Selling to Overconfident Consumers

Firms commonly offer three-part tariffs, or menus of three-part tariffs, in a variety of contexts. A three-part tariff consists of a fixed fee, an included allowance of units for which the marginal price is zero, and a positive marginal price for additional usage beyond the allowance. A prime example is the US cellular phone services market in which firms typically offer consumers plans consisting of a fixed monthly fee, an allowance of minutes, and an overage rate for minutes beyond the allowance. Pricing of Internet service is similar in many European countries, where usage is billed per megabyte (Anja Lambrecht and Bernd Skiera 2006). Other examples of threepart tariffs include car leasing contracts, which often include a mileage allowance and charge per mile thereafter. In a variety of rental markets, contracts charge a flat rate for a specified period followed by steep late fees. Finally, introductory credit card offers may also be three-part tariffs. For instance a $1,000 balance might be charged an initial balance transfer fee, zero marginal charge per month for the first six months, and a high marginal charge per month thereafter. The existing literature on nonlinear pricing does not provide a compelling explanation for such pricing patterns. For perfect competition, one expects prices to be driven down to cost, while standard nonlinear pricing models suggest the highest-demand consumer will pay the lowest marginal price. Instead, a tendency of consumers to underestimate the variance of their future demand when choosing a tariff provides a more plausible explanation of observed menus of three-part tariffs. Two important biases lead to this tendency: forecasting overconfidence, which has been well documented in the psychology literature, and projection bias, which is described by George Loewenstein, Ted O’Donoghue, and Matthew Rabin (2003).