Add-on Pricing by Asymmetric Firms

This paper uses an analytical model to examine the consequences of add-on pricing when firms are both horizontally and vertically differentiated and there is a segment of boundedly rational consumers who are unaware of the add-on fees at the time of initial purchase. We find that consumers who know the add-on fees can be penalized---and increasingly so---by the existence of boundedly rational consumers. Our consideration of quality asymmetries on base goods and add-ons, plus the inclusion of boundedly rational consumers, leads to several novel findings regarding firm profits. When quality asymmetry is on base goods only and with boundedly rational consumers, add-on pricing can diminish profit for a qualitatively superior firm and increase profit for an inferior firm (i.e., a lose--win result), compared to when add-on pricing is prohibited or infeasible. When quality asymmetries exist on both base goods and add-ons and without boundedly rational consumers, the opposite win--lose result prevails. When quality asymmetries exist on both base goods and add-ons and with boundedly rational consumers, the result can be win--win, win--lose, or lose--win, depending on the magnitude of quality differentiation on add-ons. This paper was accepted by J. Miguel Villas-Boas, marketing.