Dynamic Pricing of Network Goods with Boundedly Rational Consumers

Abstract

We present a model of dynamic monopoly pricing for a good that displaysnetwork effects. In contrast with the standard notion of arational-expectations equilibrium, we model consumers as boundedlyrational, and unable either to pay immediate attention to each pricechange, or to make accurate forecasts of the adoption of the networkgood. Our analysis shows that the seller's optimal price trajectory hasthe following structure: the price is low when the user base is below atarget level, is high when the user base is above the target, and is setto keep user base stationary once the target level has been attained. Weshow that this pricing policy is robust to a number of extensions, whichinclude the product's user base evolving over time, and consumers basingtheir choices on a mixture of a myopic and a "stubborn"expectation of adoption. Our results differ significantly from thosethat would be predicted by a model based on rational-expectationsequilibrium, and are more consistent with the pricing of network goodsobserved in practice.