Bundling, Tying, and Portfolio Effects: Part 1 Conceptual Issues

In most cases, we find that rivals would earn even less money if they formed a
competing bundle. Even so, competition could evolve into bundle versus bundle.
Dynamic considerations may lead a firm to prefer to be on a lower, but level, playing
field. Issues such as R&D spending may lead a firm to prefer earning 9 in a (9, 10)
outcome to earning 10 in a (10, 20) outcome. It is also the case that customers do much
better in a bundle versus bundle competition. To the extent that customers are active in
shaping the nature of competition, we can expect them to induce players to form
competing bundles. A firm that looks ahead to see that the gain from bundling will only
be temporary may choose not to go down this path.
As first discussed in the Cournot monopoly model, one must also consider the nature of
pricing in the market. The Cournot effect relies on the elimination of a double
marginalisation, which, in turn, relies on the inefficiency of monopoly pricing. If, instead,
firms negotiate prices and do so with full information about customer preferences, then
the outcome should be efficient, and there will be no gain from offering a bundled price.
If a customer prefers Firm A’s product to its competitor’s, and the extent of those
preferences are known, then Firm A will always win a pricing competition. It knows just
how much extra it can charge and still win the business. 48 Similarly, the firm that has the
most-preferred B product will win that bidding competition. If the two firms with the
preferred products are combined, they will still win both competitions. Whether they sell
the items individually or as a bundle, the total price premium they can charge is the same.
Nor can bundling leverage market power. Bundling provides no advantage when a firm
that has the preferred A product for some customer combines with a firm that has an
inferior B product for that customer. The premium it can charge for the A good alone is
more than the premium it can charge for the bundle, as adding good B to the bundle
makes the bundle less attractive to that customer. Thus bundling leads to lower profits.
We have looked at two simplified descriptions of the market. In the first, firms are
uninformed as to customer preferences (or unable to act on them) and thus there is one
price to all customers. Here bundling is effective. In the negotiation setting, firms have
perfect information about consumer preferences and competitors’ costs and customise
prices perfectly for each customer. Here, bundling has no impact.
While vendors are often well informed about customers and competitors, their
information is not always accurate. Firms can still negotiate prices, even with good but
imperfect information as to customer preferences. In that case, the way to model the
problem is to consider what is known about customer preferences by the end of the
negotiation process. That suggests considering the value of bundling for a series of
different customer types. For example, is bundling valuable if the customer is known to
prefer both of Firm A’s products, but the strength of those preferences is unknown?
We provide an introduction to this approach in the GE-Honeywell case study. More detail
can be found in Nalebuff and Lu (2001).
48 Here, we are assuming that the firms either know each other’s costs or learn this information through the bidding process.
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