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OpenMedia.ca/CIPPIC's Reply to CRTC 2011-77 : APPENDIX A Odlyzko Bundling Flat Rates 2011Ratings: (0)|Views: 434|Likes: 0

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https://www.scribd.com/doc/55599580/OpenMedia-ca-CIPPIC-s-Reply-to-CRTC-2011-77-APPENDIX-A-Odlyzko-Bundling-Flat-Rates-2011

05/17/2011

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Flat Versus Metered Rates, Bundling, and“Bandwidth Hogs”

Papak NabipayApplied EconomicsUniversity of MinnesotaAndrew OdlyzkoSchool of MathematicsUniversity of MinnesotaZhi-Li ZhangComputer ScienceUniversity of Minnesota

Abstract

The current push for bandwidth caps, tiered usage pricing, and other measures in both wireless and wirelinecommunications is usually justiﬁed by invoking the specter of “bandwidth hogs” consuming an unfair share of thetransmission capacity and being subsidized by the bulk of the users. This paper presents a conventional economicmodel of ﬂat rates as a form of bundling, in which consumption can be extremely unequal, and can follow theubiquitous Pareto distribution. For a monopoly service provider with negligible marginal costs, ﬂat rates turn out tomaximize proﬁts in most cases. The advantage of evening out the varying preferences for different services amongusers overcomes the disadvantage of the heaviest users consuming more than the average users. The model is tractableenough that it allows for exploration of the effects of non-zero marginal costs (which in general strengthen the casefor metered pricing), and of welfare effects.

1. I

NTRODUCTION

The telecommunications industry has often been thescene of pricing controversies, starting with regularpostal services [7]. The general pattern has not changedmuch over the centuries. Usually, industry leaders, inmodern times supported by economists, argue for ﬁne-scale metering, while consumers ﬁght for simplicity.The confusing scene in pricing of telecommunicationservices as well as many types of information goodsresults from a variety of conﬂicting factors. It is likelythat in the future, just as in the past, there will be a mix of pricing models that varies depending on technologies andlocal conditions. Many of the factors affecting pricingwere observed centuries ago, and now they are beinginvestigated more intensively. Some references are [1],[4], [6], [7], [8], and [11], as well as the papers listedthere.This paper does not consider the various behavioraleconomics aspects of pricing, such as consumer willing-ness to pay more for ﬂat rates. We take just the con-ventional economic point of view, in which consumersand producers have value functions that are well-deﬁnedand known precisely only to themselves, which they tryto maximize. Even in this setting, ﬂat rates can often beshown to be advantageous to sellers (and often to buyersas well), as they are a form of bundling, selling severalgoods or services in a single package. Bundling hasbeen a standard business practice for thousands of years.The justiﬁcation for it in the standard economic model,as a way to take advantage of uneven valuations fordifferent goods among consumers, has been developedover the last half of century, starting with the work of

This work was supported by the US National Science Foundationgrant CNS-0721510.

Stigler in 1963 [10]. The literature on bundling is vast,and we mention just a few of the seminal works, aswell as some of the most recent publications, e.g. [3],[9], and [12]. Most of this literature is concerned with just a small number of goods (often with a particulargood bought in varying quantities), and aims to explicatethe degree to which non-zero marginal costs as well ascomplementarity or substitutability of the goods affectthe gains to be obtained from bundling.In telecommunications, ﬂat rates can be viewed as aform of bundling a very large number of goods, suchas access to hundreds of millions of websites or phonecalls to potentially billions of people. Such settingswere considered in [2], [4], and [5]. This paper can beconsidered an extension of those works. The papers of Bakos and Brynjolfsson [2] and of Geng, Stinchcombe,and Whinston [5] demonstrate that for wide classes of valuations on information goods (i.e., goods with zeromarginal cost), bundling is more proﬁtable than separatesales for a monopoly seller when there are many goods.(Their results are outlined in Section 2.)There is a limitation to the models of [2] and [5]. Inthese models, when bundling is shown to be optimal,the seller extracts essentially the full amount that buyersare willing to pay, and almost all buyers have roughlythe same budgets. Thus there is no room for “bandwidthhogs,” and bundling is optimal not just for the seller,but for almost all buyers. Further, those buyers spendalmost all they are able to do, so there is practically no“consumer surplus.” Thus this is a rare situation where(almost) everybody wins.This paper proposes a model that avoids the abovelimitation. It is similar in principle to those of [2] and [5],but allows for more elaborate forms for the valuationsof goods by consumers. We consider

J

buyers, and

I

goods, such as songs to download, web sites to view, orphone calls to make.

J

can be small or large, while

I

is best thought of as very large, and many results willhold only for large

I

. We assume that buyer

j

valuesgood

i

, at

U

j

(

x

i

) =

ω

j

×

ν

ji

,

1

≤

i

≤

I

,

1

≤

j

≤

J

,where

ω

j

and

ν

ji

are independent random variables, withdifferent distributions for

ω

and

ν

. (See Section 3 forrestrictions on the distributions.) We assume that buyershave unit demands, so purchase either one or no units of a particular good. The parameters

ν

ji

(and thus

U

j

(

x

i

)

)can be zero most of the time, corresponding to mostgoods on offer being of no interest to any single user.We also assume the value of a collection of goods to aconsumer is the sum of the values of individual goods.The parameters

ω

j

’s are an indirect way to introducea budget constraint on consumers. For large

I

, buyer

j

will usually have willingness to pay for all the goods onoffer close to

ω

j

IE

[

ν

]

. Hence if the distribution of

ω

j

is,say, the common Pareto one that is frequently observedin practice, we have a very unbalanced willingness tospend among buyers, with rules like the frequent “top10% of users account for 90% of consumption.”The main results of this paper show that for zeromarginal costs in the model sketched above, bundlingis, for large number of goods

I

, almost always moreproﬁtable for the seller than separate sales. (There aresome rare technical conditions, described in Section 4,under which separate sales can produce larger proﬁts,but that happens seldom and the gain is marginal anddeclines with growing

I

.) However, willingness to spendby consumers varies widely, and so transactions oftenleave substantial consumer surplus. On the other hand,bundling, while it maximizes seller proﬁt, often resultsin prices for the bundle that are not affordable for asubstantial fraction of users (“digital exclusion”). Thusthe model allows for explorations of more interestingphenomena than previous ones, in particular of welfareeffects.Our model does allow for non-zero marginal costs, andsome examples are presented. When those costs are highenough, separate sales lead to maximal proﬁts, consistentwith general observationsin the literature.For the sake of simplicity, we assume in the cur-rent draft that valuations of goods are uncorrelated.Extensions of our methods to cases where there aredependencies, along the lines of [2] and [5], will requirefurther work.The “bandwidth hogs” that are being stigmatized bythe telecom industry can be modeled in our setting bya combination of a substantial probability that

ω

is verysmall but non-zero and that

ν

is very small but non-zero.Bundling would then lead to high usage that would besuppressed by even a low price per good under separatesales. Our result that proﬁts are maximized throughbundling applies to such cases, but in full generalityonly for zero marginal costs. When those costs are non-zero, it is necessary to work with particular distributionsof

ω

and

ν

to ﬁnd out the threshold on marginal costsbeyond which separate sales are more proﬁtable. In suchsituations it is also possible to explore the effects of imposing usage caps.In a model such as ours, with a heterogenous dis-tribution of budgets, there are several factors that op-erate. Bundling smooths out distribution of valuationsof goods. On the other hand, it allows some to obtaincollections of goods for far less than their willingnessto spend, while preventing others, with low budgets,from purchasing anything. The main contribution of thepaper is to show in a precise quantitative way thatthe advantages of bundling for the seller overcome thedisadvantages.This paper is organised as follows: In Section 2, wereview the models proposed by Bakos and Brynjolfson[2] and Geng at al. [5]. In Section 3, we describeour model. In Section 4, we prove that in this model,bundling is the optimum strategy, or close to it, for theseller. In Section 5, we consider our model for severalspeciﬁc types of distributions of willingness to pay, andconsider the effects of non-zero marginal costs, ”digitalexclusion,” and social welfare. Finally, in Section 6, wepresent the conclusions and outline potential extensionsof our model. The Appendix presents some details of theexamples discussed in Section 5.

2. R

ELATED

W

ORKS

Our model is closest to that of Bakos and Brynjolfson[2] and Geng at al. [5]. Since there are some technicalproblems with the proofs in [2], as was pointed outin [5], which has corrected statements and proofs, weconcentrate on the latter paper. Simplifying somewhat,[5] considers value functions of the form

U

j

(

x

i

) =

ν

ji

(i.e., with

ω

identically 1), where

ν

ji

’s are independent,and have the same distributions for each

j

, but thosedistributions may depend on

i

.Geng at al. [5] show that when the expected value of

U

j

(

x

1

)+

U

j

(

x

2

)+

...

+

U

j

(

x

I

)

is large compared to itsvariance, bundling is close to optimal (in that it extractsrevenues close to the maximal willingness to pay). Thatpaper also obtains conditions for this mean to be largecompared to the variance, basically requiring that themean value of

ν

ji

as a function of

i

vary smoothly. Therequired relation between mean and variance in [5] isvery similar to ours, the result of both papers relying onthe Chebyshev inequality.For our proofs to be valid, we require the distributionsof all

ν

ji

’s to be identical. We also require, at least inthe present version, that

ν

ji

’s be independent. Both Bakosand Brynjolfson [2] and Geng at al. [5] do consider some2

dependencies among the information goods. Some of thedependencies assumed there can be accommodated inour model without any additional technical work, sincewe can vary the distributions of

ν

ji

as we let

I

→ ∞

,say.Geng at al. [5] produce a counterexample to someof the claims in [2]. Their construction involves ex-pected values of

ν

ji

declining rapidly as

i

→ ∞

. Inthat particular counterexample, separate sales can beabout twice as proﬁtable as bundling. However, there isconsiderable variation in both total budgets of individualbuyers, and in valuations of individual goods. In ourmodel, bundling is optimal even when individual budgetsvary dramatically. Hence, combined with the results of [5], we are led to the suggestion that optimality of bundling depends far more on similarity in distributionof valuations of goods than in the budgets of individuals.It is well known that mixed bundling (selling bothbundles and separate goods at the same time, but withprices higher than they would be for either pure bundlingor pure separate sales) is generally more proﬁtable thaneither extreme strategy. We show an example of thiseffect, but we concentrate on comparing the extremecases of either pure bundling or pure separate sales.

3. M

ODEL

D

ESCRIPTION

In this paper, we assume that there is a single sellerproducing

I

information goods for a population of

J

buyers with

unit demand

(i.e., each buyer purchases oneor zero units of each good). We denote the collection of all

I

goods by

X

.We assume that there exist a

real-valued, non-negative

function that represents each buyer’s willingness to pay(w.t.p.) for a single product, with the w.t.p. function of buyer

j

for product

i

given by

U

j

(

x

i

) =

ω

j

×

ν

ji

,

1

≤

i

≤

I,

1

≤

j

≤

J.

(1)We further assume these funcitons are additive, so that

U

j

(

X

) =

I

i

=1

U

j

(

x

i

) =

ω

j

×

(

ν

j

1

+

...

+

ν

jI

)

,

1

≤

j

≤

J

(2)represents the

w.t.p. function for the bundle of all I goods

of buyer

j

.We assume the

ω

j

,

1

≤

j

≤

J

, are non-negative

i.i.d.

random variables with ﬁnite mean

E

[

ω

]

. The

ν

ji

,

1

≤

i

≤

I,

1

≤

j

≤

J,

are non-negative

i.i.d.

random variableswith ﬁnite mean

E

[

ν

]

and ﬁnite variance

σ

2

.We assume

ω

j

’s are also independent of

ν

ji

’s, so thatthe

U

j

(

x

i

)

,

1

≤

i

≤

I,

1

≤

j

≤

J

are non-negative

i.i.d.

random variables with ﬁnite mean. Note that we allow

ω

to have inﬁnite variance, and so

U

j

(

x

i

)

can have inﬁnitevariance.We denote the C.D.F. of

ω

by

F

ω

(

x

) =

Prob

{

ω

≤

x

}

,

∀

x

∈R

, and similarly for

F

ν

(

x

)

and

F

ων

(

x

)

.An important observation is that the distribution of

U

j

(

x

i

)

is the same for every

i

. Thus the goods in ourmodel are homogenous in this sense, although their valu-ations do vary widely (with potentially inﬁnite variance).While many of our results hold only for large numbers

I

of goods, generally the number

J

of buyers can bearbitrary, even

1

or

2

. The

ω

j

can even be completelydeterministic (with the restriction that the seller mightknow the exact distribution of the actual

ω

j

, but wouldnot know individual values of

ω

j

). However, for simplic-ity we will assume

ω

j

’s are random variables. Our resultsare valid for ﬁnite values of

I

, not just asymptotically,and the distributions of

ω

and

ν

can vary, and do not haveto be held ﬁxed as we increase

I

, say. For the validity of our main results on optimality of bundling we basicallyneed only that

σ

2

be very small compared to

IE

[

ν

]

2

.

A. Seller’s maximization problem

In our basic setting we assume zero marginal costfor the seller, so that the revenue is the proﬁt, andwe compare only the two extreme alternatives of eitherselling all goods as a bundle, or selling each separately.

1) Separate sales:

When selling each good separately,symmetry of the distributions implies that the proﬁt-maximizing strategy is to sell all goods at the same price.Let

p

be the common price for each good. Then

D

S

(

p

) =

J

×

1

−

F

ων

(

p

)

(3)is the expected number of buyers who are willing topurchase any particular item at price

p

, and the expectedrevenue (and thus proﬁt) of the seller is given by

π

S

(

p

) =

pI

D

S

(

p

)

.

(4)We use

p

∗

to denote a price (possibly more than one)which maximizes

π

S

(

p

)

.The maximum possible proﬁt for the seller (withseparate sales) is equal to the sum of the average of each user’s w.t.p. for each good. To measure how closethe seller’s proﬁt is to the optimum proﬁt we deﬁne

ρ

S

=

π

S

(

p

∗

)

IJE

[

U

(

x

)]=

π

S

(

p

∗

)

IJE

[

ω

]

E

[

ν

]

,

(5)which has the property that

0

≤

ρ

S

≤

1

.

2) Bundling:

In this paper, we mainly consider thecase of pure bundling, so that each buyer either purchasesall goods for the single price or buys nothing. By ourassumptions, the expected number of buyers who are

If the seller has complete information about each buyer’s valuation,is not facing legal restraints, and can prevent resale, she can practiceﬁrst degree price discrimination and capture the entire consumersurplus. We exclude such practices in our model.

3

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