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A Model of Add-on Pricing

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Author Info
Glenn Ellison () (Department of Economics, MIT)

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Abstract

This paper develops a model of competitive price discrimination with horizontal and vertical differentiation. The main application is to add-on pricing – advertising low prices for one good in hopes of selling additional products at high prices. Price discrimination is self-reinforcing: the model sometimes has both equilibria in which all firms practice price discrimination and equilibria in which none do. The paper focuses on the Chicago-school argument that profits earned on add-ons will be competed away via lower prices for advertised goods. The most important observation is that the adoption of add-on pricing practices can create an adverse selection problem that makes price-cutting unappealing, thereby raising equilibrium profits. Although profitable when jointly adopted, using add-on pricing is not individually rational in the simplest model with endogenous advertising strategies. Several models that could account for the prevalence of add-on pricing are discussed.

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Publisher Info
Paper provided by Institute for Advanced Study, School of Social Science in its series Economics Working Papers with number 0049.

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Length: 49 pages
Date of creation: Jun 2004
Date of revision:
Publication status: Published in The Quarterly Journal of Economics, Vol. 120(2), p. 585-637, May 2005
Handle: RePEc:ads:wpaper:0049

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Related research
Keywords: Price Discrimination; Add-on Pricing;

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Find related papers by JEL classification:
L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets
M30 - Business Administration and Business Economics; Marketing; Accounting - - Marketing and Advertising - - - General

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Verboven, Frank, 1999. "Product Line Rivalry and Market Segmentation--With an Application to Automobile Optional Engine Pricing," Journal of Industrial Economics, Blackwell Publishing, vol. 47(4), pages 399-425, December. [Downloadable!] (restricted)
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    Other versions:
  5. Xavier Gabaix & David Laibson, 2005. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," NBER Working Papers 11755, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  6. Susan Athey & Kyle Bagwell & Chris Sanchirico, 1998. "Collusion and Price Rigidity," Working papers 98-23, Massachusetts Institute of Technology (MIT), Department of Economics.
    Other versions:
  7. Pratt, John W & Wise, David A & Zeckhauser, Richard, 1979. "Price Differences in Almost Competitive Markets," The Quarterly Journal of Economics, MIT Press, vol. 93(2), pages 189-211, May. [Downloadable!] (restricted)
  8. Severin Borenstein & Jeffrey MacKie-Mason & Janet Netz, 1996. "Exercising Market Power in Proprietary Aftermarkets," Working Papers _002, University of California at Berkeley, Haas School of Business. [Downloadable!]
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  9. Kenneth S. Corts, 1998. "Third-Degree Price Discrimination in Oligopoly: All-Out Competition and Strategic Commitment," RAND Journal of Economics, The RAND Corporation, vol. 29(2), pages 306-323, Summer. [Downloadable!] (restricted)
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  11. Paul Klemperer, 1987. "The Competitiveness of Markets with Switching Costs," RAND Journal of Economics, The RAND Corporation, vol. 18(1), pages 138-150, Spring. [Downloadable!] (restricted)
  12. Rajiv Lal & Carmen Matutes, 1989. "Price Competition in Multimarket Duopolies," RAND Journal of Economics, The RAND Corporation, vol. 20(4), pages 516-537, Winter. [Downloadable!] (restricted)
  13. Lazear, Edward P, 1995. "Bait and Switch," Journal of Political Economy, University of Chicago Press, vol. 103(4), pages 813-30, August. [Downloadable!] (restricted)
  14. Glenn Ellison & Sara Fisher Ellison, 2004. "Search, Obfuscation, and Price Elasticities on the Internet," NBER Working Papers 10570, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  15. Klemperer, Paul, 1987. "Markets with Consumer Switching Costs," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 375-94, May. [Downloadable!] (restricted)
  16. Thisse, J.-F. & Vives, X., 1987. "On the strategic choice of spatial price policy," CORE Discussion Papers 1987008, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
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  17. Holmes, Thomas J, 1989. "The Effects of Third-Degree Price Discrimination in Oligopoly," American Economic Review, American Economic Association, vol. 79(1), pages 244-50, March. [Downloadable!] (restricted)
  18. Lal, Rajiv & Matutes, Carmen, 1994. "Retail Pricing and Advertising Strategies," Journal of Business, University of Chicago Press, vol. 67(3), pages 345-70, July. [Downloadable!] (restricted)
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  20. Rochet, Jean-Charles & Stole, Lars A, 2002. "Nonlinear Pricing with Random Participation," Review of Economic Studies, Blackwell Publishing, vol. 69(1), pages 277-311, January.
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  22. Armstrong, Mark & Vickers, John, 2001. "Competitive Price Discrimination," RAND Journal of Economics, The RAND Corporation, vol. 32(4), pages 579-605, Winter.
  23. Jerry Hausman & J. Sidak, 2004. "Why Do the Poor and the Less-Educated Pay More for Long-Distance Calls?," Contributions to Economic Analysis & Policy, Berkeley Electronic Press, vol. 3(1), pages 1210-1210. [Downloadable!] (restricted)
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Dmitry Shapiro & Xianwen Shi, 2008. "Market Segmentation: The Role of Opaque Travel Agencies," Working Papers tecipa-310, University of Toronto, Department of Economics. [Downloadable!]
    Other versions:
  2. DESSI, Roberta, 2009. "Contractual Execution and Strategic Incompleteness," IDEI Working Papers 465, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
  3. Glenn Ellison & Sara Fisher Ellison, 2004. "Search, Obfuscation, and Price Elasticities on the Internet," NBER Working Papers 10570, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. Glenn Ellison & Sara Fisher Ellison, 2006. "Internet Retail Demand: Taxes, Geography, and Online-Offline Competition," NBER Working Papers 12242, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. Armstrong, Mark & Chen, Yongmin, 2007. "Inattentive Consumers and Product Quality," MPRA Paper 4797, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  6. Sendhil Mullainathan & Joshua Schwartzstein & Andrei Shleifer, 2006. "Coarse Thinking and Persuasion," NBER Working Papers 12720, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  7. Xavier Gabaix & David Laibson, 2005. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," NBER Working Papers 11755, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  8. Patrick Legros, 2005. "Art and the Internet: Blessing the Curse?," Levine's Bibliography 666156000000000502, UCLA Department of Economics. [Downloadable!]
    Other versions:
  9. Simbanegavi, Witness, 2008. "Loss leader or low margin leader? Advertising and the degree of product differentiation," MPRA Paper 9694, University Library of Munich, Germany. [Downloadable!]
  10. Young Han Lee & Ulrike Malmendier, 2007. "The Bidder's Curse," NBER Working Papers 13699, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Mark Armstrong, 2005. "Recent Developments in the Economics of Price Discrimination," Industrial Organization 0511004, EconWPA. [Downloadable!]
  12. David P. Myatt & Justin P. Johnson, 2005. "Multiproduct Cournot Oligopoly," Economics Series Working Papers 145, University of Oxford, Department of Economics. [Downloadable!]
    Other versions:
  13. Sumit Agarwal & John C. Driscoll & Xavier Gabaix & David Laibson, 2007. "The Age of Reason: Financial Decisions Over the Lifecycle," NBER Working Papers 13191, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  14. Gil, Ricard & Hartmann, Wesley R., 2008. "Why Does Popcorn Cost So Much at the Movies? An Empirical Analysis of Metering Price Discrimination," Research Papers 1983, Stanford University, Graduate School of Business. [Downloadable!]
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