A model of add-on pricing

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.