Service Bundling and Quality Competition on Converging Communications Markets

During the last two decades, bundling has become a hot topic for Industrial Organization economists, mainly as a result of legal actions against Microsoft (Crampes and Hollander 2007). In this spirit, the literature has thus far focused on asymmetric settings where one firm holds a monopoly for some type of service, while the competitors have only limited or no market power. In this paper, I consider a symmetric reciprocal duopoly setting, where both firms have some additional market power in their respective home market. This market structure has been constituted in the communications industry as a direct consequence of the digital convergence phenomenon, which led previously distinct integrated network operators to offer essentially the same kinds of services. Today, voice telephony, Internet and TV services are all available from either the telephone- or cable-network incumbents, both of which frequently bundle these services to one so-called Triple Play package. Moreover, previous literature has typically considered communications services as a homogeneous good. To the contrary, I argue that these services differ in various quality measures, such as bandwidth, content, or failure rates. For the firms, the provision of high-quality services is more costly than the provision of low-quality services. Conversely, consumers have a greater reservation price for higher service qualities. Therefore firms face a trade off between revenues and cost when selecting the optimal service quality. While carefully recognizing the technological, legal and economic framework, I have investigated whether bundle pricing is indeed a profitable pricing strategy in this industry, if it can facilitate market power leverage and whether it emerges as an equilibrium strategy. To this extend, a three-stage game was considered, in which firms decide whether to offer their services in a bundle or separately in stage one, determine the quality of their services in stage two, and compete in prices in stage three. I can show that bundle pricing serves as a powerful leverage device. This is achieved through a vertical differentiation effect, which accrues as the firms wish to shield themselves from increased price competition in the market for bundles. Absent bundling, each firm can exploit its limited market power and obtain quality leadership (associated with higher profits) in its home market. Under bundle pricing, however, one firm emerges as the high-quality, high-profit provider in all markets, whereas the competing firm has to settle for low qualities and profits. This quality leverage effect is said to be 'powerful' because it holds under some fairly general terms and for a number of worst-case assumptions. First, recall that market power is rather limited in the present framework because neither firm holds a monopoly position. Nevertheless, leverage is achieved under all feasible settings. Next, I have restricted the analysis to those settings for which interior price equilibria exist for all four possible scenarios of the bundle pricing regimes. Alternative settings tend to strengthen my results. Furthermore, I have assumed consumers' quality preferences to be uncorrelated across service types. This has been shown to be least appreciated by the quality leverage effect because demand is evenly spread out up to every corner of the market. Finally, the quality leverage effect is robust to variations in the cost structure, as long as the costs of quality improvement are convex and fall on fixed costs mainly. It neither relies on service complementarity nor on any other efficiency gains due to economies of scope or transaction costs. The effect even prevails under a unilateral mixed bundling regime. Furthermore, the welfare effects of bundle pricing have been studied under various settings. Quite surprisingly, I found that both consumers' and producers' welfare generally rise, because each group assesses the impact of the price effect and the bundling effect differently: On the one hand, consumers enjoy lower average prices, while on the other hand, firms benefit from reduced service variety. However, the quality leverage effect of bundling crucially affects the distribution of firms' profits and should therefore be considered in the context of price regulation.