The reservation prices of three classes of demanders of Cable Channels Lifetime, Disney, and ESPN are given below:
Class Lifetime Disney ESPN
30 Year Old Males $4 $3 $22
30 Year Old Females $18 $8 $13
3 to 7 year olds $ 3 $20 $5
It cost $5 to produce and distribute each Channel. The cable company can sell each separately, sell them as a bundle, or both.
a. What bundling pricing strategy would you recommend?
b. How much more profitable is the best strategy compared to the next best?.
Possible to explain your reasoning and please show all work.
The important concept to understand for this question is how bundling works. A bundling pricing strategy involves taking two goods and only selling them together. This is often used by cable companies to sell channels to consumers that they wouldn't otherwise want, which consumers will buy to get a desirable channel within the bundle. This question asks you to evaluate the profit of each possible bundling strategy, determine which is most profitable, and then compare it to the next best alternative.
There are 5 possible combinations of bundles, and they are as follows:
Lifetime, Disney, ESPN (no bundles)
Lifetime + Disney, ESPN (one bundle)
Lifetime + ESPN, Disney (one bundle)
Disney + ESPN, Lifetime (one bundle)
Lifetime + Disney + ESPN (one bundle)
Note that the problem states that there is a fixed cost of distributing these channels - it costs $5 to produce and distribute them no matter how many people buy them.
As a result, it's pretty easy to calculate the profit for each bundle. I'll work through the first one (no bundles) and leave the rest to you.
For each bundle (or lack-of-bundle, in some cases), you have to evaluate what will bring in the greatest marginal revenue. Marginal cost is zero because the problem does not state that there are any variable costs, so wherever revenue is highest is where the firm will make the most money.
For Lifetime, Disney, ESPN:
For just the Lifetime channel, we evaluate three possible prices, which are each of the reservation prices of that channel - $3, $4, and $18. If we price the channel at $3, then all three people will buy it, giving us $9 in revenue. If we price the channel at $4, two people will buy it, giving us $8 in revenue. If we price the channel at $18, one person will buy it, giving us $18 in revenue. Revenue (and therefore profit) is maximized at a price of $18, so we would sell Lifetime at $18 for that one channel.
Going through the same exercises for Disney and ESPN, we get a price of $20 for Disney and $13 for ESPN (with two people buying ESPN).
To get total revenue, we add the revenue from all bundles (or non-bundles, in this example) together: $18 + $20 + $26 = $64.
Total Cost = 5 * 3 = 15 because each channel costs $5 to produce.
Remember that Profit = Total revenue - Total Cost
As a result, we get Profit = $64 - $15 = $49 for this one example. From here, you need to go through the same process for each of the four other possible bundling strategies and determine which generates the largest profit. Finally, compare that to the second-best strategy. Let me know if you have any other questions!