Businesses are constantly making decisions about which products and services will attract customers. In an era driven by the mantra of “give customers what they want,” some businesses feel compelled to offer many different versions of their products. This trend is relatively new. For years, blue jeans came in only one shade of blue and in only one style, but now they are available in a dizzying array of styles and colors. Yet some companies continue to stick to a single version of their products, making alterations only when technology impacts what they can provide or when competition shifts. Music publishers, for example, after decades of providing mainly bundles of songs on compact discs or records, have, in recent years, made individual songs available as well — thanks to technological changes that have made distribution over the Internet less costly to them and more efficient for consumers.
How can companies design products and product lines to maximize their profits? Out of all the potential configurations available, how should companies decide which ones to offer? We have developed a framework for balancing the costs of developing and offering a rich line of products and services against customer demand for additional choice. (See “About the Research.”) Our methodology allows managers to make informed decisions about product-offering architecture: which features to include in the product, which variations to include in a product line, and how the goods should evolve with technology and competition. In particular, our approach highlights how costs influence the design of the most profitable offering.1 Thus, it departs from the standard product-success metrics, such as revenue and market share, which are the primary focus of most of the work on product bundling.2
1. For a summary, see D.S. Evans and M. Salinger, “The Role of Cost in Determining When Firms Offer Bundles,” Journal of Industrial Economics, in press. See also D.S. Evans and M. Salinger, “Why Do Firms Bundle and Tie? Evidence from Competitive Markets and Implications for Tying Law,” Yale Journal on Regulation 22, no. 1 (Winter 2005): 38–89.
2. W.J. Adams & J.L. Yellen, “Commodity Bundling and the Burden of Monopoly,” Quarterly Journal of Economics 90, no. 3 (August 1976): 475–498; R. Schmalensee, “Gaussian Demand and Commodity Bundling,” Journal of Business 57, no. 1 (January 1984): S211–30; and R.P. McAfee, J. McMillan, and M.D. Whinston, “Multiproduct Monopoly, Commodity Bundling, and Correlation of Values,” The Quarterly Journal of Economics 104, no. 2 (May 1989): 371–383.
3. See http://web.archive.org/web/19990423055451/vintagecars.tqn.com/library/weekly/aa050898.htm.
4. Let n be the number of features and v be the number of product versions, then v=2n-1. Thus, with three features it is possible to construct seven different product versions, and with four features it is possible to construct 15.
5. Let o be the number of product offerings. Then o=2v-1 = 2(2n-1)-1.
6. Y. Bakos and E. Brynjolfsson, “Bundling Information Goods: Pricing, Profits, and Efficiency,” Management Science 45, no. 12 (December 1999): 1613–1630.
7. Evans, “Why Do Firms Bundle and Tie?” supra, note 1, for a summary of the evidence that automobile companies incur significant costs as a result of offering numerous different products.
8. B. Schwartz, “The Paradox of Choice: Why More Is Less” (New York: HarperCollins, 2004).
9. Bakos, “Bundling Information Goods,” supra, note 6.
10. See http://homedelivery.nytimes.com
11. Companies can also use an all-in-one offering to implement a block-booking strategy — named after a 1963 paper by that name by Nobel prize-winning economist George Stigler — that enables companies to obtain a greater portion of consumers’ willingness to pay for products. Stigler demonstrated this strategy by examining the economics of movie distribution. Suppose that theater 1 is willing to pay $8,000 and theater 2 is willing to pay $7,000 for movie A; and that theater 1 is willing to pay $2,500 and theater 2 is willing to pay $3,000 for movie B. If the movie distributor charged a single price to the two distributors, it would charge $7,000 and $2,500 to attract both theaters; the distributor would collect $9,500 from each for a total of $19,000. But consider how much the theaters would pay for both movies: Theater 1 would pay $10,500 and theater 2 would pay $10,000. Thus, if the distributor charged each $10,000 for the bundle — block-booked the movies — it would collect $20,000 and therefore make more money.
12. S. Berry, J. Levinsohn and A. Pakes, “Automobile Prices in Market Equilibrium,” Econometrica 63, no. 4 (July 1995): 841–890.
13. An extensive discussion of the long tail theory can be found in C. Anderson, “The Long Tail: Why the Future of Business Is Selling Less of More” (New York: Hyperion, 2006). The long tail theory posits that the Internet allows a large number of people access to a wide variety of items, which creates new, albeit in some cases small, profitable markets for goods and services.