Add-on markets with naïve consumers

This thesis aims to improve our understanding of firms’ incentives to offer add-ons, as well as the implications that selling add-ons has for competition and welfare. It consists of three studies. In the first study we develop two models that explain the establishment of add-on pricing equilibria in markets with physical add-on services (e.g. hotels, airlines), and in software markets (e.g. apps with microtransactions). We show that add-on pricing equilibria can emerge despite consumers being fully rational and despite the presence of a binding price floor. The second and third studies analyse markets with naïve consumers. The goal of both studies is to explore the extent to which the incentive to exploit naïve consumers’ mistakes affects firms’ choices of horizontal product differentiation in the core product market. In the second study we analyse a model in which add-ons are unwanted – they are never purchased by sophisticated consumers. We identify conditions under which firms offer maximally differentiated products in order to soften competition, and conditions under which each firm offers a product similar to its rival’s in order to maximise profits from exploitation. In the third study we develop a model in which add-ons are desirable – sophisticated consumers buy them under certain circumstances. We find that the sophisticates’ demand for add-ons complicates the relationship between prices and the degree of horizontal product differentiation. This raises the possibility that intermediate product differentiation also emerges in equilibrium. Both the second and the third study show that benefits to consumers from the firms’ choices of product differentiation can more than offset the harm to consumer welfare from the exploitation of consumer mistakes. Thus, whether conventional regulatory interventions have a positive effect on consumer welfare depends, to a large extent, on their effect on firms’ product differentiation incentive