Strategic rules of trade

When my colleague and I were working on our book on microeconomics (the first edition was published in 1988), most textbooks were very theoretical, conventional, and lacking in practical examples. My co-author and I used an unconventional approach, and our book covered such contemporary topics as the game theory, strategic behavior, asymmetrical information, and so on. In addition, we cited a number of examples of how problems can be practically solved by using a scientific approach. The Kyiv School of Economics is following a similar path in teaching its students.

The topic of my presentation today is “The Application of Microeconomic Theory to Business.” I will also talk about the practical application of microeconomics to the formation of a national economic policy. I would like to broach this subject by referring to the bundling of goods and services as an example.

I will discuss how to sell goods not as separate items but as sets or packages. There are countless examples, since this method is rather intensively employed. Before describing this method in detail, I would like to give you several examples of packaging. Take a restaurant. Many restaurants offer set meals that consist of an appetizer, a main course, and a dessert. Fast-food restaurants do the same. McDonald’s practices what they call menus. When you book accommodations at a ski resort, the package includes your airfare, hotel, ski lift, and so on.

Car sales are another example of package sales. Fifteen or twenty years ago they sold basic models and if you needed something else, like automatic locks or electric windows, a sunroof, or air conditioner, you had to order and pay for these options separately. If you think about this for a minute, you will realize that this makes no sense because buying goods separately is very expensive and inconvenient. Automobile companies realized as much, so now they sell packages. Car dealers also offer two models, a basic one and one with a package of options.

There are other examples. We all use Microsoft Windows. This is also a package. Some of us only use Word, while others use mostly PowerPoint or Excel. Microsoft Office has them all. You can buy only Word, but it will cost you more than the whole package, so everybody buys Microsoft Office. Later I will explain why Microsoft does this. We all have Microsoft Windows and Internet Explorer because they are sold as a package; you can’t get them any other way.

This subject is inexhaustible. Take medical diagnostic equipment. There are ordinary x-ray and MRI (Magnetic Resonance Imaging) devices. The latter are extremely sophisticated and are sold together with services as a package. Cars are sold the same way, with three- or four-year warranties. In other words, you buy a car and its servicing as a package. In most countries medical equipment for hospitals is also sold as packages. Large companies, like Johnson & Johnson, sell medical equipment: scalpels, scissors, endoscopic surgical devices, etc. All this is often sold as packages, so hospitals can buy everything they need from the same firm.

First, I will tell you why companies do this, and then I will talk about how good this practice is for consumers. This topic will be familiar to those who have seen my textbook or studied the microeconomics section on price discrimination. Selling goods as packages is an attempt to get the consumer’s surplus; it is a two-level tariff. When a company makes a package of their goods, they can get extra money from the consumer. Goods can be bundled if they are in demand with a negative correlation.

This can be easily explained by the following example. You go to a restaurant, and you can afford to pay for an appetizer, the main course, and a dessert. These dishes are in demand with a negative correlation. For example, people who order an appetizer and a main course do not want dessert, while those who order a dessert and an appetizer do not want the main course. This is explained by physical reasons; our stomach can hold only so much. We can’t handle all the dishes, so this results in negative correlation. Therefore, restaurants can make you pay more if they serve all three courses as a set meal. You can see that the restaurant business is not just about cooking but also about economics. For the same reason tourist services are sold as a package, as a component of resort accommodations.

We have just finished looking at the part of standard microeconomics that is taught in junior-level courses. Now I will tell you about some other things. First, I will talk about the levers that benefit competition and then I will talk about those that impede it.

Allow me first to dwell on bundling, the goal of which is to lower prices. A graphic example of bundling is the purchase of a pair of shoes; the left and the right one are sold as a package. Why? Because these goods complement each other. If you buy a right shoe, you will need the left one as well, so it will cost you less to buy both as a package rather than separately. Now you understand why shoe stores sell pairs of shoes. The same is true of cars. They are bundled in order to save money. At first, car manufacturers did not understand the possibility for economizing on this, but now they understand that bundling is possible and will save them money.

There are also products that complement each other in the course of consumption or when used together. The demand for one product results in an increase in the demand for another one. A graphic example is the Windows operating system and related programs, such as Microsoft Office, Internet Explorer, Web Browser, and so on. You’re using them as a package. If you don’t have the operating system, you can’t use any of these programs. If you have the operating system but no programs, what use is this system? Therefore, these products are used as a package.

Another example is diagnostic equipment and servicing. If you have this equipment, you need servicing. If you have the servicing facilities, how can you manage without equipment? An increase in the sales of one product leads to increased demand for the other one. What is interesting is that a firm manufacturing both of these products will set a lower price on them than if these products were made by two independent firms. The idea is that if Windows were made by Microsoft and Office by another company, the price of both products would most likely be higher than when made by a single company.

The reason is that, by lowering the price of one product, you generate additional sales of another product. When the price of Commodity B is reduced, the sales of Commodity A get a boost. If a single company sells A and B, it can profit from this by lowering the price. If A and B are made by separate companies, there is no chance of profiting from dropping the price of A, so in this case prices will be higher. Sometimes it serves one’s purpose well to keep the price of a product very low, even close to nil, or even make it negative, but in this case the goods must be sold as packages.

Suppose there are two products that complement each other. We apply the demand curve equation. Price elasticity is negative. If the price of Product 2 goes up, demand for Product 1 drops because these goods complement each other. An increase in the price of one product raises the demand for the other one. We have to select prices P1 and P2 that maximize profit. We set certain demand curve parameters. Marginal expenditures amount to $10. Then the prices to maximize the profit will be: P1=$55 and P2=$5. In other words, Product 2’s optimum selling price is five dollars, which is less than its prime cost. This is necessary to generate more profit because Product 1 sells at 55 dollars.

Some interesting things stem from this example. One of them is dumping. In the US, foreign companies are accused of dumping when they try to enter the US market by deliberately lowering their prices. Bundling goods is not dumping; it’s just a simple way to maximize your profits. Suppose you work for a company, and you have to explain why one product has to be sold at a price lower than the marginal expenditures involved in its production. This issue doesn’t just relate to economics. To apply this to business, it is crucial to know how to establish contacts to make people understand that this is not dumping but maximization of profits.

Findings show that you have to sell products at prices lower than marginal expenditures. This isn’t bundling. If you sell products in accordance with a mutually related demand - in other words, if your products are complementary or substitute goods, you have to set prices jointly, not individually. Not all businessmen are aware of this. For example, Dell sells computers and monitors; these goods complement each other, and the company is setting prices jointly, thereby maximizing its profits.

Adobe sells two kinds of programs - Photoshop and Photoshop Elements. The latter is a simplified version of the former, so its price is lower. These are substitute commodities. The company understands this and jointly sets prices on all its product lines. Xerox sells photocopying machines and servicing as packages because these goods complement each other. Pricing is also done jointly. The same is true of General Electric and its CT (Computed Tomography) and MRI machines. Supermarkets sell products for gourmets and for ordinary consumers (like milk, bread, vegetables, etc.). These are substitute goods. Supermarkets must set prices for all its product lines. It is very important to understand that if products are bundled or if they complement each other, you have to do the pricing jointly.

Now let’s replace one parameter in this model. The profit-maximizing prices are now P1=$58 and P2=$1.67. Why the negative price? Paying people to buy goods is not the best strategy. Let’s make the price of the second commodity equal to nil. So now P2=$0 and P1=$57.5. Can we offer products for free? Will this strategy work in the case of complementary products?

Suppose I have two products, a Microsoft Office and Windows package, or servicing and a car. Can I give out one product for free and sell the other one? Will this work? Companies never do this. If you give somebody something for free, there is no guarantee that somebody will use it and not dump it in the nearest garbage can. A zero price is set on the second product in order to boost the demand for the first one. If you give out the first product for free, the consumer may simply toss it in the garbage, and there will be no stimulation of demand for the first product.

Instead, you can sell goods as packages. We take Product 1 and Product 2 and make a package and price it at $57.5. Now we know that no consumer is going to junk it after paying $57.5 to get both products. Therefore, we do not give away but sell them as a package.

Take a computer company with an adequate performance, which makes complementary products but is unable to set a negative price. Here making packages is good for both the company and consumers. If the government tells this company that it can’t sell these kinds of packages and that the two products will be sold by two different companies, the prices of these goods will increase and the consumer will suffer. So, making packages is good for the consumer. Authorizing such package sales is good national politics. This aspect benefits competition.

Let’s take Internet Explorer and Windows. The world’s first Internet browser was created by Netscape in late 1994 and it started being used in early 1995. Very few people were using the Internet at the time. The Internet became more popular in 1997. It has become so popular that today people regard the Internet as a fundamental phenomenon; it is as necessary to man as electricity or transport, although it emerged quite recently.

Netscape was the first company to develop an Internet browser known as Netscape Navigator. It was selling it at $50. At the time, the company had 95 percent of the market. There were other companies, but their share of the market was very small. Then Microsoft came up with an Internet browser called Internet Explorer. At first it was a rather clumsy browser and almost no one wanted to buy it. But then Microsoft dropped the price of Microsoft Explorer from $50 to zero. Netscape Navigator followed suit. Both programs were now freeware. Despite this, Netscape was still making money because the servers ensuring the content used their software, although the browser remained freeware. That was how Netscape preserved 90 percent of the market.

Microsoft was loath to remain in an unfavorable situation, and so it issued a Microsoft Explorer upgrade available as part of the Windows package. Everyone who bought Windows automatically got Explorer. Of course, Netscape was also available, but the demand was not the same because it had to be downloaded and installed, which took time and computer memory. Netscape’s market share dropped from 90 to 80 percent, then to 70, 30, and finally almost to nil. At this point the US government, acting in accordance with the Antimonopoly law, declared that Microsoft had used its software monopoly, which had resulted in the disappearance of Netscape.

This illustrates the negative effect of anticompetitive package sales. This strategy can be used to prevent a rival company from entering the market or even to bring it to bankruptcy, as was the case with Netscape. Bundling products can be used as a pricing policy in the presence of a positive correlation of market demand, as in the case of Windows and the Explorer browser software. This is called the monopoly advantage and relates not only to business but also to national politics; a law in the US states that two rival firms conspiring to boost prices will be prosecuted.

I have mentioned the positive effect of package sales on competition. For example, a company has several complementary products - Internet Explorer, Excel, Word, and so on. But if a person only uses the computer for e- mail and Internet access, the key program is Internet Explorer. To use this program, you must have an operating system. Thus, by combining these two things and selling them as a package, Microsoft is benefiting competition. On the other hand, as is always the case in microeconomics, this company is doing things that impede competition, like crowding Netscape out of the market by using its superiority and acquiring a monopoly on the browser market. Of course, there are other browsers, like Mozilla FireFox, but their market share is insignificant.

Suppose you have market demand for two commodities, A and B, with a positive correlation. Consumers are prepared to pay $100 for each. The monopolist is making both products, selling each for $100. Suppose this monopolist believes that there is a threat of a company entering the market, which is capable of manufacturing a product that will compete with Product B. In that case, the monopolist starts selling both products as a package worth $100, which is good for consumers because they were ready to spend $100 for each product separately. Now they can buy both products as a package for $200.

Now imagine that someone wants to enter the market with only product B and sell it for $100. The demand will be very small because consumers are already buying Product B as part of a package. In other words, by using this strategy you prevent rivals from entering your market. Imagine a Caribbean island that people visit on vacations. There is a hotel with a restaurant. There are other restaurants on this island. There are local residents and tourists. The hotel has a monopoly on tourist accommodations. A hotel room costs $200 a night. The hotel’s restaurant serves breakfast, dinner, and so on, for $100 a day.

However, this hotel has no monopoly on food because there are local restaurants, and so it tries to bankrupt them. The local restaurants have current expenses and they need customers - not just locals but also tourists - to cover them. Then the hotel forms a room-and-board package deal that costs $290. You can have meals in other restaurants, but you have already paid for the hotel meals. This results in the bankruptcy of local restaurants because the local clientele is not big enough to cover their expenses. The hotel uses its monopoly power as a means to its end. It crowds out the local restaurants from the market and gets rid of the competition.

Another example concerns Microsoft Office. This software packages includes Word, Excel, PowerPoint, and so on. Some people hate Excel. There are similar programs, like Quattro. Few people know about this program, although it’s better than Excel, but why pay $100 for this program if you already have Excel for free as part of Windows? The same is true of PowerPoint; there are better presentation programs, but it is part of the Office package, so other programs cannot compete with it. It is very difficult for someone to enter the market with another kind of software. This example has positive and negative aspects in regard to competition.

That’s not all. Microsoft comes out with another package, Windows Media Player, which goes with Windows. There are also Real Player (Real Network) and Quick Time (Apple) that can be downloaded on the Internet as freeware. Real Network is irked by Microsoft’s move and considers it unfair. This is how the company responded to Microsoft’s actions. First they sued Microsoft (US), citing the Antimonopoly law, accusing this company of using its monopoly advantage. (Microsoft was forced to pay 800 million dollars’ worth of damages). In Europe, Microsoft was forced to sell the Windows Media Player separately.

The same thing happened in South Korea. The latest example is a new operating system known as Microsoft Vista. It solves a problem that earlier versions could not, by protecting the register from spam and hacker attacks. Companies specializing in system protection programs are not too happy about this. So, it is very important to ascertain which side is right. This includes both the policy of the company and the policy of the state.

Several years ago General Electric decided to merge with Honeywell. They build aircraft engines. Another jet engine supplier is Pratt & Whitney (US) and Rolls-Royce (UK). Honeywell is developing electronic navigating system for airplanes. The European Union blocked the merger of these companies because once GE merges with Honeywell they will start selling engines and avionics as packages because these are complementary products. Without them no aircraft will fly. But this is very bad for Pratt & Whitney and Rolls-Royce. A number of economists took part in making this decision. The EU Parliament determined that the anticompetitive effect of this merger would cause more harm, so the merger was banned.

What happens when there is competition among packages? Take medical equipment, for example. Johnson & Johnson sells equipment packages at lower prices than each unit separately. Another company, Tyco Healthcare, sells medical equipment. Almost all hospitals buy packages from a certain medical company. Suppose a small company tries to market a certain product, like an oximeter, an instrument that measures oxygen level in a sample of blood. This device is part of the package produced by both companies.

Masimo, a Japanese-American corporation, makes top-quality oximeters and claims that its readings are far more precise. This company sued Tyco in the US on charges of blocking their product’s entry into the market because it is competing with the one that is part of the Tyco package. This is a breach of the Antimonopoly law, and it reduces market competition because Masimo was simply unable to push its way into the market. Tyco lost the case and had to pay half a billion dollars in damages. There are many companies that are making one or two products and suing Tyco and Johnson & Johnson because their packages sales are an unfair strategy. When there is competition among goods, life becomes more competitive. If there were no rivals, every company would be selling all the parts of a package separately. When you make a package of products, you assume that they are homogeneous.

Suppose there are type A and B goods and Company 1 and Company 2 make these products. There are consumers who like Product A made by Company 1 and Product B made by Company 2. Unless a package is made, these products will be sold in a differentiated manner, depending on consumer preferences, and this increases the prices. When there is a package, there is only pricing competition because the products are similar. This is good for consumers.

Meanwhile, Masimo, with its better-quality oximeters, cannot enter the market. This is bad for consumers because innovative products cannot find their way into the market. The question is whether package sales should be authorized. This is permitted in the United States, but the issue is very topical. The same is happening in the European Union. Since there is no final answer to this question, this issue has a direct bearing on business and government, and remains extremely interesting.

(The following is a back translation of a public lecture by Dr. Robert S. Pindyck, Bank of Tokyo- Mitsubishi Professor of Economics and Finance, Sloan School of Management, Massachusetts Institute of Technology, which was organized for the progressive student communities of Ukraine, Moldova, and Belarus by the Kyiv School of Economics and the Viktor Pinchuk Foundation, with exclusive support from the newspaper Den.)