Price Discrimination Explains Everything
By Arnold Kling
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.