Price discrimination and bundling

Errol D’Souza

Email: errol@iima.ac.in
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 Errol D’Souza

Firms with market power face a downward sloping demand

curve

To sell an additional unit of output the firm must lower

its price to the consumer who buys the additional
unit as well as to all other consumers.

As in order to gain an additional consumer the monop-

olist has to lower price to all consumers it limits
his incentive to serve more consumers

Hence monopolist undersupplies product relative to

efficient outcome.

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 Errol D’Souza

What if monopolist can charge different prices to different

consumers? – Price discrimination

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 Errol D’Souza

What if monopolist can charge different prices to different

consumers? – Price discrimination

To do so successfully the monopolist must be able to

overcome two obstacles -

● Identify who is who on the demand curve.

Monopolist must know how consumers differ in
their demand for its good. Only then can
they identify consumer willingness to pay.

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 Errol D’Souza

What if monopolist can charge different prices to different

consumers? – Price discrimination

To do so successfully the monopolist must be able to

overcome two obstacles -

● Identify who is who on the demand curve.

Monopolist must know how consumers differ in
their demand for its good. Only then can
they identify consumer willingness to pay.

● Problem of arbitrage
Monopolist must be able to prevent those
customers who are offered a low price from
reselling their purchases at a higher price
to other consumers.

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 Errol D’Souza

First degree price discrimination -

This occurs when a monopolist is able to charge the
maximum price each consumer is willing to
pay for each unit sold.

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 Errol D’Souza

First degree price discrimination -

This occurs when a monopolist is able to charge the
maximum price each consumer is willing to
pay for each unit sold.

Suppose you have inherited five antique cars and are

interested in selling them.

Two collectors have approached you and whilst talking to

them you discover that the price they are willing
to pay is as follows.
Willingness to pay to own one car Rs. 50 Lakh
” ” ” ” ” second car Rs. 40 Lakh
” ” ” ” ” third car Rs. 30 Lakh
” ” ” ” ” fourth car Rs. 20 Lakh
” ” ” ” ” fifth car Rs. 10 Lakh
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 Errol D’Souza

First degree price discrimination means you are able to

sell
First two cars at a price of Rs. 50 Lakh, one to each buyer
Two additional cars at Rs. 40 Lakh, again one to each
buyer
Sell the fifth car at Rs. 30 Lakh to either one of
the buyers.
Revenue from discriminatory
pricing policy Rs. 210 Lakh

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 Errol D’Souza

First degree price discrimination means you are able to

sell
First two cars at a price of Rs. 50 Lakh, one to each buyer
Two additional cars at Rs. 40 Lakh, again one to each
buyer
Sell the fifth car at Rs. 30 Lakh to either one of
the buyers.
Revenue from discriminatory
pricing policy Rs. 210 Lakh

Under uniform pricing policy

Price per car No. sold Revenue

Rs. 50 Lakh per car 2 cars sold Rs. 100 Lakh
Rs. 40 Lakh per car 4 cars sold Rs. 160 Lakh
Rs. 30 Lakh per car 5 cars sold Rs. 150 Lakh
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 Errol D’Souza

Under first degree price discrimination the monopolist

extracts the entire surplus that the consumer is
willing to pay.

Is this a theoretical curiosity? How does a monopolist have

sufficient information and ability to prevent arbitrage
so as to implement a pricing scheme in which a
different price is charged to each buyer for each unit
bought ?

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 Errol D’Souza

Under first degree price discrimination the monopolist

extracts the entire surplus that the consumer is
willing to pay.

Is this a theoretical curiosity? How does a monopolist have

sufficient information and ability to prevent arbitrage
so as to implement a pricing scheme in which a
different price is charged to each buyer for each unit
bought ?

Problems of identification and arbitrage prevention

are not insurmountable.

Two-part or nonlinear pricing schemes

1. A fee such as a membership fee that entitles
the consumer to buy the good.
2. A price or usage fee charged for each unit
the consumer actually buys. 11
E.g.: Clubs and theme parks
 Errol D’Souza

Consider a monopoly seller, say a jazz club, where people

meet for drinks and music.

Let the club’s customers be more or less the same

in their demand for the club’s services which
consist mainly of selling drinks.

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 Errol D’Souza

Consider a monopoly seller, say a jazz club, where people

meet for drinks and music.

Let the club’s customers be more or less the same

in their demand for the club’s services which
consist mainly of selling drinks.

Q : number of drinks consumed in an evening

P : price per drink
V : maximum amount a consumer would be willing
to pay for just one drink

P V  Q
Cost function of the club
C Q   F  cQ
F : fixed cost of operating the club 13
c : cost per drink served
 Errol D’Souza
Price
V
Demand P V  Q

c MC C Q   F  cQ

Quantity
V

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 Errol D’Souza

Note:
The marginal revenue (MR) associated with a demand
curve is the change in total revenue when the
sale of output changes by 1 unit.

The general formula for a linear demand curve is given

by P = a – bQ where a and b are positive numbers.

The corresponding marginal revenue curve for a linear

demand curve is MR = a – 2bQ.

Hence when the demand is given by P = V – Q, the

marginal revenue is MR = V – 2Q .

Profit maximization for firm is where marginal revenue

equals to marginal cost, or, MR = MC.
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 Errol D’Souza
Price
V
Demand P  V  Q
V c
2

c MC
MR

V c V 2 Quantity
V
2

Total Revenue = PQ  VQ  Q 2

Marginal Revenue = V – 2Q

V c V c
Setting MR = MC gives us Q and P
2 2
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 Errol D’Souza
Price
V
Demand
V c
2

c MC
MR

V c V 2 Quantity
V
2
V c V c
Setting MR = MC gives us Q
2
and P
2
V  c
2

Hence, monopolist earns a surplus of  U  P  c Q 

4

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 Errol D’Souza
Price
V
Demand
V c
2

c MC
MR

V c V 2 Quantity
V
2
V c V c
Setting MR = MC gives us Q
2
and P
2
V  c
2

Hence, monopolist earns a surplus of  U  P  c Q 

4

Monopoly profits if there are n customers will be given by

  n U  F  n
V  c
2

F
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 Errol D’Souza
Price
V
Demand
V c
2

c MC
MR

V c V 2 Quantity
V
2
Suppose V  10 and c  2
V c V c
P 6 Q 4
2 2
Surplus earned per customer  P  c Q =(6 – 2)*4 = 16

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 Errol D’Souza
Price
V a
Demand
V c
b
2 d

c MC
MR

V c V 2 Quantity
V
2
Suppose V  10 and c  2
V c V c
P 6 Q 4
2 2
Surplus earned per customer = (6 – 2)*4 = 16
At uniform price of 6, customers of the club enjoy 20
consumers surplus given by striped triangle abd
 Errol D’Souza
Price
V a
Demand
V c
b
2 d

c MC
MR

V c V 2 Quantity
V
2
abd represents amount consumer was willing to pay for
units of output up to (V – c)/2 but which the club does
not extract as it charges a uniform price.
 V  c  V  c  1 V  c  V  10
2

Consumer surplus = V   
 2  2 2 8 c2
= 8 per customer 21
 Errol D’Souza

To appropriate some of the surplus the club owner can

switch to a two-part tariff.
V  c 2  8 V  c
2

Charge an entry fee = 8

Consumers Surplus 
8

V c
Continue to charge a price per drink = P
2
6

Since the entry fee is independent of the amount the

customer actually drinks, each customer will
continue to buy the same number of drinks as
before.
However, entire consumer surplus is now transferred
to the owner via the entry fee.

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 Errol D’Souza

To appropriate some of the surplus the club owner can

switch to a two-part tariff.
V  c 2  8
Charge an entry fee = 8
V c
Continue to charge a price per drink = P
2
6

Since the entry fee is independent of the amount the

customer actually drinks, each customer will
continue to buy the same number of drinks as
before.
However, entire consumer surplus is now transferred
to the owner via the entry fee.

Club owner can do better still.

Reducing the price per drink permits him to increase

consumer surplus and in turns permits him 23
to increase the entry fee and increase profit.
 Errol D’Souza
Price
V a
Demand
V c
b
2 d

f
c MC
g
MR

V c V 2 Quantity
V
2
1. Set the price per drink equal to marginal cost
2. At this price consumer surplus is area of triangle afg

V  c V  c  1  V  c   10  2  32
2 2

Consumer surplus = 2 2 2
Charge an entry fee equal to this consumer surplus of
24 32
 Errol D’Souza

With drinks sold at costs there is no profit to be

earned from selling drinks.

However, entry fee paid by each customer is profit.

Total profit has increased to 32 > 16 earned under

uniform pricing

Also, each customer is buying the quantity of drinks

that would have been bought had the drinks
been priced competitively. The monopoly now
offers the competitive level of output and the
average price per drink is none other than the
profit maximizing uniform price.

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 Errol D’Souza

Second Degree Price Discrimination

Two phenomena made first degree price discrimination

possible -
1. Customers are more or less identical or are
distinguishable by means of a simple mechanism.

2. Club has ability to deny access to those not

paying the cover charge.

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 Errol D’Souza

Second Degree Price Discrimination

Two phenomena made first degree price discrimination

possible -
1. Customers are more or less identical or are
distinguishable by means of a simple mechanism.

2. Club has ability to deny access to those not

paying the cover charge.

Not all services can be marketed in this way -

E.g. – monopoly seller is a refreshment stand located
within a campus. – This makes limiting entry
by means of a cover charge impossible.
Block pricing or second degree price discrimination possible
in such a situation
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 Errol D’Souza

Monopolist knows the market contains consumers of

different types but does not know which type of
consumer is which.

Problem is to devise a pricing scheme that will

result in consumers revealing their type through
their actual purchases.

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 Errol D’Souza

Monopolist knows the market contains consumers of

different types but does not know which type of
consumer is which.

Problem is to devise a pricing scheme that will

result in consumers revealing their type through
their actual purchases.

Let there be 2 types of customers -

High demand customers Ph 16  Qh

Low demand customers Pl 12  Ql

Differentiated two part tariff does not work as both types

of customers will claim to be low demand types
when entering the club so as to pay lower entry fee.
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 Errol D’Souza

High demand customer Low demand customer

P P
16
12
Rs. 32
8 Rs. 32
Rs. 32
4 MC 4 MC
Rs. 32
Q Q
8 12 16 8 12
Club owner knows that low demand customers are willing
to pay a total of Rs. 64 for eight drinks.

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 Errol D’Souza

High demand customer Low demand customer

P P
16
12
Rs. 32
8 Rs. 32
Rs. 32
4 MC 4 MC
Rs. 32 Rs. 32
Q Q
8 12 16 8 12
Club owner knows that low demand customers are willing
to pay a total of Rs. 64 for eight drinks.
Rather than charging this amount through a two part tariff
entry is offered plus the right to consume 8 drinks
for a total charge of Rs. 64
Low demand customers will accept the charge as it is equals
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their willingness to pay
 Errol D’Souza

High demand customer Low demand customer

P P
16
12
Rs. 32
8 Rs. 32
Rs. 32
4 MC 4 MC
Rs. 32 Rs. 32
Q Q
8 12 16 8 12
High demand customers will also be willing to pay Rs. 64 for
this package as their willingness to pay for 8 drinks
is Rs. 96 and they get consumer surplus.

Profit to the club from such a package sold = Rs. 32 per

customer
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 Errol D’Souza

High demand customer Low demand customer

P P
16
12
Rs. 32
8 Rs. 32
Rs. 32
Rs. 8
4 MC 4 MC
Rs. 32 Rs. 16 Rs. 32
Q Q
8 12 16 8 12

However, club owner knows high demand customers are

willing to pay Rs. 120 for 12 drinks.
High demand customer cannot be charged this amount
because he can buy the Rs. 64, 8 drinks package
and enjoy consumer surplus of Rs. 32
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 Errol D’Souza

High demand customer Low demand customer

P P
16
12
Rs. 32
8 Rs. 32
Rs. 32
Rs. 8
4 MC 4 MC
Rs. 32 Rs. 16 Rs. 32
Q Q
8 12 16 8 12

Best owner can do is to create a package that offers high

demand customer at least Rs. 32 consumer surplus.

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 Errol D’Souza

High demand customer Low demand customer

P P
16
12
Rs. 32
8 Rs. 32
Rs. 32
Rs. 8
4 MC 4 MC
Rs. 32 Rs. 16 Rs. 32
Q Q
8 12 16 8 12

Best owner can do is to create a package that offers high

demand customer at least Rs. 32 consumer surplus.

Offer of second package of entry plus 12 drinks for a charge

of Rs. 88 = Rs. (120 -32)

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 Errol D’Souza

High demand customer Low demand customer

P P
16
12
Rs. 32
8 Rs. 32
Rs. 32
Rs. 8
4 MC 4 MC
Rs. 32 Rs. 16 Rs. 32
Rs. 8
Q Q
8 12 16 8 12

Best owner can do is to create a package that offers high

demand customer at least Rs. 32 consumer surplus.

Offer of second package of entry plus 12 drinks for a charge

of Rs. 88 = Rs. (120 -32)
Low demand customer will not buy this package as his
willingness to pay for 12 drinks is Rs. 72, but high
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demand customer will buy this package.

 Errol D’Souza

1. These two packages – Rs. 64 + 8 drinks and Rs. 88 +

12 drinks – have succeeded in making the club’s
customers reveal their types through their purchases.

2. The second package increases the profit that the club

owner gets from high demand customers.
From Rs. 64, 8 drinks package he earns Rs. 32
From Rs. 88, 12 drinks package he earns Rs. 40

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 Errol D’Souza

1. These two packages – Rs. 64 + 8 drinks and Rs. 88 +

12 drinks – have succeeded in making the club’s
customers reveal their types through their purchases.

2. The second package increases the profit that the club

owner gets from high demand customers.
From Rs. 64, 8 drinks package he earns Rs. 32
From Rs. 88, 12 drinks package he earns Rs. 40

3. Feature of second degree price discrimination is that

it involves quantity discounts.
Average price per drink of Rs. 64, 8 drink package = Rs. 8
Average price per drink of Rs. 88, 12 drink package
= Rs. 7.3

Movie theatres, restaurants, concert halls, stadiums,

and supermarkets all use this type of pricing.
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 Errol D’Souza

E.g.: Cheaper to buy one huge container of popcorn than many

small ones.

Wine sold by the glass is per unit more expensive than wine
sold by the bottle.

Cheaper to buy a five day ticket for a test match than to

buy tickets for each day individually.

Issue for consideration: Any package designed to attract the

low demand customer constrains the ability of the
monopolist to extract surplus from high demand
customer.

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 Errol D’Souza

High demand customer Low demand customer

P P
16
12
Rs. 32
8 Rs. 32
Rs. 32
Rs. 8
4 MC 4 MC
Rs. 32 Rs. 16 Rs. 32
Rs. 8
Q Q
8 12 16 8 12
E.g.: If club owner decides not to attract low demand
customer he can offer a package to high demand
customer of entry + 12 drinks for Rs. 120 giving a
  Rs. 72 per package sold.
Block pricing represents a compromise between setting a high
charge that loses sales to low demand buyers and a low charge
that foregoes significant surplus that can be earned from high 40
demand buyers.
 Errol D’Souza

Third degree price discrimination -

This differs from first and second degree price discrimination

with respect to pricing policy the monopolist adopts.

Here the monopolist charges a uniform price to all

consumers within a particular group.
Thus there is some observable criterion such as age,
income, geographic location, or education by
which consumers can be grouped in terms of
their willingness to pay.

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 Errol D’Souza

Third degree price discrimination -

This differs from first and second degree price discrimination

with respect to pricing policy the monopolist adopts.

Here the monopolist charges a uniform price to all

consumers within a particular group.
Thus there is some observable criterion such as age,
income, geographic location, or education by
which consumers can be grouped in terms of
their willingness to pay.

Discrimination arises because the uniform price

charged to one group need not be the same
as uniform price charged to another group.
E.g.: Senior citizen discounts and “kids are free”
programmes are types of third degree price
discrimination. 42
 Errol D’Souza

E.g. Journals discriminate on the basis of income

Annual Membership Fee for American Economic Association

Regular member with annual income < $40,000 $ 59

Regular member with annual income
$40,000 – 53,000 $ 71
Regular member with annual income > $53, 000 $ 83
Junior member (available to registered students
for five years maximum) $ 30

E.g.: Restaurants offer “early bird specials”

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 Errol D’Souza

Assume there are two types of consumers and the monopolist

is able to identify these types and to prevent arbitrage
between them.

Market demand by type 1 consumer is less elastic at any

product price than market demand by type 2
consumers.

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 Errol D’Souza

Assume there are two types of consumers and the monopolist

is able to identify these types and to prevent arbitrage
between them.

Market demand by type 1 consumer is less elastic at any

product price than market demand by type 2
consumers.
First necessary condition for  maximization -
Sales in each market is such that MR is the same.
If this did not hold then the monopolist can
MR1  MR2
raise revenue and  by shifting sales from
the low MR market to the high one.

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 Errol D’Souza

Assume there are two types of consumers and the monopolist

is able to identify these types and to prevent arbitrage
between them.

Market demand by type 1 consumer is less elastic at any

product price than market demand by type 2
consumers.
First necessary condition for  maximization -
Sales in each market is such that MR is the same.
If this did not hold then the monopolist can
MR1  MR2
raise revenue and  by shifting sales from
the low MR market to the high one.
Second condition -
Marginal revenue in each market must equal MC.
If this were not the case in either market, the
MR1  MC
last unit sold is generating either more or less
MR2  MC in cost than it is earning in revenue. Cutting
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back or increasing output would then raise 
 Errol D’Souza

P Market 1 P Market 2 P Aggregate

Marginal
Revenue
MC

D1 MR1  MR2
MR1 MR2 D2

Q Q Q1 * Q2 * Q

Marginal revenue curves MR1 and MR2 are added horizontally

to give the aggregate marginal revenue curve MR1  MR2
This is equated with marginal cost.

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 Errol D’Souza

P Market 1 P Market 2 P Aggregate

Marginal
Revenue

P1 *
MC
P2 *

D1 MR1  MR2
MR1 MR2 D2

Q1 * Q Q2 * Q Q1 * Q2 * Q

Marginal revenue curves MR1 and MR2 are added horizontally

to give the aggregate marginal revenue curve MR1  MR2
This is equated with marginal cost. Projecting back
to the individual markets gives the discriminatory
prices in these markets.
Consumers for whom elasticity of demand is low should be
charged a higher price than consumers with higher elasticities
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of demand.
 Errol D’Souza

Product and Pricing Strategies for the Multiproduct Firm

Commodity bundling is the practice of selling two or more

products in a single package.

E.g.: a complete stereo system in contrast to

separate components.

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 Errol D’Souza

Commodity bundling is the practice of selling two or more

products in a single package.

E.g.: a complete stereo system in contrast to

separate components.

Bundled goods are always combined in fixed

proportions.

E.g.: Fixed price menu at a restaurant will typically

specify one appetizer, one entrée, and one
dessert – all sold at one price.
A holiday travel package might consist of one
return ticket, five nights accommodation, and
three trips to the theatre.

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 Errol D’Souza

Tie-in sales are less restrictive in that the mix of goods is

not so rigidly prescribed.

All that is mandated is that the purchase of some

amount of one good be conditional on the
purchase of some amount of a second, tied
product.

E.g.: In the early days of business machines IBM sold

machines with the condition that buyer uses only
IBM produced tabulating cards.

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 Errol D’Souza

Tie-in sales are less restrictive in that the mix of goods is

not so rigidly prescribed.

All that is mandated is that the purchase of some

amount of one good be conditional on the
purchase of some amount of a second, tied
product.

E.g.: In the early days of business machines IBM sold

machines with the condition that buyer uses only
IBM produced tabulating cards.

In modern times tie-in sales are technology based rather

than contractual as in IBM case.

E.g.: When you buy a printer you are committed to

buying ink cartridges that fit it. HP cartridges do
not fit Canon printers, and vice versa.
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What is tied is the brand, not its quantity.
 Errol D’Souza

George Stigler was first to understand commodity bundling.

In 1950s and 1960s airing older Hollywood films was a

standard part of television fare.

Film distributors who owned rights to the films would sell

presentation rights for a fee to local t.v. stations.

Films were rarely sold individually and were usually sold

in packages combining screen gems such as
Casablanca and Treasure of Sierra Madre with grade
B losers such as Gorilla Man and Tear Gas Squad.

53
 Errol D’Souza

George Stigler was first to understand commodity bundling.

In 1950s and 1960s airing older Hollywood films was a

standard part of television fare.

Film distributors who owned rights to the films would sell

presentation rights for a fee to local t.v. stations.

Films were rarely sold individually and were usually sold

in packages combining screen gems such as
Casablanca and Treasure of Sierra Madre with grade
B losers such as Gorilla Man and Tear Gas Squad.

Suppose there are two films – X and Y –

two stations located in different cities – A and B.

54
 Errol D’Souza

Maximum Willingness Max. willingness

to pay for Film X to pay for Film Y
Station A $ 8,000 $ 2,500
Station B $ 7,000 $ 3,000

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 Errol D’Souza

Maximum Willingness Max. willingness

to pay for Film X to pay for Film Y
Station A $ 8,000 $ 2,500
Station B $ 7,000 $ 3,000

If distributor is forced to charge a uniform price then he

could charge
For Film X $ 7,000
For Film Y $ 2,500

Both stations would buy both the films and the distributor’s
total revenue will be $ 19,000

56
 Errol D’Souza

Maximum Willingness Max. willingness

to pay for Film X to pay for Film Y
Station A $ 8,000 $ 2,500
Station B $ 7,000 $ 3,000

If distributor is forced to charge a uniform price then he

could charge
For Film X $ 7,000
For Film Y $ 2,500

Both stations would buy both the films and the distributor’s
total revenue will be $ 19,000
Suppose, however, distributor offers the films as a bundle
for a combined price of $ 10,000

Both stations value the bundle at least this highly, and both
will purchase the bundle giving distributor a revenue
of $ 20,000 57
 Errol D’Souza

Maximum Willingness Max. willingness

to pay for Film X to pay for Film Y
Station A $ 8,000 $ 2,500
Station B $ 7,000 $ 3,000

When films are unbundled the highest price that can be

charged for any specific film is the minimum reser-
vation price either station would pay for that film,
i.e., $ 7,000 for Film X and $ 2,500 for Film Y.

When products are bundled, the highest bundle price that

can be charged is the minimum of the sums of each
station’s reservation prices.

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 Errol D’Souza

When films are unbundled the highest price that can be

charged for any specific film is the minimum reser-
vation price either station would pay for that film,
i.e., $ 7,000 for Film X and $ 2,500 for Film Y.
When products are bundled, the highest bundle price that
can be charged is the minimum of the sums of each
station’s reservation prices.

Bundling permits the distributor to circumvent the

low value station A places on Film Y and
exploit its relatively high valuation of Film X.

It also avoids the need to charge a low price

for film X in order to induce station B to buy
it by exploiting B’s relatively high willingness
to pay for film Y.
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 Errol D’Souza

Stigler’s insight incomplete on two counts -

1. No discussion of production costs. The distributor’s

cost is either sunk or nonexistent.

2. Does not consider strategy of mixed bundling –

selling both products individually as well as
in a bundle.

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 Errol D’Souza

In mixed bundling consumers are partitioned into 4 groups

than under pure bundling where there are 2 groups.

Mixed bundling always increases the monopolist’s sales.

However, it is less clear whether bundling increases the

monopolist’s profits.

Profit impact of commodity bundling is dependent on the

precise distribution of consumer preferences for the
goods on offer and the costs of making those goods.

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 Errol D’Souza

In mixed bundling consumers are partitioned into 4 groups

than under pure bundling where there are 2 groups.

Mixed bundling always increases the monopolist’s sales.

However, it is less clear whether bundling increases the

monopolist’s profits.

Profit impact of commodity bundling is dependent on the

precise distribution of consumer preferences for the
goods on offer and the costs of making those goods.

Suppose monopolist had four customers A,B,C, and D,

and the marginal cost of the goods is
c1  Rs. 100 c2  Rs.150
Consumer reservation prices are as follows -
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 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer

A 50 450 500

B 250 275 525

C 300 220 520

D 450 50 500

We can use this information to construct the demand

schedule for the two goods.

Also, the profit  associated with each level of

demand can be calculated as we know the
marginal cost of producing the two goods.
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 Errol D’Souza

Reservation price
for good 1(Rs.)
Consumer

A 50

B 250

C 300

D 450
Good 1: c1  Rs.100
Price Demand T.R. 
450 1 450 350
300 2 600 400
250 3 750 450
50 4 200 -200
T.R.: Total Revenue  : Profit 64
 Errol D’Souza

Reservation price Reservation price

for good 1(Rs.) for good 2(Rs.)
Consumer

A 50 450

B 250 275

C 300 220

D 450 50
Good 1: c1  Rs.100 Good 2: c2  Rs.150
Price Demand T.R.  Price Demand T.R. 
450 1 450 350 450 1 450 300
300 2 600 400 275 2 550 250
250 3 750 450 220 3 660 210
50 4 200 -200 50 4 200 -400
T.R.: Total Revenue  : Profit 65
 Errol D’Souza

Good 1: c1  Rs.100 Good 2: c2  Rs.150

Price Demand T.R.  Price Demand T.R. 
450 1 450 350 450 1 450 300
300 2 600 400 275 2 550 250
250 3 750 450 220 3 660 210
50 4 200 -200 50 4 200 -400

Suppose monopolist decides to adopt simple monopoly pricing

 max for good 1 is at Rs. 450 with a price of Rs. 250 and sales
to consumers B, C, and D.

 max for good 2 is at Rs. 300 with a price of Rs. 450 and sales
only to consumer A.

Total profit from simple monopoly pricing = Rs. 450 + 300

= Rs. 750
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 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer

A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Pure bundling strategy

67
 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer

A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Pure bundling strategy
1. Bundle price of Rs. 525: Only consumer B purchases.
  525  (100  150)  275
2. Bundle price of Rs. 520: Consumers B and C purchase.
  2(520)  2(100  150)  540
3. Bundle price of Rs. 500: All 4 consumers purchase
  4(500)  4(100  150)  1000
Pure bundling gives higher profits than simple monopoly68
pricing.
 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer
R1 R2 R1  R2
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Mixed bundling strategy : Suppose monopolist sets prices
P1  Rs. 450 P2  Rs. 450 PB  Rs. 520

69
 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer
R1 R2 R1  R2
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Mixed bundling strategy : Suppose monopolist sets prices
P1  Rs. 450 P2  Rs. 450 PB  Rs. 520
Consumer A: R1  P1 , R2  P2 , R1  R2  PB Buy only good 2

70
 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer
R1 R2 R1  R2
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Mixed bundling strategy : Suppose monopolist sets prices
P1  Rs. 450 P2  Rs. 450 PB  Rs. 520
Consumer A: R1  P1 , R2  P2 , R1  R2  PB Buy only good 2

Consumer B: R1  P1 , R2  P2 , R1  R2  PB Buy bundle

71
 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer
R1 R2 R1  R2
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Mixed bundling strategy : Suppose monopolist sets prices
P1  Rs. 450 P2  Rs. 450 PB  Rs. 520
Consumer A: R1  P1 , R2  P2 , R1  R2  PB Buy only good 2

Consumer B: R1  P1 , R2  P2 , R1  R2  PB Buy bundle

Consumer C: R1  P1 , R2  P2 , R1  R2  PB Buy bundle

72
 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer
R1 R2 R1  R2
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Mixed bundling strategy : Suppose monopolist sets prices
P1  Rs. 450 P2  Rs. 450 PB  Rs. 520
Consumer A: R1  P1 , R2  P2 , R1  R2  PB Buy only good 2

Consumer B: R1  P1 , R2  P2 , R1  R2  PB Buy bundle

Consumer C: R1  P1 , R2  P2 , R1  R2  PB Buy bundle

Consumer D: R1  P1, R2  P2 , R1  R2  PB Buy only good 1

73
 Errol D’Souza

Reservation price Reservation price Sum of Reservation

for good 1(Rs.) for good 2(Rs.) prices
Consumer
R1 R2 R1  R2
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Mixed bundling strategy : Suppose monopolist sets prices
P1  Rs. 450 P2  Rs. 450 PB  Rs. 520
Consumer A: R1  P1 , R2  P2 , R1  R2  PB Buy only good 2

Consumer B: R1  P1 , R2  P2 , R1  R2  PB Buy bundle

Consumer C: R1  P1 , R2  P2 , R1  R2  PB Buy bundle

Consumer D: R1  P1, R2  P2 , R1  R2  PB Buy only good 1

  (450  150)  [520  (100  150)]  [520  (100  150)]  (450  100)  174
,190
 Errol D’Souza

Effective mixed bundling is always at least as profitable as

pure bundling.

Mixed bundling strategy   1,190

Pure bundling strategy   1,000

However, it is not always the case that some sort of bundling

is more profitable than no bundling at all.

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 Errol D’Souza

Effective mixed bundling is always at least as profitable as

pure bundling.

However, it is not always the case that some sort of bundling

is more profitable than no bundling at all.

Drawback of bundling is that some customers may

buy the bundle at a reservation price for one of the
goods that is less than marginal production costs.
- See slide 85.

Bundling is likely to be profitable only when the variation

in consumer valuations of the goods is significant.

Above example: Consumers A and D who buy a single good

have very different valuations of the individual goods.
Consumers B and C who buy the bundled good have 76
very similar valuations.
 Errol D’Souza

“Some people may value an appetizer relatively

highly (soup on a cold day), others may value dessert
relatively highly (Baked Alaska, unavailable at home),
but all may wish to pay roughly the same amount for
a complete dinner. The a la carte menu is designed to
capture consumer surplus from those gastronomes
with extremely high valuations of particular dishes,
while the complete dinner is designed to retain those
with lower variance” - Adams and Yellen, p. 488

Basic point can be seen in context of Stigler’s example -

77
 Errol D’Souza

Maximum Willingness Max. willingness

to pay for Film X to pay for Film Y
Station A $ 8,000 $ 2,500 Stigler’s
Station B $ 7,000 $ 3,000 example
Slide 67
Maximum Willingness Max. willingness
to pay for Film X to pay for Film Y
Revised
Station A $ 8,000 $ 8,000
valuations
Station B $ 3,500 $ 3,500

Differences in relative valuation of the products vanish.

Bundling no longer a profitable strategy.

78