Dynamic Pricing of Network Goods with Boundedly Rational Consumers

Abstract

We present a model of dynamic monopoly pricing for a good that displays network effects. In contrast with the standard notion of a rational-expectations equilibrium, we model consumers as boundedly rational, and unable either to pay immediate attention to each price change, or to make accurate forecasts of the adoption of the network good. Our analysis shows that the seller's optimal price trajectory has the following structure: the price is low when the user base is below a target level, is high when the user base is above the target, and is set to keep user base stationary once the target level has been attained. We show that this pricing policy is robust to a number of extensions, which include the product's user base evolving over time, and consumers basing their choices on a mixture of a myopic and a "stubborn" expectation of adoption. Our results differ significantly from those that would be predicted by a model based on rational-expectations equilibrium, and are more consistent with the pricing of network goods observed in practice.