Pricing Diagnosis-Based Services When Customers Exhibit Sunk Cost Bias

Abstract

Significant evidence has emerged in the past few decades that consumers are boundedly rational. A well-known departure from rationality is the inclination to account for sunk costs in 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 customer classes, sophisticated and naive, both of whom experience the sunk cost bias but are different in their awareness of the bias. We find that a monopolist service provider adopts the time-based pricing scheme if the sunk cost bias is small and adopts the fixed fee scheme otherwise. In a competitive setting, a time-based scheme is more likely in markets with either sophisticated or naive customers. Competition mitigates the sunk cost bias and makes the time-based scheme more attractive than for a monopolist. When the market consists of both sophisticated and naive customer classes, it is not optimal to differentiate between naive and sophisticated customers by offering both pricing schemes. Paradoxically, while a monopolist is unable to differentiate between the two customer classes using the two pricing schemes, competing providers are able to differentiate while enjoying positive profits.