Drip Pricing When Consumers Have Limited Foresight: Evidence from Driving School Fees

Abstract

This paper empirically investigates the add-on or \drip" pricing behavior of firms in the Portuguese market for driving instruction. We present a model in which consumers purchase a base and, with some probability, an add-on product from the same firm, but are not always aware of the possible need for the add-on product. We show that a loss leader pricing strategy emerges whereby firms price the upfront product below single-product pricing levels, but the add-on at monopoly levels. We then test the implications of the model using a detailed snapshot of industry data on student characteristics and preferences, school attributes including prices 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, including that firms have a profit motive in the add-on market. Prices for the base product, but not the add-on products, decline in the number of competitors a firm faces. Estimates of an empirical version of the model suggest that approximately one-quarter of students are inattentive to the add-on when making their school choice, closely matching the share of students who are uninformed about the add-ons' prices in a survey. This result has important policy implications about the cross-subsidization from those students who are unaware of the add-on to those who are.