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BUNDLING & TYING: Examples Virgin Pricing Case: Aem 4160: Strategic Pricing Prof.: Jura Liaukonyte
BUNDLING & TYING: Examples Virgin Pricing Case: Aem 4160: Strategic Pricing Prof.: Jura Liaukonyte
: JURA LIAUKONYTE
Bundling: an example
Bundling: an example 2
Willingness to pay for Casablanca Station A
Station B
$8,000
$7,000
bundling likely to increase profit if consumers' demands for bundled products are
negatively correlated: consumers who value one good much more than other and there are heterogeneity in tastes.
Bundling
Setting
Suppose a firm is selling two goods, 1 and 2 A consumers reservation prices for the two goods are given by R1 and R2 Without bundling, the firm sets the prices of the goods P1 and P2 With bundling, the firm sets a price PB per bundle containing one unit of each good
R1 P 1 R2 P2
II
Consumers buy only good 2
R1 P 1 R2 P2
I
Consumers buy both goods
P2
R1 P 1 R2 P2
III
Consumers buy neither good
R1 P 1 R2 P2
IV
Consumers buy only Good 1
P1
r1
For any prices P1 and P2, consumers can be categorized according to whether they have higher reservation prices R1 and R2 for one of the goods, none of the goods, or both of the goods
Pure Bundling
R2 I
Consumers buy bundle
With pure bundling only bundles, and not separate goods, are offered
R1+ R2 >PB
R1+ R2 =PB
II
Consumers do not buy bundle
R1+ R2 <PB R1
entree
3 2
1 1 2 3
Profits = 8
Key idea: Make consumers more homogeneous by aggregation. Can be less extreme.
bundling likely to increase profit if consumers' demands for bundled products are
negatively correlated: consumers who value one good much more than other and there are heterogeneity in tastes.
Bundling
Example
Suppose the firm produces two goods, 1, and 2, at unit cost c=0.5 There are two consumers:
has reservation prices R1J=1 and R2J=2 Karen has reservation prices R1K=2 and R2K=1
James
Without bundling the firm should set P1=2 and P2=2 and sell one unit of each good This would give a profit of 22-20.5=3 With pure bundling, the firm could charge PB=3 for each bundle This would give profit 23-40.5=4
Suppose there are two more consumers Al has reservation prices R1A=2 and R2A=0.5 and Beth has reservation prices R1B=0.5 and R2B=2 Without bundling the optimal prices would be P1=2, P2=2 giving a profit of 42-40.5=6 With pure bundling neither Al nor Beth would buy the bundle at price PB=3
However, if the goods were also sold separately at prices P1=2 and P2=2, then Al would buy good 1, Beth would buy good 2, and James and Karen would buy the bundle This would give a profit of 23+22-60.5=7
Bundling again
Bundling does not always work Mixed bundling is usually more profitable than pure bundling But pure bundling is not necessarily better than no bundling
Requires that there are reasonably large differences in consumer valuations of the goods
VIRGIN PRICING
Issue
Pricing decision:
Entering a highly saturated cell phone service industry, while targeting an unsaturated market segment Attempting to earn a profit from a limited income market Target market is:
Different spending habits Different usage Different needs Limited purchasing power According to marketing research, target market does not trust industry pricing plans. -Dan Schulman, CEO, Virgin Mobile USA
Objectives
Create value and profitability in cell phone service industry Target market ages 15-29, opportunity for growth with this market segment 1 million subscribers by year 1, 3 million by year 4 By focusing on the youth market from the ground up, were putting ourselves in a position to serve these customers in a way they have never been served before
-Dan Schulman, CEO, Virgin Mobile USA
Options
Pros
Cons
Competitive with other cell phone providers and packages; does not support strong market differentiation
Pros
Cons
Drive sales and market share Accounts for limited spending power of target market
Pros
Cons
Differentiate from competition Cater to the needs of target market Flexibility is attractive to target market Profitability is key Eliminates risk of missed payments
Contracts:
Annual churn rate WITH contracts Annual churn rate WITHOUT contracts 72% (p.8) The difference:
Take AT&T example: customer base = 20.5 million If AT&T abandons the contract based plan how many new customers would it need to acquire to offset customers from an increased churn rate?
Additional customers lost to churn: Acquisition cost per customer: Total cost of offsetting higher churn rate:
Not surprising that major players still continue to hold the contracts.
Bucket/Menu pricing
In reality most consumers are paying more than their optimal rate = if they new exactly how much they will consume industry makes money from consumer confusion Pricing menus allow carriers to advertise low per minute rates But most consumers end up choosing the wrong menu.
Hidden Fees
Able to promote low per minute prices, but still collect additional revenues
Acquisition costs
Advertising per gross add: from $75 to $100 (p.5) Sales commission paid per subscriber: $100 (p.5)
Handset subsidy provided to the subscriber: $100 to $200 (p.9) Total: from $275 to $405
In the cellular industry the monthly margin is relatively fixed across periods, therefore the traditional LTV can be simplified (assuming infinite horizon): LTV = M 1- r+ i
M = margin the customer generates in a year r = annual retention rate = (1-12*monthly churn rate) i = interest rate (assume 5%) AC = acquisition cost
= ______________
LTV =
- 370 =
$ 29 cellular bill becomes $35 due to hidden costs Increase of 21% If these costs were eliminated, the $22 margin would be reduced to _______________ Break even would become _________= __________
Elimination of contracts drives LTV below zero Hidden costs boost the bottom line
contracts Fail credit checks Ideal plan: no contracts, no menus, no hidden fees
How
to differentiate itself, and have a positive LTV Look at the factors that affect LTV
Handset subsidies:
Acquisition costs
commission: $30 Advertising per gross add: $60 Handset Subsidy $30 Total: _______
Break Even analysis: at what per minute price would Virgin break even:
Assume Virgins customers use 200 minutes per month (midpoint of estimate between 100 and 300, p.7) Assume monlty cost to serve is 45% of revenues (Exhibit 11)
LTV =
- _____ > 0
p > ________
What if Virgin charged per minute price comparable to other industry prices, somewhere in between 10 and 25 cents:
At 10 cents:
LTV =
- ____ = _____
At 25 cents:
LTV =
- _____ = ____
A prepaid plan No contracts No hidden charges No peak off peak hours Very low handset subsidies No credit checks No Monthly bills Price: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest of the day No exact numbers, but churn rate lower than 6%