Add‐On Pricing in a Distribution Channel

Abstract

We consider add‐on pricing in a distribution channel where a retailer sells a base good and an add‐on, supplied by two manufacturers, respectively, to consumers. The retailer decides whether to sell the two products through either bundling or add‐on pricing and sets the corresponding retail prices. Under add‐on pricing, the add‐on price is unobservable to consumers when they make the purchase decision of the base good. Each manufacturer, if independent of the retailer, sets the wholesale price. Under four channel structures differed by whether either manufacturer is independent of the retailer, we specify the scenario that is optimal for the retailer to adopt add‐on pricing and show the contrasting impact from the two manufacturers. When all three firms are integrated, the retailer in general prefers add‐on pricing to bundling when the cost of base good is low and the cost of add‐on is high. Using this case as the benchmark, we show that add‐on pricing is more (less) likely to be adopted when the add‐on (base) manufacturer is independent, and add‐on pricing is again more likely to be adopted when all three firms are independent. In addition to the demand smoothing effect of bundling, we identify two drivers from the supply side: the margin squeezing effect of bundling from the add‐on manufacturer and the margin smoothing effect of bundling from the base manufacturer, where the former encourages add‐on pricing whereas the latter discourages it. The interplay of these drivers largely influences the retailer's add‐on strategy and renders the preceding results. Several extensions are discussed, including correlated consumer valuations of base good and add‐on, an alternate decision sequence, knowledgeable consumers (about add‐on price), simultaneous offering of bundling and add‐on pricing, and bilateral monopoly.