Teaching Pure & Mixed Bundling using a Spreadsheet

Permanent: Current (until July 15, 2004):

Stacey Brook Stacey Brook

Associate Professor of Economics 8200 N. Laurelglen Blvd. #2010
Vucurevich School of Business Bakersfield, CA 93311
University of Sioux Falls
1101 W. 22nd St.
Sioux Falls, SD 57105
stacey.brook@usiouxfalls.edu
Voice: 605.331.6706
Fax: 605.331.6574

Abstract

Adams & Yellens (1976) classic analysis of commodity bundling is the backbone of
most discussions of pure and mixed bundling in undergraduate economic texts. This
paper incorporates a spreadsheet based on Adams & Yellens bundling model that
quickly calculates total revenue or total profit using a variety of pricing tactics. This
frees up a lot of time doing repetitious calculations, and can be better used discussing
different pure and mixed bundling examples compared to other pricing tactics.

JEL Classification: A22

Key Words: Pure Bundling, Mixed Bundling, Spreadsheet

 Teaching Pure & Mixed Bundling using a Spreadsheet

Abstract

Adams & Yellens (1976) classic analysis of commodity bundling is the backbone of
most discussions of pure and mixed bundling in undergraduate economic texts. This
paper incorporates a spreadsheet based on Adams & Yellens bundling model that
quickly calculates total revenue or total profit using a variety of pricing tactics. This
frees up a lot of time doing repetitious calculations, and can be better used discussing
different pure and mixed bundling examples compared to other pricing tactics.

1
 Teaching Pure & Mixed Bundling using a Spreadsheet

Introduction

Covering pure and mixed bundling in my upper division applied micro courses

used to be one of the lectures I dreaded since the material takes a lot of class time doing

repetitious calculations that lose student interest. A solution to this problem was to create

a spreadsheet with a pure bundling worksheet, and a mixed bundling worksheet. In class,

after a brief introduction to bundling, I introduce the bundling spreadsheet and go through

a variety of scenarios comparing pure (and mixed) bundling to other pricing tactics. If

the profit-maximizing monopoly model and Pigouvian 1st degree price discrimination

have previously been introduced, this lecture can be completed within a 50 minute class

period.

Literature Review

Bundling, either pure or mixed, is covered in Managerial Economics,

Intermediate Microeconomics (Price Theory) and Industrial Organization texts. For

example, the two-customer, two-good pure bundling model found in Perloff (2001) and

Truett & Truett (2001); and the mixed bundling models found in Pindyck & Rubinfeld

(2001), Pepall, Richards & Norman (2002) and Carlton & Perloff (2000) each use a

simplified version of Adams & Yellens bundling model in their discussion of firm

pricing tactics.

Spreadsheets have increasing been used in the literature1 as a means of teaching a

variety of economics models. Literature on microeconomics and spreadsheets started

2
generally with Smith & Smith (1988), and Paetow (1994). Brown (1999), Cahill &

Kosicki (2000), Mixon & Tohamy (1999), (2002) and Brook (2003) have expanded the

literature to focus on specific microeconomics models such as input market models,

consumer theory, the Heckscher-Ohlin Model, costs, and firm decision making.

Pure & Mixed Bundling Spreadsheet Primer2

The pure and mixed bundling spreadsheet is designed to be as general as possible.

Only parameters (reservation prices, bundling prices, and costs) need to be entered into

the spreadsheet3. The pure bundling worksheet calculates total revenue under Pigouvian

1st degree price discrimination4, monopoly pricing5, and pure bundling. The only

substantial difference in the mixed bundling worksheet is that, well, the mixed bundling

pricing tactic is also included. Since all the formulas are entered, this allows the

instructor to focus on the economics of bundling as opposed to the bundling solution

mechanism, saving valuable class time if changes in the parameter values are to be made.

Pure Bundling Spreadsheet

A monopolist producing two-goods and facing two consumers is presented where

marginal production costs are assumed to equal zero for both goods, and fixed costs are

also assumed to equal zero, so total revenue equals total profit. The zero marginal cost

assumption is relaxed in the mixed bundling worksheet.

I like to set up the bundling discussion by asking why cable companies make us

buy all of those television channels that we do not watch. Can bundling be a profit

maximizing tactic if the firm cannot charge each customer their reservation price?

3
Example #1: Negatively Correlated Reservation Prices

Using the Pure Bundling worksheet, suppose customer 1s reservation prices

for good 1 (network TV) and good 2 (sport TV) are $16.00 and $12.00, and customer 2s

reservation prices for network TV and sport TV are $12.00 and $20.00. Under 1st degree

price discrimination, the firm sells each good to each customer at their reservation price.

Total revenue is $60.00. Under monopoly pricing, the firm sells each good for $12.00,

generating $48.00 in total revenue. If the monopolist charges a higher price than $12.00

the firm sells one less good and total revenue declines. What if the firm sold each of the

two goods packaged together? Since the pure bundled price is the minimum of the two

customers reservation prices, the firms pure bundled price is $28.00 for both goods

earning $56.00 in total revenue.

Finally, notice the correlation coefficient in cell B15. When the correlation

coefficient of the customers reservation prices is negative pure bundling can be a profit

maximizing tactic. I will refer back to negatively correlated reservation prices later.

In just a few minutes, the main pure bundling result can be demonstrated with

very little class time spent on calculating total revenue under each pricing tactic. The

spreadsheet also allows the instructor to explore other issues involving bundling.

Example #2: Positively Correlated Reservation Prices

Pindyck & Rubinfeld and Perloff address positively correlated reservation prices,

and can be easily introduced using this spreadsheet. Suppose the reservation prices

remain the same with the exception that customer 2s reservation price for sport TV

decreases to $5.00, changing cell C5 to 5. Notice that the correlation coefficient is now

positive. When reservation prices are positively correlated, pure bundling yields revenue

4
no better than monopoly pricing (try cell C5 = 10), and in this case pure bundling yields

lower total revenue than monopoly pricing. Using a spreadsheet allows more class time

to focus on the discussion of why positively correlated reservation prices do not yield

higher profits under pure bundling as compared with monopoly pricing.

Mixed Bundling with Positive Marginal Production Costs Spreadsheet

Mixed bundling is the case where the firm offers their customers the option of

buying one or both goods individually at a price (but it does not have to be the monopoly

profit maximizing price), or buying both goods together. Mixed bundling is just that, a

mixture of different prices.

The Mixed Bundling worksheet uses two goods, and up to four consumers,

where marginal production costs can be positive. Using Pindyck & Rubinfeld (2001) pp.

397 - 399 as a guide, mixed bundling will be contrasted with Pigouvian 1st degree price

discrimination, monopoly pricing and pure bundling.

Under 1st degree price discrimination, if the reservation price is greater than or

equal to the marginal production cost, then the firm offers to sell each product to each

customer at their reservation price. With up to four consumers, to find the monopoly

price, a demand schedule is constructed from the consumers reservation prices, so that

marginal revenue can be calculated. Marginal revenue is then set equal to each goods

marginal cost to calculate the monopoly price. If the monopoly prices are given in the

text, it is not that great of a stretch to just type in the monopoly price, but if you start to

change the original reservation prices, it is easy to forget to re-calculate the monopoly

price for each good.

5
 For mixed bundling, total revenue is calculated by first comparing the consumer

surplus of consuming one good separately with the goods separate price and the

consumer surplus of consuming both goods simultaneously with the bundled price. If

consumer surplus is higher just consuming one good, then only that good is purchased by

the consumer. Otherwise the spreadsheet looks to determine if the sum of the consumers

reservation prices are greater than the mixed bundled price, in which case the consumer

does not buy either good separately or bundled. Otherwise the consumer buys the

bundled good. A formula similar in spirit is created to determine the total costs.

Example #3: Mixed Bundling as Profit Maximizing Behavior

Suppose the two goods reservation prices for the four customers are listed in

Table 1. After the reservation prices are entered, the instructor must also enter the

marginal costs for network TV = 20, and sport TV = 30; the bundled goods price = 100,

and the mixed bundled price for both goods separately = 89.99.

Table 1: Hypothetical Reservation Prices (Pindyck & Rubenfeld 2001 p. 397)

Good 1 Good 2
Customer 1 $10.00 $90.00
Customer 2 $50.00 $50.00
Customer 3 $60.00 $40.00
Customer 4 $90.00 $10.00

Since only customer 1 for network TV and customer 4 for sport TV have

reservation prices below the respective goods marginal cost, under Pigouvain 1st degree

price discrimination the firm earns total revenue of $380.00, incurs a total cost equal to

$150.00, making $230.00 in total profit. Monopoly pricing is also calculated yielding

$240.00 in total revenue, $90.00 in total costs, and profit of $150.00. Pure bundling

yields $200.00 in total profit. The optimal mixed bundling pricing tactic yields total

6
revenue of $379.98, total costs of $150.00 and $229.98 in profit, which is greater than

under monopoly or pure bundling pricing.

The instructor can quickly show that profit under mixed bundling decreases by

increasing or decreasing the mixed bundle prices for each good from $89.99.

Additionally, increasing or decreasing the mixed bundled price from $100.00 yields

lower profits.

Returning to the reservation prices in Table 1, but setting marginal costs equal to

$0.00, then pure bundling is the more profitable pricing tactic. The spreadsheet quickly

demonstrates that changes in marginal costs can lead to different optimal pricing tactics

for the profit-maximizing firm.

Projecting the spreadsheet in the classroom, the instructor can quickly go over the

mechanics of pure and mixed bundling without spending a great amount of class time

setting up repetitious calculations that lose student interest. Yet, the real value is in

asking students what happens when one (or more) of the reservation prices change, which

is discussed next.

Example #4: Reservation Prices that are not Perfectly Correlated

One final issue that is rarely covered is the impact of different pricing tactics

when reservation prices are not perfectly negatively correlated. The bundling spreadsheet

can show that use mixed bundling is a profit-maximizing pricing tactic even without

perfectly negatively correlated reservation prices.

Using reservation prices in Table 2, and assuming that marginal production costs

are zero for each product6; even when reservation prices are not perfectly negatively

correlated, the firm maximizes its profits under mixed bundling. Under mixed bundling,

7
the firm earns $420.00 in total profit, compared to $400.00 with pure bundling and

$320.00 with monopoly pricing of each good separately.

Table 2: Hypothetical Reservation Prices (Pindyck & Rubenfeld 2001 p. 399)

Good 1 Good 2
Customer 1 $10.00 $90.00
Customer 2 $40.00 $80.00
Customer 3 $80.00 $40.00
Customer 4 $90.00 $10.00

Pure & Mixed Bundling Extensions

Two issues that are not mentioned in undergraduate economics texts are the

possible inferiority of pure bundling even when reservation prices in the two-good, two

consumer model is negatively correlated, and the issue of lower profits in the mixed

bundling model when reservation prices are not perfectly negatively correlated.

Extension #1: Is Pure Bundling Always Optimal with Perfectly Negative Correlated

Reservation Prices?

To get the discussion of why negatively correlated reservation prices do not

always yield higher profits for a firm that offers a pure bundle, the instructor (or

insightful student) may ask the following: Why is pay-per-view not included into the

regular or premium cable package? Undergraduate texts commonly write that bundling is

beneficial for a firm when reservation prices are negatively correlated; leaving the reader

to believe that bundling is always beneficial when reservation prices are negatively

correlated. For example Perloff (2001) writes,

that bundling a pair of goods pays only if their demands are negatively
correlated: When a good or service is sold to different people, the
price is determined by the purchaser with the lowest reservation price. If
reservation prices differ substantially across consumers, a monopoly has to
charge a relatively low price to make any sales. By bundling when

8
 demands are negatively correlated, the monopoly reduces the dispersion in
reservation prices, so it can charge more and still sell to a large number of
customers (p. 413).

This is not always true. Specifically, price is not determined by the purchaser with the

lowest reservation price. This statement taken to its logical extreme would result in all

prices to be zero. In Perloffs example his statement does work, but a different example

will show that a monopolist can make a greater profit by not always charging the lowest

reservation price when reservation prices of two pairs of goods are negatively correlated.

Returning to the reservation prices for network TV and sport TV in example #1,

except that for customer #2, sport TVs reservation price is now $40.00. The only

difference between this example and the first is that customer 2s sports TV reservation

price is now twice that in the previous case. Notice the reservation prices are still

negatively correlated. Should the monopolist pure bundle network TV and sport TV, or

is there a more profitable pricing scheme? The monopolist should now sell network TV

and sports TV separately. Now the firm charges $12.00 for network TV to each

customer, making $24.00 in total revenue from network TV and sells sport TV only to

customer 2 for $40.00 realizing total revenue of $64.00, which is higher than under pure

bundling. Pure bundling is not always a more profitable pricing tactic even when

reservation prices are perfectly negatively correlated.

Extension #2: Mixed Bundling Profit Reduction under Negatively Correlated

Reservation Prices

The second issue focuses on when consumers have higher reservation prices for

both products, yet choose the packaged bundled price. Returning to the reservation

9
prices and marginal costs in example #3, except changing customer 4s reservation price

for sports TV to $85.00, mixed bundling yields lower profit than when customer 4s

reservation price for sport TV was $10.00. Overall profits declined from $229.98 to

$209.99. Of the three pricing tactics, mixed bundling still yields the highest profit, the

firm has lower profits. One of the dangers of mixed bundling is that some high valued

customers can buy the bundled product and the firm is unable to segment those dual high

valued customers away from the bundle. If customer 4s reservation price for sport TV =

$95.00, the correlation coefficient is still negative, yet monopoly pricing is now slightly

more profitable than mixed bundling.

Conclusion

A benefit of using spreadsheets is that it eliminates repetitious in-class

calculations and allows the instructor to focus on teaching economics.

10
References

Adams, W. J. and J. L. Yellen. 1976. Commodity Bundling and the Burden of

Monopoly. The Quarterly Review of Economics, 90 (May):475-498.

Brook, S. 2003. Teaching Industrial Organization with Microsoft Excel. Papers and
Proceedings of the Fourteenth Annual Teaching Economics Conference, 10-18.

Brown, B. W. 1999. A Computer Enhanced Course in Microeconomics. Journal for

Computer Enhanced Learning, 99:1.

Cahill, M. and G. Kosicki. 2000. Exploring economic models using excel. Southern
Economic Journal, 66 (January):770-792.

Carlton, D. and J. Perloff. 2000. Modern Industrial Organization, 3rd ed. Reading, MA:
Addison-Wesley Longman.

Mixon, J. W. Jr. and S. M. Tohamy. 1999. The Heckscher-Ohlin Model with variable
input coefficients in spreadsheets. Computers in Higher Education Economics
Review 13,2.

-----. 2002. Cost Curves and How They Relate. Journal of Economic Education 33,1:89.

Paetow, H. 1994. Illustrating Microeconomic Theory by using Spreadsheets. Computers

in Higher Education Economics Review 22.

Pepall, L., D. Richards, and G. Norman. 2002. Industrial Organization: Contempory

Theory and Practice, Southwestern.

Perloff, J. 2001. Microeconomics, 2nd ed., Addison-Wesley, Upper Saddle River, NJ.

Pindyck, R. and D. Rubinfeld. 2001. Microeconomics, 5th ed., Prentice Hall,

Smith, L.M. and L.C. Smith. 1988. Teaching Microeconomics with Microcomputer
Spreadsheets. Journal of Economic Education, 18 4:363-382.

Truett, L. and D. Truett. 2001. Managerial Economics: Analysis, Problems, Cases, 7th
ed., South-Western College Publishing, Cincinnati, OH.

11
Endnotes
1
An excellent resource of the literature for teaching economics with spreadsheets is found at:
http://econltsn.ilrt.bris.ac.uk/advice/spreadsheets.htm.

2
The reader is encouraged to download the pure and mixed bundling Microsoft Excel spreadsheet at:
http://www.usiouxfalls.edu/academic/business/economics/Bundling.xls.
3
Light yellow cells indicate a parameter value is to be entered, and light blue cells indicate a formula is
provided.
4
In the spreadsheet, Pigouvain 1st degree price discrimination is referred to as Personalized Pricing.
5
In the spreadsheet, the Principles of Microeconomics profit-maximizing monopoly model is referred to as
uniform pricing.
6
In the spreadsheet, cells B9 and B10 = $0.00, cell B11 = $120.00, and cells B12 and B13 = $90.00.

12