Thursday, July 28, 2011

Business Model Analysis, Part 7: Bundling

This post is part of a series on business model analysis for entrepreneurs. The first post in the series presents a comprehensive list of issues (available as a downloadable PDF) entrepreneurs should consider when designing a business model. Others delve into specific issues; this one provides an overview of bundling.

Bundling entails selling, in a single transaction, two or more items that could conceivably be sold separately.  A printed newspaper, for example, is a bundle of news stories, classified ads, comics, obituaries, stock tables, sports scores, etc. Microsoft Office bundles several productivity applications in a software suite.

The ubiquity of bundling is not an accident: the strategy can provide significant benefits, including superior surplus extraction (i.e., capturing a greater share of customers’ willingness to pay), economies of scope, product design improvements, and strategic advantages.

However, pursuing a bundling strategy can be challenging for a resource-constrained startup Most early-stage ventures strain their capabilities to develop and sell a single product, so bundling multiple products from the outset may not be an option. Nevertheless, entrepreneurs should keep the potential benefits from bundling in mind as they design their business models and plan for future product launches.

These benefits include :
  • Surplus Extraction. Economists define consumer surplus as the difference between a customer’s willingness-to-pay (WTP) for a product and its price. When a firm offers the same price to all customers (i.e., when it does not engage in price discrimination via negotiated pricing, auctions, etc.), bundling two or more products may allow the firm to extract a larger share of total available consumer surplus — and earn higher profits — than it would from selling the items separately. To illustrate this potential benefit, consider an example with two customers, Jack and Jill, and two products, A and B, each sold by the same monopolist. A and B both have zero marginal cost (as with many information goods), and the firm must offer a single price for each product to all customers. Jack’s maximum WTP is $10 for A and $4 for B. Jill’s maximum WTP is the reverse: $4 for A and $10 for B. If the firm sells A and B separately for $4 each, it will sell one unit of each product to both customers and earn total profits of $16. By pricing each product at $10, it will sell one unit of A to Jack and one unit of B to Jill and earn profits of $20. However, if the firm offers an A+B bundle for $14, it will sell the bundle to both customers and earn profits of $28. Bundling is more likely to increase profits in this way when: 1) the marginal cost of bundled items is low or zero; and 2) the correlation of consumers’ valuations for individual items is weak. Weak correlation means that when customers evaluate the items in a bundle, they don't all have the same favorites. Real world examples of surplus extraction through bundling abound. Some HBO subscribers, for example, value its recent theatrical films highly; others love its original series (e.g., True Blood, Entourage); still others are drawn to HBO's boxing matches or concerts. This varied programming mix allows customers with very different preferences to each justify paying a $10 monthly subscription fee.
  • Economies of Scope. Compared to selling items separately, bundling can also reduce a firm’s costs. Firms can realize economies of scope in customer acquisition activities because they can sell the bundle with a single marketing message, rather than two separate ads or two sales calls for two distinct products. Likewise, economies of scope in production are available when integrated designs leverage shared components (e.g., a single screen and battery when combining a cell phone and MP3 player).
  • Product Design. Integrated designs may also yield quality advantages through simplification of interfaces, as with Google’s use of a common password across all of its applications and its integration of Gmail into its search service.
  • Strategic Advantages. Under certain conditions (described in this academic paper), bundling may allow a company that monopolizes a market for one product (call it "A") to profitably leverage its way into the market for a crucial complement to A (call it "B") which previously was supplied only by independent companies. Products are complements when they are frequently or always consumed in tandem (e.g., browsers and PCs; beer and pizza). By offering only an A+B bundle (i.e., "tying" A and B and not allowing customers to buy A separately), the market A monopolist forecloses access to its customers, denying standalone suppliers of B the opportunity to sell to them. The resulting reduction in revenue weakens the standalone suppliers of B and may even force them to exit the market. Of course, such a strategy can run afoul of antitrust law, as Microsoft discovered when it tied the Internet Explorer browser to its monopoly Windows operating system.