Kindle Unlimited and the Economics of Bundling

Today, Amazon announced Kindle Unlimited, a subscription service for $9.99 per month that gives buyers all-you-can-read access to more than 600,000 books. And it took, oh, five minutes before someone called this the death of publishing.

Calm down. This isn’t the end of publishing—it is a natural extension of market forces and is potentially good for everyone.

Amazon is taking advantage of the economics of bundling—selling multiple products at an identical price regardless of how much the consumer uses each component. Bundles are all over the place; cable TV, Netflix, Spotify, and Microsoft Office are all examples of bundles. These business plans are pervasive because they work, they bring in a lot of money for their providers, and they leave consumers better off as well.

Wait, what!? How is it possible that both providers and consumers are better off by bundling? A while back, I too believed that this was insane and that bundles were a scam to get me to pay more money than I wanted to. (Why should I pay $1 for Home and Gardening when all I want is ESPN?) But then I read up on bundling and understood my folly.

An example will clarify things (and potentially amaze you, as it did for me not too long ago). As usual, I will keep thing simple to illustrate the fundamental logic without getting us bogged down in unnecessarily complicated math. Imagine a world with only two books available for purchase:

Further, let’s assume that there are only two customers in the world. Let’s call them Albert and Barbara. Albert and Barbara have different tastes in books. Albert prefers Hunger Games to Game Theory 101; he would pay at most $4.99 to read Hunger Games but only $1.50 at most for Game Theory 101. Barbara has the opposite preference; she would pay at most $2.25 to read Hunger Games and $3.99 to read Game Theory 101. You might find the following graphical representation more digestible:

Finally, assume that the marginal cost of each book is $0.00. That is, once the book has been written, it costs $0.00 to distribute each book. This is a bit of an exaggeration, but it is close to reality for electronic books. However, it is definitely not true for physical books (printing, shipping, etc.). This distinction will be important later.

With all those preliminaries out of the way, consider how a seller should price those books in a world without bundling. There are two options. First, you can price a book at a low price to capture the entire market share. Second, you can publish the book at a high price; it will sell fewer copies but make more money per unit.

Let’s apply that decision to Hunger Games. Selling at the low price means a cost of $2.25 so that both Albert and Barbara purchase it. (This is because Barbara’s maximum price for it is $2.25). That brings in $4.50 of revenue. Alternatively, you could sell at a high price of $4.99. This ensures that only Albert will buy. But it also brings in $4.99 in revenue, which is more than if you had set a low price. So you would sell Hunger Games for $4.99.

Now consider the price for Game Theory 101. Selling at the low price requires a cost of $1.50 so that both Albert and Barbara purchase it. (This is because Albert’s maximum price for it is $1.50.) That brings in $3.00 of revenue. Alternatively, you could sell at a price of $3.99. Only Barbara would buy it at this price. But it also nets $3.99 in revenue, which is more than if you had set a low price. So you would sell Game Theory 101 for $3.99. (Not coincidentally, if you click on the books above, you will find that they are priced like that in real life.)

Let’s recap the world without bundling. Hunger Games costs $4.99 and Game Theory 101 costs $3.99. The seller brings in $7.98 in revenue. Neither Albert nor Barbara benefit from this arrangement; Albert is paying $4.99 for a book that he values at $4.99, while Barbara is paying $3.99 for a book she values at $3.99.

Now for the magic of bundling. Suppose the seller bundle of both books for $5.99. Who is willing to buy here? Albert values Hunger Games and Game Theory 101 at $4.99 and $1.50 respectively. Thus, he is willing to pay up to $6.49 for the pair. So he will definitely purchase the bundle for $5.99. In fact, he’s much happier than he was before because he internalizing a net gain of $0.50 whereas he had no gain before.

What about Barbara? She was willing to pay respective prices of $2.25 and $3.99. Consequently, she is willing to pay up to $6.24 for the pair. So she will also definitely purchase the bundle for $5.99. And similar to Albert, she is internalizing a net gain of $0.25, up from no gain before.

So Albert and Barbara both win. But so do the producers—rather than bringing in a total of $7.98, the producers now earn $11.98. Every. Body. Wins. (!)

(Yes, I know that Kindle Unlimited costs $9.99 per month. If we added another book to this puzzle, we could get Albert and Barbara to want to pay that price. But that would require more math, and we don’t want more math.)

Why does this work? Bundling has two keys. First, as previewed earlier, the marginal cost of the products must be very small. If they were larger, those costs would make distributing more goods look comparatively less attractive. This would drive up the cost of the bundle and make it less attractive for the consumers, perhaps forcing them to prefer the a la carte pricing. That helps explain why book bundling is just now catching on; electronic books only cost server space whereas physical copies involve UPS.

Second, it helps when customer preferences are negatively correlated. This pushes everyone’s reservation price for the bundle closer together, which in turn makes the producer more likely to want to sell at the bundled price.

Before wrapping up, bundling has an important secondary effect for authors. The main takeaway here is that producers of the materials can make more money through bundling. This gives authors more incentive to create additional materials—an author who would otherwise only make $10,000 from a novel could now make, say, $15,000 instead. So an author on the fence whether to produce the book is more likely to follow through. This further enhances consumer welfare because those buyers can now read a book that would otherwise not exist.

Finally, “producers” here has meant a combination of authors and Amazon. A skeptic might worry that Amazon will end up taking away all of the revenues. That may be an issue in the long run if Amazon becomes a monopoly, but the revenue share is more than fair for now. Indeed, Amazon is giving authors roughly $2 every time a Kindle Unlimited subscriber reads 10% of a book, which is substantial. And with Kindle Unlimited reaching more consumers than a la carte pricing would, writers can earn revenue from a larger share of readers.

If you want to know more about bundling, I highly recommend you read the Marginal Revolution post on the subject.