Giving Away to Increase Profits? Price-Discrimination and the Effect of Free Goods

Abstract

This paper considers the single-period pricing problem of a monopolist serving consumers with private, heterogeneous willingness to pay for quality. A standard approach is to model as an adverse selection problem. Motivated by empirical evidence that consumer utility becomes discontinuous when service is free (e.g. “zero-price transaction utility”), we examine situations where giving away service increases profit. We find that free service increases profit when (i) the transaction utility from free service is high, and (ii) the adverse selection pricing schedule results in a small margin for low-valuation customers. When these conditions are met, a pricing policy that serves some consumers for free generates higher profit, even in the absence of volume-dependent cost. When a provider benefits from economies of scale in cost and endogenously selects its target market, free service still increases profit when (i) and (ii) hold. To prove this result, we generalize the adverse selection model to allow for volume-dependent cost.