Add-on pricing under cost asymmetries and consumer naïveté

Two firms with asymmetric costs sell vertically and horizontally differentiated goods. Some consumers are naïve and do not observe, or consider, add-on prices until after they have committed to purchasing the base good from a firm. We find that a rise in naïveté distorts product match and lowers consumer surplus despite lower prices paid, on average, by consumers. A greater mass of naïve consumers makes poor decisions, purchasing the cheaper bundle from the efficient firm when they would have been better off buying the costlier bundle from its rival. Although industry profits rise, the efficient firm’s profits decline. An increase in cost asymmetries reduces consumer surplus and increases the mass of consumers who make poor decisions while having opposing effects on the firms’ profits. These findings suggest that interventions aimed at reducing naïveté or cost asymmetries may not be Pareto-improving. An extension of the model explores how market outcomes change as the fraction of consumers with a high valuation of quality varies.