Product-bundling and Incentives for Merger and Strategic Alliance

This paper analyzes firms' choice between a merger and a strategic alliance in bundling their product with other complementary products. We consider a framework in which firms can improve profits only from product-bundling. While mixed bundling is not profitable, pure bundling is because pure bundling reduces consumers' choices, and thus softens competition among firms. Firms benefit the most from this reduced competition if they form an alliance. Firms do not gain as much from a merger because, internalizing the complementarity between the two products, a merged firm is inclined to pursue aggressive pricing to gain market share. Yet, firms may be motivated to choose a merger over an alliance because of foreclosure possibility as foreclosure is not possible under strategic alliance. However, in response, unmerged rivals can use a strategic alliance to avert foreclosure. Hence, the possibility of counter-bundling via strategic alliance by rivals reduces the incentives for merger. In equilibrium, bundling is offered only through strategic alliances.