Journal Article

A Model of Add-On Pricing

Glenn Ellison

in The Quarterly Journal of Economics

Published on behalf of President and Fellows of Harvard University

Volume 120, issue 2, pages 585-637
Published in print May 2005 | ISSN: 0033-5533
Published online May 2005 | e-ISSN: 1531-4650 | DOI: https://dx.doi.org/10.1093/qje/120.2.585
A Model of Add-On Pricing

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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.

Journal Article.  0 words. 

Subjects: Economics

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