Bundling Effects On Welfare In The Pay Tv Market

1. Introduction

Bundling is a common feature in many imperfectly competitive product markets. Firms in the telecommunications, financial services, health care, and information industries frequently offer products in bundles. While often innocuous, recent research has identified settings in which bundling can be used by firms to price discriminate among consumers or to extend market power into related product markets ([Adams and Yellen, 1976], [Bakos and Brynjolfsson, 1999] and [Nalebuff, 2004]).

We conduct a numerical analysis of bundling’s impact on the prices and networks offered by a “typical” US cable television system and assess the consequences of these choices for consumer, producer, and total welfare. We do so to speak to the current public policy debate about bundling in cable markets. Motivated by consumer dis-satisfaction over ever-increasing cable prices, law- and policy-makers are looking at unbundling вЂ" or “Ð" la carte” pricing вЂ" as a possible policy solution.1 Most cable television systems and the networks provided on them are strongly opposed to the idea, in part claiming that doing so would (possibly dramatically) reduce the number of (especially smaller) networks that can survive in an Ð" la carte environment (Booz Allen Hamilton, 2004).2

Existing theory bears out both of these views. On bundling and pricing, a substantial theoretical literature suggests that bundling may be used to sort consumers in a manner similar to second-degree price discrimination ([Stigler, 1968], [Adams and Yellen, 1976], [McAfee et al., 1989], [Bakos and Brynjolfsson, 1999] and [Armstrong, 1999]). When consumers have heterogeneous tastes for several products, bundling reduces that heterogeneity, allowing the firm to earn greater profit than would be possible with component (unbundled) prices. While firms clearly benefit in this case, consumer welfare generally falls, particularly when bundling requires consumers to purchase products in which they have little interest.

Less well established are the implications of bundling on the products offered by firms. It is well known that a single-product monopolist will not offer some products that increase social welfare because of the non-appropriability of total surplus (e.g. Tirole, 1988, Chapter 2). A key factor in the extent of the distortion is the shape of consumer preferences; all else equal, products with more elastic demand are more likely to be offered as the monopolist can better appropriate surplus for such goods. In the multi-product case, theory is ambiguous: under-provision due to non-appropriability is still a problem, but if products are substitutes, monopoly pricing on one good may increase demand for a second enough to encourage its (inefficient) offering. In this (multi-product) case, bundling can also influence the calculus of product choice. Because bundling aggregates preferences for bundle components, it makes tastes more homogenous, increasing the elasticity of demand ([Bakos and Brynjolfsson, 1999] and [Crawford, 2006]). If marginal costs for bundle components are zero, Bakos and Brynjolfsson (1999) show that as bundle size increases without bound, the product choice problem is solved; bundle profit converges to total surplus and both the monopolist and social planner will offer the same portfolio of goods.

When marginal costs are not zero, however, bundling can work too well. Because bundling requires all consumers purchase all goods, some sales may arise to consumers that value components at less then their cost. This is particularly problematic when there is strong negative correlation in tastes. Bundling is especially profitable in such settings ([Adams and Yellen, 1976] and [Schmalensee, 1984]) and the profit gains from correlation may outweigh the profit losses from below-cost sales. If so, the bundling monopolist may offer products that actually reduce total welfare. Even if not, consumer welfare may be lower from bundling; while some consumers will benefit from a new product, these gains may be outweighed by losses to existing consumers of the bundle.3

What are the implications of these results for the Ð" la carte debate in cable markets? The first branch of the literature strongly suggests that, for a given set of networks, bundling reduces consumer welfare to the benefit of firms. The second branch, however, suggests that by providing stronger incentives to offer new products, bundling may increase consumer (and total) welfare. The natural solution is to attempt to address this question empirically, a topic of related work in progress (Crawford and Yurukoglu, 2007). In this paper, we take a numerical approach. We make assumptions about households’ willingness-to-pay (WTP) and firms’ costs for television networks. We then calibrate these assumptions to replicate the offerings of an “average” 2004 cable system (California Cable of Monterey, CA) and simulate the profit and welfare consequences of alternative Ð" la carte policy proposals. We do not consider the impact of Ð" la carte on competition and the advertising market (two important caveats), but we do consider the consequence of increased marginal costs to cable systems of Ð" la carte offerings.

Several interesting results emerge from our numerical simulations. We consider two Ð" la carte scenarios: “Full Ð"Ђ La Carte” and “Theme Tiers”. As expected, if all networks continue to be offered, consumers gain and firms lose from Full Ð"Ђ La Carte: average per-household consumers surplus is estimated to increase by $6.80 (a 65.6% increase), gross firm profit is estimated to fall by $9.08 (a 44.2% decrease), and gross total surplus is estimated to fall by $2.28 (a 7.4% decrease). These impacts almost surely outweigh any compensating benefit of Ð" la carte to enhance incentives to offer networks: we estimate that 41 of the 50 offered cable networks in Monterey would have to exit for consumers surplus under Full Ð"Ђ La Carte to be no higher than that under bundling. Theme tiers offer similar, though smaller, effects (a 14.2% increase in consumers surplus, a 15.7% decrease in profit, a 5.7% decrease in total surplus, and 24 networks needed to exit to equate consumer benefits). These results suggest consumers might well benefit from Ð" la carte sales of cable networks.

2. The welfare effects of bundling

In this section we illustrate the welfare effects of bundling by a multi-product monopolist. In the first subsection, we illustrate the discriminatory effects of bundling for a given set of products.