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.