### Strategic Pricing AEM 4160

```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
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
 Consumer Demand is
1.
2.
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
separately
products in a bundle and
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
only good 2
P2

both goods
R1  P1
R1  P1
R2  P2
R2  P2
III
IV
neither good
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

With pure bundling only
bundles, and not separate
goods, are offered

good if and only if
R1+ R2 ≥ PB
I
Consumers
R1+ R2 >PB
R1+ R2 =PB
II
Consumers do
R1+ R2 <PB
R1
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:
 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
 Consumer Demand is
1.
2.
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
separately
products in a bundle and
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
 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
 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

Situation




Target
Market
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
“According to marketing research, target market does not trust
industry pricing plans.” -Dan Schulman, CEO, Virgin Mobile USA

Objectives
1
Create value and profitability in cell phone service industry
2
Target market ages 15-29, opportunity for growth with this
market segment
3
1 million subscribers by year 1 and 3 million by year 4
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
1
Clone Industry Prices: contracts
2
Set prices below competition: contracts
3
A whole new plan: prepaid pricing
Clone Industry Prices
Pros
Cons

Give customers more features
for the same price

May drive margins down if

Easy to promote, use current
models


Difficult to penetrate saturated
market with similar offer as
competitors

Competitive with other cell
phone providers and packages;
does not support strong market
differentiation


Limited spending power on
promotion may be a justifiable
factor
Viable with Virgin Mobile’s
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
Risk of limited returns and
loyalty

Churn rate may increase

Flexibility is attractive to target
market

Profitability is key

Eliminates risk of missed
payments
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?

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)
__________________

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”


But most consumers end up choosing the wrong menu.
Hidden Fees

Able to promote low per minute prices, but still collect
Acquisition Costs


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 _________= __________
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




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
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
 Assume Virgin’s customers use 200 minutes per month
(midpoint of estimate between 100 and 300, p.7)
Monthly cost to serve: ______________
 Assume monlty 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%
```