Question

Question 4- McDonald is famous for the Extra Value Meal, a form of mixed bundling with a leader combined with large French Fries and medium soft drink. The following table gives you the Bundled Price and the Separate Price. SEPARATE PRICE Non Bundled Price BUNDLED PRICE Large French Fries 1.39 Medium Soft Drink 1.09 McGrill Chicken Sandwich 2.69 4.29 2.69 +1.09+1.39-5.1 7 3.48 McChicken Sandwich Double Cheeseburger Quarter Pounder2.1 3.39 3.39 3.79 1.00 1.00 3.48 4.67 1. Do each of bundles create the same value for the customer? Show evidence. 2. Is this direct or indirect price discrimination? Explain. 3. Why would McDonald choose to create bundles? How would they go about designing effective bundles?

Answer 1

1. The practice of selling two or more goods both separately and as a package is known as mixed bundling. The package price will be below the sum of the individual prices. Here, McDonald has two strategies – 1) Charge a separate price for each of the combinations, given by the nun bundled price column in table 2) Charge bundled price for each of the combinations, given by the bundled price column in the table. Suppose, there are two consumers – A & B. Let each of the four combinations – Large French fries and medium soft drink combined with Mcgrill Chicken Sandwich, McChicken sandwich, Double Cheeseburger, Quarter Pounder be denoted by C1, C2, C3, C4, where 1,2,3,4 be the respective products. For each consumer, their willingness to pay differs. The reservation price is the price at which each consumer is indifferent between buying or not buying.

Let R_A¹, R_A², R_A³, R_A⁴ be the reservation price for consumer A for each of the goods 1, 2, 3, and 4 and that for Large French fries and medium soft drink be R_A^F, R_A^S. Similarly, let R_B¹, R_B², R_B³, R_B⁴ be the reservation price for consumer B for each of the goods 1, 2, 3, and 4 and that for Large French fries and medium soft drink be R_B^F, R_B^S. Consumers will buy a good if the reservation price exceeds the price of the individual good. Similarly, consumers will buy a bundle if the reservation price exceeds the price of the bundle. Suppose that the reservation prices of consumer A for each product are –

R_A¹ = 2.8, R_A² =0.90, R_A³=1.2, R_A⁴=2 and R_A^F=1.4, R_A^S=1.05.

Then, for each bundle, his reservation price would be as follows –

C1 = R_A^F+ R_A^S + R_A¹ = 1.4 + 1.05 + 2.8 = 5.25

C2 = R_A^F+ R_A^S + R_A² = 1.4 + 1.05 + 0.95 = 3.35

C1 = R_A^F+ R_A^S + R_A³ = 1.4 + 1.05 + 1.2 = 3.65

C1 = R_A^F+ R_A^S + R_A⁴ = 1.4 + 1.05 + 2 = 4.45

Thus we see that based on reservation price, the value of each bundle to consumer varies. In the above example, the consumer A will never buy C2 since the price of the bundle is greater than his combined reservation price.

2. In the case of mixed bundling, the consumers are not forced to choose a particular bundle or quantity. They have their freedom of choice. However, the firm here is able to capture much of the consumer surplus. The more negative correlation between the demand for each good, more the consumer surplus a firm is able to extract. It is price discrimination as it enables the producer to charge more to consumers who value the goods more. Indirect price discrimination is practised through customer choices by giving them offers, unlike direct price discrimination that is based on individual buyer. So, this is indirect price discrimination.

3. Bundling is a profitable venture as the strategy enables them to extract consumer surplus for consumers. It also helps to increase the sales by clubbing together a relatively high value good with a relatively less valuable one. It allows the firm to discriminate between consumers based on their willingness to pay. The most effective mixed bundle design would be the one where the reservation price of an additional product to a bundle is greater than the difference between the price of the bundle and buying the items separately.