Arnold Kling  

Price Discrimination Explains Everything

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Trying to explain cable TV bundling, James Surowiecki writes (his name makes me dyslexic),


The appeal of bundling is partly that it reduces transaction costs: instead of having to figure out how much each part of a package is worth to you, you can make a blanket judgment. Bundling eliminates the problem of fretting about small expenditures, which may be one reason that flat-rate pricing is very common in the vacation industry (cruise ships, all-inclusive travel packages, and so on). It also offers what economists call option value: you may never watch those sixty other channels, but the fact that you could if you wanted to is worth something. Many consumers also perceive bundles as bargains; getting a bunch of things for one price feels like a deal, even when it's not.

I think that most economists' first choice for explaining cable TV bundling would be "price discrimination." As a cable provider, most of your costs are fixed. Your variable costs are low. If you charge a low price, you maximize total demand, which makes sense, but you get too little revenue. If you charge a high price, you cover your fixed costs, but you drive away some customers who could be served profitably.

What you would like to do is charge a high price to consumers who get a lot of value out of cable TV, while charging the less-eager consumers a low price that keeps them from declining the service altogether. Hence, bundling. You offer a "basic" service that attracts the low-demand consumers. You offer a premium bundle that gets you the high-demand consumers.

Another way to look at it is this. Suppose you would pay a lot for a premium sports channel, and I would pay a lot for a food channel. The cable company wants to charge me a high price for the food channel and a low price for the sports channel, and it wants to do the opposite with you. It cannot do that. The next best thing is to charge us both a moderately high price for a bundle that includes both channels. I behave as if I am paying mostly for the food channel and getting the sports channel at a zero marginal cost, and you behave as if you are paying mostly for the sports channel and getting the food channel at zero marginal cost.



COMMENTS (8 to date)
ryan yin writes:

I think it's Surowiecki, not Surowiecke.

hubert writes:

“Another way to look at it” is a completely different way to look at it, I think. In the last paragraph you decribe the reason behind bundling which I would describe as making a heterogenous valuation for different (related) products homogeneous by bundling the different products and selling them for one price. This is what I understand.

I do not understand the bundling rational in the second paragraph however. In essence this sounds like quality differentiation and not bundling. You sell a service with less quality for users that value the service less. For the consumers that value the premium service there is no reason to bundle. You could just as well sell the premium service seperately (which is often done with premium content cable TV).

Brad Warbiany writes:

I do think that one of the cable companies' responses is accurate -- that some channels would cease to exist if not bundled.

The problem is that for low-demand channels (say, 4% of cable customers buying the bundle would actually pay for it individually), they're making a small bit of money from everyone who buys the bundle. If they're unbundled, they cannot sell their channel for the same fee, they have to sell it 25x more expensive -- because they must earn the same revenue from a dramatically smaller customer base.

For example, ESPN is in enough demand that many people would buy it as a default, and thus the price charged per subscriber would be pretty close whether bundled or not.

Other channels, though, such as the Biography channel, will probably not have many regular viewers. Sure, we may all tune in from time to time if they're profiling someone that interests us, but wouldn't value it highly enough to pay monthly. So their unbundled price would be high.

As that unbundled price gets higher, they then price themselves out of the market. Paying $1 a month for Biography HD seems a lot easier than paying $10 a month for the same channel, even if you're a pretty big fan. Thus the subscriber base dwindles even further and the channel goes out of business -- or, as one might suggest with Biography (which is owned by A&E, the owner of the History Channel) gets automatically bundled by A&E with other channels.

Bundling allows a large economic entity (the cable company) to bargain down the cost of the channels, but only if they can deliver a large subscriber base. Offering piecemeal subscriber ship destroys that subscriber base and erodes their bargaining power.

Joel West writes:

Arnold,

I've been following this for a while, both as a consumer and as an economist. I think you're underestimating two points.

First, cable TV operators (or at least my provider, Comcast) behaves like every bit the monopolist that Ma Bell was in its heyday.

Second, as part of their franchise agreement with cities, operators are usually required to offer a "basic" service at a regulated price; over time, the gap between premium and basic service has grown from 2:1 to 10:1 or more. Even quality-adjusted, the gap between basic and near-basic has gone from say 1.2:1 or 1.5:1 to (today in San Jose) 4:1.

Joel

agnostic writes:

The concept of "bundling" doesn't really make sense because everything is a bundle if you look at it the right way. Consider a commodity food (like wheat) that has two nutrients, X and Y, being sold to two groups of consumers, one that is deficient in X and another that is deficient in Y.

Of course, you could "de-bundle" these nutrients and sell them separately, as you see with the looong aisles of supplements, vitamins, extracts, etc., in every grocery store or specialty health store. In this sense, wheat is a bundle of goods.

You'd like to charge X-deficient people a lot for X and little for Y, and Y-deficient people a lot for Y and little for X. Unable to do that, you bundle them together and charge a moderately high price for the combination found in wheat.

But since wheat producers operate in the closest thing to textbook competitive markets, they have no market power to get away with these shenanigans -- some other wheat producer will charge less for the bundle, so the price discriminator won't be able to earn extra profits.

You see the same thing in one competitive industry after another. Why bundle hot oil, potatoes, and salt into French fries? Or fries, soda, and burger into a value meal? So, the suspicion of bundles is not very helpful and certainly doesn't suggest price discrimination.

Stan Liebowitz and Stephen Margolis have a great review article on different types of bundles, why they persist, etc. Free version from SSRN:

Bundles of joy

agnostic writes:

As a thought experiment, assume that any network could broadcast American Idol -- no exclusivity. American Idol is a bundle of goods: there's the singing (which itself could be de-bundled into songs from various genres), the funny insults from Simon, the pretty face of Paula Abdul, etc.

Presumably there are some viewers who only watch the show to look at Paula Abdul and don't care about the rest of the content, and others who just watch to laugh at Simon's remarks, others who only enjoy hearing cover songs (perhaps only in country, not R&B or rock), and so on.

In your price discrimination model, the producers bundle all of these goods into a single show and charge a high price since they can't slice the show up into separate shows and price-discriminate the good old fashioned way.

But if entry is open to competitors, someone could start up a cable provider company that sold the bundled show at a lower price. Or they might slice it up so that there were just a series of shots of Paula Abdul and sell that to Paula-preferring viewers at a lower price than that of the whole bundle. And similarly for the other de-bundled goods at lower-than-bundle prices.

But we don't see that. So, it must be that consumers of cable TV prefer buying bundles of channels, and that competition prevents price discrimination. After all, you never know which channel might have an interesting show on at any given hour. If a channel you seldom watch has a great show on, you don't want to go through the hassle of re-negotiating your contract with the cable company -- as though every single 30-minute chunk of content were pay-per-view -- across all possible instances of this event occurring.

So we just say "give us all those channels" to diversify our portfolio and lower the chance of there being nothing to watch.

Moreover, you could also construe a single channel as a bundle -- namely, of all the shows that it broadcasts! In your view, even the provider of a single channel would be a price discriminator since some viewers only subscribe to it for one show, and other viewers only for some other show. Even then, we'd demand the entire bundle of shows on the channel, again to reduce the risk of there being nothing to watch.

The key is that each chunk of content is new and unlike all the others, so we don't know if it's good until we watch it. (Arthur De Vany makes this point about movies.) In order to discover as many good 30-minute chunks as possible, where each one might as well be a coin flip in quality, we cast as wide of a net as possible. Trial and error works best when you try a lot, and that's why we demand bundles.

DavidJones writes:

I work in a related industry, and can say that another reason is that companies that own multiple channels often demand bundling of their less-popular channels with their more-popular channels.

Colin K writes:

Coming from the software world, which has some similar dynamics, I would say that as marginal cost approaches zero, the primary issue becomes cost of sale.

I'd pay $5-$10/mo just to get the original shows on HBO or Showtime. But, the minimum cost for me to get any cable package with just one premium channel in Boston is ~$70/mo. That pays for Netflix and a lot of purchases from iTunes.

The only reasons I see to buy anything more than an high-bandwidth Internet connection are the premium shows and live sports. This is a big reason, I suspect, why the cable telcos do not like the idea of net neutrality. When MLB and the NFL start going direct-to-consumer, the rationale for cable will be dead.

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