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A Model of Add-on Pricing

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  • Glenn Ellison

    (Department of Economics, MIT)

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.

Suggested Citation

  • Glenn Ellison, 2004. "A Model of Add-on Pricing," Economics Working Papers 0049, Institute for Advanced Study, School of Social Science.
    • Handle: RePEc:ads:wpaper:0049
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    More about this item

    Keywords

    Price Discrimination; Add-on Pricing;

    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; Personnel Economics - - Marketing and Advertising - - - General

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