In many businesses it is customary to advertise a base price
for a product and to try to sell additional “add-ons” at high prices
at the point of sale. The quoted price for a hotel room typically
does not include phone calls, in-room movies, minibar items, dry
cleaning, or meals in the hotel restaurant. Personal computers
advertised in weekly sales circulars typically have little memory,
a low-capacity hard disk, and no separate video card. Appliance
stores push extended warranties. Car rental agencies push insurance
and prepaid gasoline. Manufacturers of new homes offer a
plethora of upgrades and options that can add tens or hundreds of
thousands of dollars to a home’s price. In some cases, add-ons can
be thought of as a classic price discrimination strategy: the base
good and the base good plus the add-on are two different quality
levels. In many of the above applications, however, there is a
noteworthy feature absent from the classic price discrimination
model: add-on prices are not advertised and would be costly or
difficult to learn before one arrives at the point of sale.
ticated consumers as the high types. Unsophisticated consumers
may be less sensitive to price differences because they are worse
at comparison shopping.3 They may also be more likely to intentionally
or unintentionally buy overpriced add-ons; e.g., they may
incur late-payment fees on their credit cards or be talked into
unnecessary rental car insurance. There are, of course, other
markets where willingness to pay for add-ons and sensitivity to
interfirm price differences are better modeled as independent or
having the reverse correlation. My analysis will not apply to
these.4
The analysis consists primarily of contrasting the outcome of
two games.5 In the “standard pricing game” the firms publicly
announce both a price for the base good and a price for a bundle
containing the base good and the add-on. This game is relevant
for applications in which add-on prices are as readily observable
as base-good prices. For example, the price of movie-theater popcorn
is just as observable to consumers as ticket prices: neither
price tends to be advertised, and both are posted at the theater
and known to repeat customers.
The second game, the “add-on pricing game,” is intended to
apply to situations in which add-on prices are not as readily
observable. For example, it is typically much harder to learn a
hotel’s long-distance telephone charges or the quality-adjusted
price of its restaurant than it is to learn the hotel’s room rate. In
this game, firms are assumed to only announce base-good prices,
and consumers must incur a (possibly small) sunk cost to learn a
firm’s add-on price.6 Consumers, of course, have rational expectations
and will correctly infer the unobserved prices in any pure
strategy equilibrium, but may not learn about deviations from the