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Lecture 7: Bundling and Tying – Examples;
Virgin Pricing Case
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
2
Bundling: An Example

Two television stations offered two old Hollywood films

Casablanca and Son of Godzilla
Willingness to pay
Willingness to
pay for
Casablanca
Willingness to
pay for
Godzilla
Station A
$8,000
$2,500
Station B
$7,000
$3,000
Bundling: An Example
Willingness to pay
Willingness to
pay for
Casablanca
Willingness to
pay for
Godzilla
Total
Willingness
to pay
Station A
$8,000
$2,500
$10,500
Station B
$7,000
$3,000
$10,000
When Bundling Increases Profit
Requirement to increase profits

1.
2.
Consumer Demand is negatively correlated:
Consumers who value one good much more than
other
There is heterogeneity in tastes.
Bundling

Extend this example to allow for


Costs
Mixed bundling: offering products in a bundle and separately
Setting




Suppose a firm is selling two goods, 1 and 2
A consumer’s 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
With bundling, the firm sets a price PB per bundle
containing one unit of each good
Consumption Without Bundling
r2
R1  P1
R1  P1
R2  P2
R2  P2
II
I
Consumers buy
only good 2
P2

Consumers buy
both goods
R1  P1
R1  P1
R2  P2
R2  P2
III
IV
Consumers buy
neither good
Consumers buy
only Good 1
P1
r1
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
Pure Bundling
R2

I
Consumers
buy bundle
R1+ R2 >PB

R1+ R2 =PB
II
Consumers do
not buy bundle
R1+ R2 <PB
R1
With pure bundling
only bundles, and not
separate goods, are
offered
Consumers will buy
the good if and only
if
R1+ R2 ≥ PB
Bundling – Basic Idea



entree
Two consumers
Two goods (E,D)
Valuations of consumers:
(3,1), (1,3)
3
2
1
1
2
3
dessert

Price goods separately:
 pE = pD = 3
 Profits = 6
Bundling – Basic Idea



entree
Two consumers
Two goods (E,D)
Valuations of consumers:
(3,1), (1,3)



3

2

1
1
2
3
dessert
Price goods separately:
 pE = pD = 3
 Profits = 6
Better alternative:
 sell menus for $4
 Profits = 8
Key idea: Make consumers
more homogeneous by
aggregation.
Can be less extreme.
Necessary condition: Negative
correlation in values (Rank
reversal )
When Bundling Increases Profit
Requirement to increase profits

1.
2.
Consumer Demand is negatively correlated:
Consumers who value one good much more than
other
There is heterogeneity in tastes.
Bundling

Extend this example to allow for

Mixed bundling: offering products in a bundle and
separately
Example


Suppose the firm produces two goods, 1, and 2, at
unit cost c=0.5
There are two consumers:


James has reservation prices R1J=1 and R2J=2
Karen has reservation prices R1K=2 and R2K=1
Example: No Bundling or Pure Bundling

What will be the profits without and with bundling?
Example: No Bundling or Pure Bundling




Without bundling the firm should set P1=2 and P2=2 and sell
one unit of each good
This would give a profit of 2•2-2•0.5=3
With pure bundling, the firm could charge PB=3 for each
bundle
This would give profit 2•3-4•0.5=4
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
Without bundling the optimal prices would be
P1=2, P2=2 giving a profit of 4•2-4•0.5=6
With pure bundling neither Al nor Beth would
buy the bundle at price PB=3
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
This would give a profit of
2•3+2•2-6•0.5=7
Bundling Again



Bundling does not always work
Mixed 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 is a form of price discrimination
May limit competition
VIRGIN PRICING CASE
Issue

Problem: How should Virgin Mobile price its plans
 Entering a highly saturated cell phone service industry,
while targeting an unsaturated market segment
 Attempting to earn a profit from a limited income market

Young (15-29)
Trendy
Different than traditional cell phone users
 Different spending habits
 Different usage
 Different needs
 Limited purchasing power
Situation


Target
Market
“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 and 3 million by year 4
Be different:“By focusing on the youth market from the
ground up, we’re 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
Clone Industry Prices
Pros




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
Mobile’s limited
advertising budget
Cons
Clone Industry Prices
Pros
 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 Mobile’s
limited advertising budget
Cons




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
Price Below Competition
Pros


Cons
Drive sales and market
share
Accounts for limited
spending power of target
market
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
A Whole New Plan: Prepaid Pricing
Pros





Cons
Differentiate from
competition
Cater to the needs of
target market
Flexibility is attractive to
target market
Profitability is key
Eliminates risk of missed
payments
A Whole New Plan: Prepaid Pricing
Pros





Cons
Differentiate from
competition
Cater to the needs of
target market
Flexibility is attractive to
target market
Profitability is key
Eliminates risk of missed
payments


Risk of limited returns and
loyalty
Churn rate may increase
Pricing Structure from the Carrier
Perspective

Contracts:





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%
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:

Not surprising that major players still continue to hold the contracts.


__________________
$370 (case p.2)
__________________
Different Acquisition Costs across industries
Travel: Priceline.com: $7
 Telecom: Sprint PCS: $315
 Retail: Barnesandnoble.com: $10
 Financial: TD Waterhouse: $175

“Menu” Pricing: Actual Usage
Bucket/“Menu” Pricing




In reality most consumers are paying more than their
optimal rate = if they knew 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

(let’s 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 _________= __________
Eliminate Hidden Costs

If hidden costs were eliminated, the margin would
certainly be reduced.

Assume that it would be reduced to $18 from $22.

Break even would become _________= __________
What Happens to LTV?


Without hidden costs, but with contracts
Without hidden costs and without contracts
LTV =


- 370 =
Elimination of contracts drives LTV below zero
Hidden costs boost the bottom line
LTV =
- 370 =
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%
Virgin’s handset cost: $60 to $100 (assume $80)
Assume Virgin’s subsidy around 30% = $30
Acquisition Costs

Then Virgin’s 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:

Virgin’s monthly ARPU: ______________ where p=price per
minute


Monthly cost to serve: ______________


Assume Virgin’s customers use 200 minutes per month (midpoint of
estimate between 100 and 300, p.7)
Assume monthly cost to serve is 45% of revenues (Exhibit 11)
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 =
- _____ = ____
Virgin’s 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%