Selling Substitute Goods to Loss-Averse Consumers: Limited Availability, Bargains and Rip-offs

I characterize the profit-maximizing pricing and product-availability strategies for a retailer selling two substitute goods to loss-averse consumers. Consumers have unit demand, are interested in buying at most one good, and their reference point is given by their recent rational expectations about what consumption value they would receive and what price they would pay. If the goods are close substitutes, the seller maximizes profits by creating an “attachment effect”for the consumers through a tempting discount on a good available only in limited supply (the bargain) and cashing in with a high price on the other good (the rip-off). Consumers are enticed by the possibility of getting a bargain, but, if it is not there, they buy a substitute good as a means of minimizing disappointment. The seller tends to use the more valuable product as a bargain because consumers feel a larger loss, in terms of forgone consumption, if this item is not available and are hence willing to pay a larger premium to reduce uncertainty in their consumption. I also show that the bargain can be priced below marginal cost, that the seller’s product mix differs from the welfare-maximizing one and that she might supply a socially wasteful product. JEL classification: D11; D42; L11.