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Lecture 7: Bundling and Tying Examples Virgin Pricing Case

AEM 4160: Strategic Pricing Prof. Jura Liaukonyte
1

Bundling: An Example

Two television stations offered two old Hollywood films

Casablanca and Son of Godzilla

Willingness to pay is:

Willingness to pay for Casablanca Station A Station B $8,000 $7,000

Willingness to pay for Godzilla $2,500 $3,000

+ Bundling: An Example

Willingness to pay for Casablanca Station A Station B $8,000 $7,000

Willingness to pay for Godzilla $2,500 $3,000

Total Willingness to pay $10,500 $10,000

When Bundling Increases Profit

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 is heterogeneity in tastes.

Bundling
Extend
Costs Mixed

this example to allow for

bundling: offering products in a bundle and separately

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

bundling, the firm sets a price PB per bundle containing one unit of each good

With

Consumption Without Bundling

r2

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

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

P1

r1

Pure Bundling

R2 I
Consumers buy bundle

With pure bundling only bundles, and not separate goods, are offered Consumers will buy the good if and only if R1+ R2 PB

R1+ R2 >PB

R1+ R2 =PB
II
Consumers do not buy bundle

R1+ R2 <PB R1

Bundling Basic Idea

Two consumers

Two goods (E,D) Valuations of consumers: (3,1), (1,3)

Price goods separately: pE = p D = 3 Profits = 6 Better alternative: sell menus for $4 Profits = 8

entree

3 2 1 1 2 3
dessert

Key idea: Make consumers more homogeneous by aggregation.

Can be less extreme.

Necessary condition: Negative correlation in values (Rank reversal )

When Bundling Increases Profit

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
Extend
Mixed

this example to allow for

bundling: offering products in a bundle and separately

Example
Suppose

the firm produces two goods, 1, and 2, at unit cost c=0.5

are two consumers:
James

There

has reservation prices R1J=1 and R2J=2 Karen has reservation prices R1K=2 and R2K=1

Example: No Bundling or Pure Bundling

Without

bundling the firm should set P1=2 and P2=2 and sell one unit of each good
would give a profit of 22-20.5=3

This With

pure bundling, the firm could charge PB=3 for each bundle
would give profit 23-40.5=4

This

Example: Mixed Bundling

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 bundling the optimal prices would be P1=2, P2=2 giving a profit of 42-40.5=6
pure bundling neither Al nor Beth would buy the bundle at price PB=3

Without

With

Example: Mixed Bundling

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
would give a profit of 23+22-60.5=7

This

Bundling Again
Bundling
Mixed

does not always work

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

Bundling May

is a form of price discrimination

limit competition

VIRGIN PRICING CASE

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:

Young (15-29)

Trendy
Different than traditional cell phone users

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

Discussed Alternatives

Clone Industry Prices: contracts

Set prices below competition: contracts

A whole new plan: prepaid pricing

Clone Industry Prices

Pros

Cons

Give customers more features for the same price Easy to promote, use current models Limited spending power on promotion may be a justifiable factor Viable with Virgin Mobiles limited advertising budget

May drive margins down if additional features are costly Reduces competitive advantage Difficult to penetrate saturated market with similar offer as competitors Competitive with other cell phone providers and packages; does not support strong market differentiation

Price Below Competition

Pros

Cons

Drive sales and market share Accounts for limited spending power of target market

Margins and profitability will be driven down Inconsistent with company goal of profitability Cannot compete in price wars Not a long term solution

+ A Whole New Plan: Prepaid Pricing

Pros

Cons

Differentiate from competition Cater to the needs of target market Flexibility is attractive to target market

Risk of limited returns and loyalty Churn rate may increase

Profitability is key
Eliminates risk of missed payments

Pricing Structure from the Carrier Perspective

Annual churn rate WITH contracts Annual churn rate WITHOUT contracts The difference: =2% * 12 months = 24% (p.8) =6% * 12 months = 72% (p.8) 72% - 24% = 48%

Contracts:

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:

__________________
$370 (case p.2) __________________

Not surprising that major players still continue to hold the contracts.

Menu Pricing: Actual Usage

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

(lets assume somewhere in the middle = $370)

Break Even Point

Monthly ARPU (average revenue per unit): $52 (p.3)

Monthly Cost-to-Serve: $30 (p.3)

Monthly Margin: $22 Time required to break even on the acquisition cost = __________________ 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

- AC

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 With Contracts

The annual retention rate in the industry

= ______________

LTV =

- 370 =

LTV Without Contracts

Eliminate contracts -> churn rate increases to 6%

Calculate the LTV:

LTV =

- 370 =

Eliminate Hidden Costs

$ 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 _________= __________

What Happens to LTV?

Without hidden costs, but with contracts

LTV =

- 370 =

Without hidden costs and without contracts

LTV =

- 370 =

Elimination of contracts drives LTV below zero

Hidden costs boost the bottom line

Option 3: Different Pricing Approach

Target audience: Youth

Loathe 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

Options for Lowering Acquisition Costs

Advertising costs per customer

Industry=from $75 to $100 Virgin planned ad costs = 60 mil/1min= $60 (p.5)

Handset subsidies:

Current industry handset cost: $150 to $300 (assume $225) (p.5) Current industry handset subsidy: $100 to $200 (assume $150) (p.9) Current industry handset subsidy as a %: 67% Virgins handset cost: $60 to $100 (assume $80) Assume Virgins subsidy around 30% = $30

Acquisition Costs

Then Virgins AC would be just ____vs. industry average $370

Sales commission: $30 Advertising per gross add: $60 Handset Subsidy $30 Total: _______

Consumer Friendly Plan: How to Achieve Profitability

Break Even analysis: at what per minute price would Virgin break even:

Virgins monthly ARPU: ______________ where p=price per minute

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)

Monthly cost to serve: ______________

Monthly margin: _______________

LTV =

- _____ > 0
p > ________

Other Price Points

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 =

- _____ = ____

Virgins Pricing Plan: What Happened?

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%