Product Variety and Endogenous Pricing with Evaluation Costs

One important decision firms must make is to select the product line (characteristics and number of products) to offer consumers. This paper explores the effect of the interaction between consumer evaluation costs and pricing on the optimal product line length to offer consumers. Before deciding to buy a product among all products offered, a consumer learns the product line length. Given the product line length, a consumer decides whether to evaluate the products available and their prices. This decision to evaluate depends on the expected consumer surplus after the evaluation being greater than the evaluation costs. When the firm offers few products, the firm may not attract many consumers because of lack of product fit and may be forced to offer low prices. When the firm offers many products, all consumers will find a great product fit; that is, the variance of consumer valuations per product chosen is lower. This allows the firm to charge high prices to extract ex post consumer surplus, resulting in lower ex ante expected consumer surplus, which may lead consumers not to evaluate the products in the first place. That is, by offering fewer products a firm can commit not to extract all possible consumer surplus. These two forces may then lead to the existence of an interior optimal number of products to offer. The optimal number of products offered is decreasing in the evaluation costs.