A Model of Add-On Pricing

Abstract

This paper examines competitive price discrimination with horizontal and vertical taste differences. Consumers with higher valuations for quality are assumed to have stronger brand preferences. Two models are considered: a standard competitive price discrimination model in which consumers observe all prices; and an “add-on pricing” game in which add-on prices are naturally unobserved and firms may advertise a base good at a low price in hopes of selling add-ons at high unadvertised prices. In the standard game price discrimination is self-reinforcing: the model sometimes has both equilibria in which the firms practice price discrimination and equilibria in which they do not. The analysis of the add-on pricing game focuses on the Chicago-school argument that profits earned on add-ons will be competed away via lower prices for advertised goods. A conclusion is that add-on practices can raise equilibrium profits by creating an adverse selection problem that makes price-cutting unappealing. Although profitable when jointly adopted, using add-on pricing is not individually rational in a simple extension with endogenous advertising practices and costless advertising. Several models that could account for add-on pricing are discussed.