Bundling and Behavioral Economics

 

Consumers expend mental effort to make purchase decisions. Comparing a large number of products can result in “decision fatigue”. For example, a couple planning a vacation could be overwhelmed when selecting from multiple destinations and activities.

Behavioral economics has found that when decisions are perceived as complex, people often rely on mental shortcuts (Thaler, 1985;1999). Predetermined packages, in which destinations and activities are selected by the offering company, simplify decision making. These packages are referred to as “bundles”.

Customers often do not calculate the actual savings from the bundle vs. purchase of the individual items in the bundle. However, bundles can increase perceived value through the convenience of the predetermined package and reduction of “decision fatigue” (Thaler, 1985).

Bundling can also be used to attract new customer segments (Nagle, Hogan & Zale. 2011).

Example: A 100-room ski lodge in the Pacific Northwest offers rooms during the peak of ski season for $300 per night. This price attracts enough skiers to fill 80% of rooms. Each room costs the lodge $250 per night for insurance, maintenance, staff, etc.

Profit per night = %Occupancy x #Rooms x (Price per room – Cost per room)

Total Profit Skiers = 80% occupancy x 100 rooms x ($300 per room - $250 per room)

Total Profit Skiers = $4000 per night

The lodge is considering a price reduction to fill the unoccupied rooms. The lodge believes a reduction in the price to $275 per night would result in 100% occupancy.

Total Profit (Price Reduction) = 100% occupancy x 100 rooms x ($275 per room - $250 per room)

Total Profit Price Reduction = $2500 per night

The price reduction reduces profit despite the increased occupancy. Clearly, an unsound strategy.

Instead of price reductions the lodge could strategically use bundling to attract a different customer segment to fill the remaining 20% of rooms. The lodge is located near restaurants of interest to culinary tourists. The lodge could bundle transportation to evening dining and restaurant prix fixe menus with the room price, creating “The Pacific Northwest Hotel and Dinner Dining” bundle.

The actual cost to the lodge for the bundle would depend on the cost of transportation and partnerships with restaurants. For this example, it is assumed that the lodge is able to use their existing shuttles for a cost of 5$ per passenger per night. It is further assumed that the lodge has partnered with restaurants for prix fixe menus at an average cost of $35 per customer. This amounts to cost to the lodge of $330 per night per room for two guests ($5 x 2 for transportation + $35 x 2 for dinner dining + $250 per room per night). Given these costs, and the customer value proposition, the lodge charges $380 per night for two guests per room for the “Pacific Northwest Hotel and Dinner Dining” bundle. Skiers are uninterested in this more expensive bundle and continue with 80% occupancy at $300 per night.

Total Profit from Bundle (assuming 20% occupancy) = 20% occupancy x 20 rooms x ($380 per room - $330 per room)

Total Profit Bundle (assuming 20% occupancy) = $1000 per night

The total profit from the combined skier and culinary tourist segments is:

Total Profit Skiers + Bundle = $4000 per night + $1000 per night = $5000 per night

Conclusion: Bundles can be strategically used to attract a new customer segments. Profits from existing customer segments remain intact when the bundle includes products that offer little incentive for the existing segment to alter their purchase behavior. Price reductions erode margins and may result in profit loss.

References

Nagle, T., Hogan J., Zale J. (2011). The Strategy and Tactics of Pricing. Prentice Hall: Upper Saddle River, NJ.

Thaler, R. H. (1985). Mental accounting and consumer choice. Marketing Science, 4(3), 199–214.

Thaler, R. H. (1999). Mental accounting matters. Journal of Behavioral Decision Making, 12(3), 183–206.