is the preferred method by firms when they experience marginal production costs.

Mixed bundling allows the firm to capture the greatest amount of consumer surplus. Since they motivate people to buy both goods via the bundle, they maximize the revenue from those who want to purchase both while also capturing those consumers who only want to buy one good or the other.

Bundling Pricing

Bundling pricing can get confusing. To appropriately price bundles, we have to look at the price of both goods, how their demand correlates, and if there are marginal costs associated with their production.

When looking at a graph, the price of the goods is denoted as r, representing the consumer's reservation price. We can assume that a consumer will only buy the bundle if the price of the bundle (P_B) is less than the total of both their reservation prices for good 1 (r₁) and good 2 (r₂).

\[P_B=r_1+r_2\]

Figure 1 below shows the bundle price (P_B) as the boundary between consumers buying the bundle versus not buying it.

Fig. 1 - Pure Bundling

As long as r₁ + r₂ is less than the price of the bundle (P_B), they will fall in region 2, where consumers do not buy the bundle. In the case of pure bundling, which is what Figure 1 shows, they cannot buy either good. If r₁ + r₂ is greater than P_B, then the consumers fall in region 1 and do buy the bundle. With mixed bundling, we have to take marginal costs into account.

Bundling Example

Let's go over a bundling example using some numbers. The first example will be pure bundling using only two consumers, while the second will be mixed bundling. Mixed bundling can be a little more complicated since it requires us to take the existence of marginal costs into account when deciding how to select and price the bundle.

Pure Bundling Example

If the goods are sold separately, the highest price the firm could charge for good 1 is $110 and $30 for good 2. The highest yield from each consumer will be $140, for a total profit of $280. If the firm chooses to bundle the goods, Joe values both goods at $160, and Fred values them at $170.

The highest the bundle price can be is $160 because, otherwise, Joe will be excluded, and the total profit from both goods will be $170. If the bundle costs $160, they will sell two, and the total profit will be $320. Bundling the goods is more profitable. If the demand for the two goods does not have a strong negative correlation and the firm experiences marginal production costs, the firm might go with mixed bundling.

Another example of a pure bundling strategy would be a gym that allows its members to use the entire facility whenever they want. The gym pass includes the use of the gym, changing rooms, basketball courts, pool, and sauna. You would not be able to purchase a pass only for the gym or the pool.

Mixed Bundling Example

Now, let's look at a situation where mixed bundling will provide maximum profit. In this case, a firm has to consider the marginal cost of production. A good example of mixed bundling is a dinner menu at a restaurant. You can choose to buy the dinner menu that includes an appetizer, salad, main course, dessert, and espresso, for one set price, or you can choose to order all of these items separately. If you buy them separately, their individual prices will add up to more than the cost of the dinner menu.

Let's say the marginal cost for good 1 is $25 and for good 2 is $20.

The firm has three pricing options:

• No bundling: the price of good 1 is $45 and $85 for good 2.
• Pure bundling: the price is $100.
• Mixed bundling: the individual price is $84 per good or $100 for the bundle.

If the firm sold the two goods separately, only consumer A would buy good 2 because its price is above the other's reservation price, but Consumer A would not buy good 1 because it is above A's reservation price. Consumers B, C, and D would buy only good 1. The total profit for the firm would be:

\(1($85-$20)+3($45-$25)=$125\)

If they were to use pure bundling, all four consumers would buy the bundle, and the total profit would be:

\(4($100-$20-$25)=$220\)

If they use mixed bundling, Consumer A will buy only good 2 for $84, and consumer D will buy only good 1 for $84. They are enticed to buy these corresponding products because the price is just below their reservation price. Consumers B and C will buy the bundle for $100.

\(1($84-$20)+1($84-$25)+2($100-$20-$25)=$233\)

The mixed bundle fetches the highest profit.

Figure 2 shows us where four different consumer reservation prices fall. Since consumer A's reservation price falls below good 1's marginal cost, it is not in the firm's best interest to try and capture consumer A in their market bundle since they would be losing money. The same goes for consumer D and good 2.

Fig. 2 - Mixed bundling with marginal costs

Bundling Benefits

Some bundling benefits are:

• higher profits,
• lower distribution costs,
• and lower advertising costs.

When a firm can bundle goods together, it can increase the quantity that they sell and increase its average order price. Either they choose pure bundling, and consumers have to buy both goods in the bundle for a higher price than they would pay for only one, or they choose mixed bundling and sell goods to everyone willing to pay their price.

Bundling means the firm can reduce the amount spent on advertising each product since it will be exposed to the consumer via the other good, or the two goods can be advertised together. Bundling also reduces distribution and storage costs since the bundled goods must be located close to each other so that the bundle can be honored. Companies won't have to worry about shipping different products to as many different locations.