Tariff Choice with Consumer Learning: Sorting-Induced Biases and Illusive Surplus

Ronald Goettler and Karen Clay

No 2003-E35, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: Firms often offer menus of two-part tariffs to price discriminate among consumers with heterogeneous preferences. In this paper we study the effectiveness of this screening mechanism when consumers are uncertain about the quality of the good and resolve this uncertainty through consumption experiences. We use consumer-level data to estimate a dynamic structural model of forward-looking consumers with heterogeneous demands, both ex-ante and ex-post, for an experience good sold by a monopolist offering a fixed menu of two-part tariffs. Our analysis highlights three elements that influence consumer behavior and affect pricing strategies: beliefs, experiential learning, and switching costs. We test the rational expectations assumption against a weaker assumption about beliefs that retains unbiasedness, on average across all consumers, but allows beliefs to be biased conditional on tariff choice. The rational expectations assumption is rejected: consumers on flat fee tariffs tend to have optimistic priors whereas consumers on per-use tariffs tend to have pessimistic priors. If switching costs are sufficiently high, this sorting-induced bias implies that flat fee tariffs can yield high profits for the firm even after optimistic consumers revise their beliefs. This dynamic lock-in effect of flat fees augments their traditional role in static settings of extracting consumer surplus. Biased priors also lead to biased expectations of consumer surplus. Realized surplus is on average negative, despite expectations of a large and positive discounted lifetime surplus.

Date: 2006-12
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