Theory of Product Differentiation in the presence of the Attraction Effect

We apply the theoretical model of endogenous reference-dependence of Ok, Ortoleva and Riella (2011) to the theory of vertical product differentiation. We analyze the standard problem of a monopolist who offers a menu of alternatives to consumers of different types, but we allow for agents to exhibit a form of endogenous reference dependence like the attraction effect. We show that the presence of such biases might allow the monopolist to overcome some of the incentive compatibility constraints of the standard problem, leading the economy back towards the efficient equilibrium in which the monopolist extracts all the surplus. We then discuss welfare implications, showing that an increase in the fraction of customers who are subject to the attraction effect might not only increase the monopolist’s profits and total welfare, but consumer’s welfare as well.