CREST Microeconomics Seminar : 

Abstract: This paper empirically investigates the add-on or “drip” pricing behavior of firms. We present a model in which consumers purchase a base product and, with some probability, an add-on product from the same firm, but are not always attentive to their possible need for the add-on product. We show that a loss leader pricing strategy emerges whereby firms price the base product below, and the add-on above, standalone pricing levels. We test the implications of the model in the Portuguese market for driving instruction where students frequently pay for repeat driving exams and additional lessons upon failing their initial exam. Relying on a detailed, nationwide data set on student characteristics and preferences, school attributes including fees and costs, and market demographics for a cross-section of local markets with differing numbers of school competitors, we find evidence in support of the model predictions. Most notably, prices for the base course of instruction, but not the add-on repeat courses, decline in the number of competitors a firm faces. We complement these results with survey evidence on possible sources of consumer inattention that the observational data does not speak to. The consumer survey suggests that approximately one quarter of students are inattentive to repeat fees when making their school choice driven both by an underestimation of fail propensities and an unawareness of the actual cost of a repeat exam. This result has important policy implications regarding the cross-subsidization of students who are aware of the add-on by those who are not.