Tying

In this talk, we're going to look at another common form of price discrimination, but not necessarily an obvious one, namely tying. Let's get right to it.

Tying is a form of price discrimination where one good, called the base good, is tied to a second good, called the variable good. Let's consider some examples: printers and ink. Here, printers are the base good. You buy one printer -- it's tied to a second good. You must buy the ink from the same company to be able to use it in that printer. The ink -- you could buy a little bit or you could buy a lot. The more pictures you want to print, the more ink you have to buy. One printer plus the variable amount of the second good, the ink.

What's another example? Well, cell phones plus a service plan based on data. The cell phone is the base good. The service plan based on data, well that comes in variable amounts. Some people use a little bit of data and other people consume a lot of data. Here's another example -- the Kindle Fire plus services from Amazon. You buy the Kindle Fire and then you rent or purchase books or magazines or other services from Amazon. The Kindle Fire is the base good. The second good are the services, the music, and so on. Those can be bought in variable amounts. Some people buy a little bit, other people buy a lot.

What's the economics here? A clue to what is going on can be found by noticing that the base good is typically pretty cheap. That is -- the printer, the cell phone, the Kindle Fire -- while the tied good is generally priced at well above marginal cost. Think about HP printers. You can buy a color printer for $70, but one set of ink refills might cost you $50. Just a few ink refills and you've already spent more on the ink than on the printer itself. The ink, by the way, doesn't cost that much to produce. It's just that the markup on the ink is pretty high. Note also that to print on HP printers, you must use HP ink. HP, in fact, puts the printer head in the ink cartridge and they have a patent on the printer head. That means only HP can sell the printer head, which means in turn that only HP can sell HP ink cartridges.

Again, what's going on? Think about the good, which is being bought and sold, as the ability to print color photos. Some people have a high willingness to pay for this good -- other people a lower willingness to pay. Ideally, what the monopolist wants to do is to charge everyone his or her willingness to pay -- a different price for different persons to march them down the demand curve just as we saw with our discussion of perfect price discrimination. Remarkably, tying can help the producer approach this profit maximizing ideal.

Suppose that the people with a high willingness to pay are the people who want to print a lot of color photos. That's a pretty reasonable assumption. In this case, since price is greater than marginal cost for the ink, the people who have a high willingness to pay are being charged much more than the people with the lower willingness to pay. Indeed, the price is different depending on exactly how many photos you print. Tying is a pretty flexible way of charging different prices to different people. Another way of thinking about this is that the tied good acts like a meter. The more the meter reads the higher the price is relative to marginal cost.

Notice again that we see exactly the same structure with cell phones which are very cheap compared to data, which is expensive relative to marginal cost. Similarly, the Kindle Fire is sold at close to marginal cost but the games, text, and other items are sold at above marginal cost. The Xbox console and the Xbox games are sold in pretty much the same way. That's because tying is a very flexible form of price discrimination. Tying tends to increase social welfare because it typically increases output.

If printers were not tied to ink, for example, printers would be much more expensive and ink would be cheaper. Under this system people who want to print a lot of color photos, well, they'll continue to buy. They'll be better off. But, the people who only wanted to print a few photos however they probably won't buy at all. The entry fee -- that is the cost of buying the printer, would then for them be too high and they won't buy the printer at all just to print only a few photos.

Output, therefore, in total, is probably lower without tying. That also means social welfare would be lower. And again, the higher profits which tying allows for also help to encourage research and development and spread its fixed cost over a larger number of users. For color photo printers, that R&D can be quite a bit. It's a very extensive market with a lot of research and development and a lot of product quality improvement. Tying therefore can also help the people who want to buy the product and who want to buy a lot of color photos because over time it increases R&D and increases the quality of the product available.

We have a whole other talk on bundling, so I'm just going to cover bundling very briefly here to note the difference between bundling and tying. Bundling requires that products are bought together in a bundler package. Microsoft Office is a bundle of programs. You buy Word, Excel, PowerPoint all together. Cable TV is a bundle of stations. You buy a package and you get everything in that package. The newspaper -- it's a bundle of sections. You get the sports page and the business section even if you read only the business section.

Both bundling and tying are types of price discrimination. The difference is that tied goods are sold one to many. The quantity of the tied good is variable. You can buy a little bit of ink or a lot of ink. The tied good is a form of metering. In bundling, the bundled goods are simply one to one in fixed proportion. You just get the package. You buy the Microsoft Office package -- it's not that you're charged extra every time you use Excel -- that would be a type of tying. Instead you're just getting Excel, PowerPoint, Word and other features together in a bundle. The same is usually true with cable TV and newspapers. Next time, we'll be looking at bundling in more detail. That's a fascinating topic. Thanks.