Everyone knows that airlines charge different prices to different customers for the same flight. Senior citizen and student discounts are obvious. Universities advertise their scholarship policies—even if they don’t always advertise that this is a way of increasing profit! But other types of price discrimination are more subtle and difficult to see. Let’s take a look at tying and bundling, two types of price discrimination that are hidden to the untrained observer.

Why are printers so cheap and ink so expensive? As we write this chapter, one remarkable Hewlett-Packard (HP) photo printer/scanner/copier sells for just $69. A full set of color ink cartridges, however, will set you back $44. At that price, it almost pays to buy a new printer (which comes with a cartridge) every time you run out of ink! Clearly, HP is pricing its printers low and making its profit from selling ink. HP is not alone in pursuing this strategy. Xbox game consoles are priced below cost, and Xbox games are priced above cost. Cell phones are priced below cost and phone calls are priced above cost. Why?

Think of HP as selling not printers and ink, but the package good, “ability to print color photos.” HP wants to charge a high price to consumers with a high willingness to pay and a low price to consumers with a low willingness to pay. Consumers with a high willingness to pay for the “ability to print color photos” probably want to print a lot of color photos. Consumers with a low willingness to pay probably want to print only the occasional color photo. By charging a high price for ink, HP is charging high-willingness-to-pay consumers a high price. Yet, because the price of printers is low, consumers who have only a low willingness to pay are charged a low price.

HP’s pricing scheme is especially brilliant because the price is so flexible. Instead of two prices, there are many: one for a consumer who prints 10 photos a month, another for a consumer who prints 15 photos a month, and yet another for a consumer who prints 100 photos a month.

For HP’s scheme to work, it’s critical that no one else but HP be allowed to sell ink for HP printers—HP must tie its printers to HP ink cartridges, which is why this form of price discrimination is called tying. If competitors could easily enter the market for ink, the price of ink would fall to marginal cost and HP’s pricing scheme would fall apart. HP manages to keep competitors out of the market for ink in a clever way—the HP ink cartridge contains not just ink, but also a crucial and patented component of the printer head. Since other firms are forbidden by law from manufacturing the printer head, and since the head and the ink must be packaged together, HP manages to keep competitors out of the market for ink. Well, almost. There is an active market in refilling HP printer heads, which is much cheaper than buying them new.

269

HP’s strategy illustrates both the benefits and costs of price discrimination. Price discrimination, as usual, may increase output by lowering the price to users who only want to print the occasional photo. Price discrimination also spreads the fixed costs of research and development—which are extensive for color photo printers—over more users, thus encouraging more innovation. But putting printer heads in the ink cartridge rather than in the printer probably raises the total cost of printing. Although there are some advantages to disposable printer heads, HP is spending the extra money not to benefit consumers but to keep competitors out of the ink business. Since the extra costs of production don’t benefit consumers, they are a cost of price discrimination.

By the way, in addition to price discrimination, HP is probably also taking advantage of a bit of consumer irrationality. When comparing printers, consumers should look at the total price, printer plus ink, over the entire lifetime of the printer. But it takes some work to estimate the total price, and consumers who are shortsighted may focus on amazingly cheap printers rather than astonishingly expensive ink.

Goods are bundled when they must be bought in a package. Nike doesn’t sell right and left shoes individually; Nike sells shoes only in a right-and-left bundle.* Toyota doesn’t sell engines, steering columns, and wheels it sells a bundle called a car. As the examples suggest, most bundling is easily explained as a way to reduce costs. But why does Microsoft sell Word, Excel, Outlook, Access, and PowerPoint in a bundle called Microsoft Office?

Unlike buying a car piece by piece, it would not be difficult for consumers to buy the Office products individually and assemble them as they wanted. Almost every car buyer wants an engine and four wheels, but not every Office buyer wants Microsoft Access. So why does Microsoft bundle? Note that Microsoft does sell most Office products individually, but the sum of the individual prices far exceeds the price of the bundle, so most consumers buy Office.

Bundling is a type of price discrimination. Suppose that we have two consumers, Amanda and Yvonne, whose maximum willingness to pay for Word and Excel is as given in Table 14.2.

Microsoft can sell each product individually or it can sell Word and Excel together as a bundle. Let’s calculate profit for each possibility. To make our lives simple, we will assume that the marginal costs of production are zero (which is approximately true—it costs very little to download Word).

If Microsoft sets prices individually, there are two sensible choices for the price of Word: $40 or $100. If Microsoft sets a price of $40 for Word, both Amanda and Yvonne will buy and profit will be $80. If Microsoft sets a price of $100, Amanda alone will buy but profit will be higher, $100. Similarly, Microsoft can sensibly sell Excel for $20 or $90. Profit is higher at a price of $90 because 2 × $20 = $40 < $90. If Microsoft sets prices individually, therefore, it will charge $100 for Word and $90 for Excel for a total profit of $190 = $100 + $90.

270

Now consider bundling Word and Excel and selling them as Office. What price to set? To calculate this, we need to know the maximum amount that Amanda and Yvonne will pay for Word plus Excel. We calculate this in Table 14.3.

Amanda is willing to pay up to $120 for the Office bundle and Yvonne is willing to pay up to $130. What is the profit-maximizing price for the Office bundle? Microsoft will set the bundle price at $120 and sell two Office bundles for a total profit of $240. What has happened to Microsoft’s profit compared with when it set prices individually? When Microsoft priced Word and Excel individually, its profit was just $190. When Microsoft sells Word and Excel in a bundle called Office, its profits increase by $50, or 26%. Why?

Notice that in this example bundling is equivalent to a sophisticated scheme of (almost) perfect price discrimination. At a bundle price of $120, we can think of Amanda as being charged $100 for Word and $20 for Excel, and Yvonne as being charged $40 for Word and $80 for Excel. But in order to implement this price discrimination scheme directly, Microsoft would have to know a lot about Amanda’s and Yvonne’s willingness to pay for Word and Excel and Microsoft would have to prevent Yvonne from buying Word at $40 and reselling it to Amanda (and similarly keep Amanda from reselling Excel to Yvonne). When Microsoft bundles, however, it’s easier to price-discriminate because although Amanda and Yvonne place very different values on Word and Excel, they have similar values for Office. Microsoft, therefore, knows more about the demand for Office than about the demand for Word or Excel, and the more Microsoft knows about demand, the easier it is for Microsoft to price-discriminate.

As with other forms of price discrimination, bundling can increase effici ency especially when fixed costs are high and marginal costs are low. In our example, when Microsoft set prices individually, only Amanda bought Word and only Yvonne bought Excel. This is inefficient because Amanda values Excel at $20 and the costs of providing Excel is zero (and similarly for Yvonne and Word). When Microsoft bundles, Amanda and Yvonne buy both Word and Excel, which increases total surplus.

Total surplus without bundling is $190. What is total surplus with bundling? It’s $250. Check that you understand where this number came from.

Furthermore, the costs of producing software are primarily the fixed costs of research and development. Bundling means that these fixed costs are spread across more consumers, which raises the incentive to innovate.

Bundling is quite common. LexisNexis sells online access to a bundle of thousands of newspapers, journals, and references. Disneyland bundles many attractions and sells them for a single entrance fee. The buffet at China Garden is a bundle of food. Bundling, however, can be controversial. Cable TV operators sell television channels in a bundle. Recently, this practice has come under attack with many politicians arguing for “à la carte” pricing, that is, pricing by the channel. Critics of bundling complain that consumers should not be forced to pay for channels that they don’t watch. The claim seems sensible at first, but does it add up? Would the critics also say that the buffet at China Garden forces consumers of kung pao chicken to pay for unwanted egg foo young?

271

Bundle pricing makes sense for cable operators because customers have a high willingness to pay for some channels and a low willingness to pay for other channels, but the high- and low-value channels differ by customer. The demand for the bundle, however, is more similar across customers. Since it costs the cable company very little to offer every channel to every customer, bundling can increase profit and efficiency. The idea is exactly the same as we showed with the Office example. In Table 14.3, change Word to the Food Network and Excel to Lifetime (and see also end-of-chapter Challenges question 1).

As usual, bundling is most likely to be beneficial in a high fixed cost, low marginal cost industry. Cable TV is a high fixed cost, low marginal cost industry. Over the last decade, for example, one cable operator, Comcast, spent $40 billion laying new cable. Once the cable is laid, the marginal cost of carrying another channel is low, especially with high bandwidth fiber optic cable. In cases like this, bundling doesn’t cost the firm very much (and may even be cheaper than individual pricing), and by increasing profit, it increases the incentive to spend resources on the fixed costs of development.