Pricing Diagnosis-Based Services When Customers Exhibit Sunk Cost Bias
47 Pages Posted: 8 Sep 2015 Last revised: 22 Jan 2017
Date Written: November 30, 2016
Significant evidence has emerged that consumers are boundedly rational and display a sunk cost bias when making decisions. We compare two commonly used pricing schemes, fixed fee and time-based pricing, when customers exhibit sunk cost bias in a service setting with diagnosis and treatment phases. We consider two classes of customers, sophisticated and naive, both of whom experience the sunk cost bias but naive customers also display dynamically inconsistent preferences. We find that a monopolist service provider will adopt the time-based pricing scheme if the sunk cost bias is small and adopt the fixed fee scheme otherwise. In a competitive setting where the market comprises of either sophisticated or naive customers, a time-based scheme is more likely to emerge as the equilibrium outcome. Competition mitigates the sunk cost bias and makes the time-based scheme more attractive than in a monopoly setting. While the equilibrium choice of pricing scheme depends on the level of sunk cost bias in the case of sophisticated customers, surprisingly the sunk cost bias does not impact the equilibrium choice in the case of naive customers. In a scenario wherein the market consists of both sophisticated and naive customer classes, a monopolist provider does not find it optimal to differentiate between naive and sophisticated customers by offering both pricing schemes and instead offers only one of the two pricing schemes.
Keywords: diagnosis service, sunk cost bias, behavioral contract, service operations
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