TCS Daily

Pandora's Bundle

By Arnold Kling - April 5, 2004 12:00 AM

"Block booking of movies was the offer of a fixed package of movies to an exhibitor; the exhibitor could not pick and choose among the movies in the package. The Supreme Court banned the practice on the grounds that the movie companies were compounding a monopoly by using the popularity of the winning movies to compel exhibitors to purchase the losers.

Stigler disagreed and presented a simple alternative argument. If Gone with the Wind is worth $10,000 to the exhibitor and Getting Gertie's Garter is worth nothing, wrote Stigler, the distributor could get the whole $10,000 by selling Gone with the Wind. Throwing in a worthless movie would not cause the exhibitor to pay any more than $10,000. Therefore, reasoned Stigler, the Supreme Court's explanation seemed wrong."

-- from the Concise Encyclopedia of Economics Biography of George J. Stigler

Selling items in a package rather than separately is known as bundling. Bundling is viewed with suspicion by politicians, and it has long been considered an activity that justifies interference in markets. For example, in 1948, the Supreme Court banned "block booking," in which movie studios sold movie theaters movies as a package. See F. Andrew Hanssen.

Today, cable TV packaging is under fire the way that "block booking" was in 1948. Congress is considering passing legislation to force the cable industry to offer "a la carte" pricing, instead of the package pricing that exists today. As Senator John McCain put it, "When I go to the grocery store to buy a quart of milk, I don't have to buy a package of celery and a bunch of broccoli."

The attempt to criminalize bundling strikes me as opening up a Pandora's Box. Because bundling is so widespread, a paternalistic legislator or court could use bundling as an excuse to interfere in almost any business in America. If the existence of bundling is to be treated as justification for government intervention, then we might as well hand every product and pricing decision over to bureaucrats, and take that as our road to serfdom.

What George Stigler showed is that ordinary intuition about bundling is wrong. Your intuition is that the reason that the seller engages in bundling is to force you to buy something that you do not want. However, as Stigler pointed out, if that were the case, it would be cheaper for the seller to leave out the unwanted good and just charge you for what you want. That is why grocery stores do not bundle milk with broccoli -- it's cheaper for them just to sell you the milk.

Actually, grocery stores engage in bundling all the time. For example, my local grocery store offers "free milk" as part of a bundle where if you buy six bottles of milk you get the seventh one for free. As another example, the "large, economy size" is a form of bundling. To get the lower price per ounce, you have to buy 24 ounces instead of 16 ounces.

The Economics of Bundling

At least since Stigler's critique of the Supreme Court decision on "block booking," economists have known that sellers do not engage in bundling as a way of forcing consumers to pay for what they do not want. However, the economic theory of why sellers do engage in bundling is unsettled.

One hypothesis, which probably accounts for bundling in the Cable TV industry, is that bundling is a way for sellers to recover fixed costs. For example, Disneyland offers access to its rides as a bundle, rather than charging you separately for each ride. That is because most of Disneyland's costs are fixed -- they have to maintain the park and keep the rides going even if a particular ride attracts few riders. This example was used in an often-cited, cleverly-titled article by Walter Oi, called A Disneyland Dilemma: Two-Part Tariffs for a Mickey Mouse Monopoly.

Another reason for bundling is to save on the consumer's mental transaction costs. Most consumers would prefer to pay a flat rate for phone service or internet service rather than worry about per-minute pricing. I myself do not pay to download papers like Walter Oi's individually, but I would consider paying a monthly fee that would allow me to download whatever papers that I like. The monthly fee might work out to more than what I would pay for individual papers, but I would save on mental transaction costs.

Information goods are almost impossible to sell without bundling. As Carl Shapiro and Hal Varian pointed out in their classic book Information Rules, information goods are characterized by very low marginal cost of production and distribution, as well as by uncertainty on the part of the buyer as to the value (until you've actually obtained the good). Accordingly, for producers of information goods, such as software or music, Shapiro and Varian recommend various strategies that involve bundling. One strategy they call "versioning," in which the revenue-producing version consists of the free version bundled in some way. For example, zonelabs offers a free version of a firewall, but many desirable features are bundled into the paid version.

The Bundler from Redmond

The most successful software bundler is Microsoft. They are also the most hated software bundler, because they make it difficult for competitors to earn profits. They do this the way Wal-Mart does -- by offering lower prices than their competitors wish to charge. The largest anti-trust cases against Microsoft have centered around their decision to offer software for free.

Some competitors argue that Microsoft's strategy impedes innovation. Lawyers argue that small companies will not try to develop new products if Microsoft has the potential to give away something equivalent.

I am an investor in a small, privately-held software company developing a product in a space where we expect Microsoft will someday have its own offering. The way that we look at it, when Microsoft chooses to enter this market, they will have to decide whether it is cheaper to buy our company or build the software themselves. That "make or buy" decision does not depend on whether Microsoft chooses to sell the product separately or not. Instead, the decision depends on whether they think that the product we have is worth more than the cost that they would have to undertake to develop a viable competing product. If they believe that they can develop a product more cheaply and effectively internally, then they will choose not to buy our company. In that case, we will have to compete with them, and that may be difficult. But that's life.

Today, if a government official were to prevent Microsoft from offering a product in our market, then that would spare us a potential competitor. But by the same token it would deprive us of a potentially valuable partner and a possibly lucrative exit strategy.

Our attitude toward the bundler from Redmond would change if they were to make a final decision to enter our market without including our software in the bundle. In that case, it will clearly be in our interest to have them slapped down in court. However, as far as I can tell, there would be no public purpose served by such a court action.

Selective Central Planning vs. Local Knowledge

In the real world, competition is almost always messy. This leads to what I call the conflict between Hayekians and Stiglitzians. Friedrich Hayek believed that local knowledge is important, so that messy markets should be left alone. Joseph Stiglitz believes that economic theory of imperfect markets is important, so that government should intervene.

Stiglitzians look for opportunities to fine tune the market whenever it departs from the theoretical model of perfect competition. In theoretically perfect markets, there is no bundling. Stiglitzians can rationalize government intervention in any situation where there is bundling. In practice, however, their choices are somewhat arbitrary. The Europeans recently decided that Microsoft is not allowed to bundle a media player with its software, although nobody stops automobile manufacturers from bundling media players (car stereos) with their products.

In theory, the government could intervene everywhere it finds bundling. It could stop stores from offering two-for-one specials. It could ban frequent-flyer miles, which are a form of bundling. It could force cable TV operators to offer service by-the-channel instead of as a package, or by-the-minute instead of by-the-month. It could force cable TV operators to offer service by-the-minute, by-the-channel, for that matter.

A Stiglitzian economist could come up with a theory to justify such interventions, based on analysis that fits some features of a market while leaving out others. However, it is impossible for an economist to have a complete picture of the industry's cost structure, the tastes of consumers, potential substitutes, and potential innovations -- all of which need to be taken into account in order to determine the effect of bundling. The Hayekian view is that it is better to allow local knowledge to be applied in a market with messy competition than to ask a central planner to try and dictate outcomes based on his own incomplete information.

The Ultimate Bundler

Thomas Sowell recently wrote that if it were up to him, "Cabinet-level departments, for example, would be reduced to just two -- the Defense Department and the State Department... Departments of Agriculture, Commerce, Labor, etc., would all be abolished as just money-wasting bureaucracies serving outside special interests." However, we have to take the entire package. Government is the ultimate bundler.

Even though markets are not perfect, there are competitive checks operating. Inefficient businesses ultimately fail. Unwanted products get left on the shelf. Even if a product is very popular, such as Cable TV, I still do not have to buy it (and I don't). Even if Microsoft gives away a product, such as Outlook Express, I still do not have to use it (and I use a small company's email product instead). In contrast, the ultimate bundler faces no markets tests, and as taxpayers Sowell and I must help "buy" all of the products of government that we do not want.

The only check on government is voter action. We need to understand that bundling is not a crime, and we need to convey this knowledge through the electoral process. Instead, as long as we reward politicians who make selective attacks on bundling, then we are subjecting private businesses to unlimited interference by arrogant, posturing politicians.


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