Price Discrimination Explains Everything
Trying to explain cable TV bundling, James Surowiecki writes (his name makes me dyslexic),
The appeal of bundling is partly that it reduces transaction costs: instead of having to figure out how much each part of a package is worth to you, you can make a blanket judgment. Bundling eliminates the problem of fretting about small expenditures, which may be one reason that flat-rate pricing is very common in the vacation industry (cruise ships, all-inclusive travel packages, and so on). It also offers what economists call option value: you may never watch those sixty other channels, but the fact that you could if you wanted to is worth something. Many consumers also perceive bundles as bargains; getting a bunch of things for one price feels like a deal, even when it’s not.
I think that most economists’ first choice for explaining cable TV bundling would be “price discrimination.” As a cable provider, most of your costs are fixed. Your variable costs are low. If you charge a low price, you maximize total demand, which makes sense, but you get too little revenue. If you charge a high price, you cover your fixed costs, but you drive away some customers who could be served profitably.
What you would like to do is charge a high price to consumers who get a lot of value out of cable TV, while charging the less-eager consumers a low price that keeps them from declining the service altogether. Hence, bundling. You offer a “basic” service that attracts the low-demand consumers. You offer a premium bundle that gets you the high-demand consumers.
Another way to look at it is this. Suppose you would pay a lot for a premium sports channel, and I would pay a lot for a food channel. The cable company wants to charge me a high price for the food channel and a low price for the sports channel, and it wants to do the opposite with you. It cannot do that. The next best thing is to charge us both a moderately high price for a bundle that includes both channels. I behave as if I am paying mostly for the food channel and getting the sports channel at a zero marginal cost, and you behave as if you are paying mostly for the sports channel and getting the food channel at zero marginal cost.