A Model of Add-on Pricing

Glenn Ellison ()

No 49, Economics Working Papers from Institute for Advanced Study, School of Social Science

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.

Keywords: Price Discrimination; Add-on Pricing (search for similar items in EconPapers)
JEL-codes: L13 M30 (search for similar items in EconPapers)
Date: 2004-06
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Published in The Quarterly Journal of Economics, Vol. 120(2), p. 585-637, May 2005

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Working Paper: A Model of Add-on Pricing (2003)
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