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 simple structure: the price is zero when the product user base is below a specific threshold, and is chosen to keep user base stationary once this threshold demand level has been attained. We show that our prescribed pricing policy is robust to a number of extensions, which include the product's user base evolving over time, a fraction of consumers being sufficiently rational to make accurate adoption forecasts, 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.

Keywords: network externalities, network effects, bounded rationality, myopic, target policy

JEL Classification: D42, L12, C61