11 Bundling and tying

• Definition of bundling:

— to sell packages ("bundles") containing more than one unit of the

product.
∗ this is another form of non-linear pricing → second-degree
price discrimination.

• Definition of tying:

— to sell packages containing at least two different products.

11.1 The profitability of bundling

• Consider a monopoly selling a product to a single consumer whose
demand curve is given by

Q (p) = a − p.

• Assume that production is costless

• The profit-maximising unit price for this good is given by

a
pm = arg max {π = Q (p) p = (a − p) p} = .
2

a


 a2
• The price pm = 2
gives a profit π m = a − a2 a2 = 4
.

• For pm = a2 , the consumer will buy a

2
units of the good and the consumer

2 2
surplus is CS = 12 a2 = a8 .

• The firm can increase its profits by bundling. If the unit price is zero,
the consumer will by a units. In this case, the consumer surplus is
2
given by a2 .

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 • Suppose that the firm bundles a units together and offers the package
2
for a total price of a2 minus 1 cent.

• The consumer will prefer to buy the package since it gives a higher
consumer surplus (1 cent) than not to buy (zero).
a2
• Offering this bundle will given the firm a profit of 2
(minus 1 cent),
2
which is clearly higher than π m = a4 .

• Thus, the firm is able to extract the entire consumer surplus by bundling
a units together and sell it in one package.

11.2 The profitability of tying

• Tying can be a profitable strategy if consumers have different tastes.

• Consider a monopoly selling two different goods, x and y.

• Assume that there are no production costs.

• There are two consumers who buy at most one unit of each good.

• The consumers have different valuations of the two goods:

— Consumer 1 has a maximum willingness-to-pay of H for good x

and L for good y.
— Consumer 2 has a maximum willingness-to-pay of L for good x
and H for good y.
— H>L

• The monopolist can choose between tying the two goods or not.

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11.2.1 No tying

• The monopolist has two options:

1. Setting a low price and sell both products to both consumers:

px = py = L. Total profit is then 4L.
2. Setting a high price and sell only good x to consumer 1 and only
good y to consumer 2: px = py = H. Total profit is then 2H.

• The profit-maximising choice is to set low prices if H < 2L and high

prices if H > 2L.

11.2.2 Tying

• Suppose that the monopolist sells only packages that contain one unit
of x and one unit of y.

• By setting a price pT = H + L for each package, both consumers will

buy one package each and all consumer surplus is extracted.

• The monopolist sells two packages and earns a profit of 2 (H + L),

which is higher than what the firm can earn without tying.

11.3 Mixed tying

• Under some conditions, it can be even more profitable for the firm to
sell the two products separately in addition to packages containing both
products.

• Assume now that there are three consumers with the following willingness-
to-pay (WTP) for the two products:

— Consumer 1 has a WTP of 4 for good x and 0 for good y.

— Consumer 2 has a WTP of 3 for good x and 3 for good y.
— Consumer 3 has a WTP of 0 for good x and 4 for good y.

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11.3.1 No tying

• With no tying, the firm has two possible pricing strategies:

1. If px = py = 3, then consumer 1 buys x, consumer 3 buys y, and

consumer 2 buys one unit of x and one unit of y. The firm’s profit
is 3 · 4 = 12.
2. If px = py = 4, then consumer 1 buys x, consumer 3 buys y, and
consumer 2 does not buy any good. The firm’s profit is 2 · 4 = 8.

• Clearly, px = py = 3 is the optimal choice.

11.3.2 Pure tying

• With pure tying, the firm sells packages containing one unit of x and
one unit of y for a single price pT .

• Again, there are two possible pricing strategies:

1. If pT = 4, then all three consumers buy the tied package and the
firm’s profit is 3 · 4 = 12.
2. If pT = 6, then only consumer 2 buys the tied package and the
firm’s profit is 1 · 6 = 6.

• Clearly, pT = 4 is the optimal choice.

11.3.3 Mixed tying

• With mixed tying, the firm sells x and y separately in addition to

packages containing one unit of x and one unit of y.

• Suppose that the firm sells the tied package for a price of pT = 6 and
also sells the individual products for prices px = py = 4.

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 • In this case, consumer 2 will buy the package, while consumer 1 will
buy good x and consumer 3 will buy good y.

• Total profit for the firm is 6 + 4 + 4 = 14.

• Thus, mixed tying gives higher profit than pure tying, which gives
higher profit than no tying.

11.4 Tying as product differentiation

• Tying can be used as a strategy to relax price competition by making
product more differentiated.

• Consider a homogeneous product that is sold by two firms.

• Each firm can choose whether to offer the product with or without
supporting services (e.g., the firms can tie the product with supporting
services).

• Consumers attach the same basic value B to the homogeneous product,

but have different willingness-to-pay s for the supporting services.

• Consumer utility is given by


B − pN if the product is bought without services
U= ,
B + s − pS if the product is bought with services

— pN is the price of the product without services, and pS is the price

of the product with services.
— the willingness-to-pay for services, s, is uniformly distributed on
the interval [0, 1], with density equal to 1.

• The unit cost of producing the basic product is m and the unit cost of
providing services is w.

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 • Consider the following 2-stage game:

1. Each firm decides whether to sell the product with or without a

unit of services.
2. The firms compete in prices.

• When solving for the subgame perfect Nash equilibrium, we need to

consider three different cases at the second stage of the game: (i) neither
firm ties services, (ii) both firms tie services, (iii) one firm ties services
and the other does not.

11.4.1 Neither firm ties services

• In this case, the two firms sell homogeneous products (the basic prod-
uct) and the equilibrium price is equal to marginal cost, pN = m, which
means that the firms make zero profits.

11.4.2 Both firms tie services

• Again, the two firms sell homogeneous products (the basic product
+ services) and the equilibrium price is equal to marginal cost, pS =
m + w, which means that the firms make zero profits.

11.4.3 One firm ties services while the other does not

• In this case, the two firms sell vertically differentiated products. If

pS > pN , consumers with low WTP for services will buy the untied
product while consumers with high WTP for services will buy the tied
product.

• The location of the indifferent consumer,

s , is given by

B + s − pS = B − pN

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 ⇐⇒
s = pS − pN .


• Thus, the firm that offers an untied product has demand s, while the
firm that offers a tied product has demand (1 − 
s) .

• In the Bertrand subgame, the two firms solves the following profit max-
imisation problems:

max π N = (pN − m) 
s,
pN

max π S = (pS − m − w) (1 − s) .

pS

• The best-response functions are given by

1
pS = (1 + m + w + pN ) ,
2
1
pN = (m + pS ) .
2
— Notice that prices are strategic complements, as usual.

• The equilibrium prices are

2
pS = (1 + w) + m,
3
1
pN = (1 + w) + m.
3
— The firm offering the tied product charges a higher price.

• Equilibrium market shares are

1
s = (1 + w) ,
3

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 1
1 − s = (2 − w) .
3
— The equilibrium exists only if w < 2.

• Equilibrium profits are

1
πS = (2 − w)2 ,
9
1
πN = (1 + w)2 .
9
• As long as w < 2, both firms make a positive profit if one firm ties the
product with services and the other firm does not. This is therefore a
subgame perfect Nash equilibrium of the full game.

• Thus, tying by one firm is a mechanism to create vertical product

differentiation, which reduces competition between the two firms.

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