30 Seconds or Free! Managing Quality Uncertainty Through Contingency Pricing

Authors: Hemant K. Bhargava, Shankar Sundaresan

This paper demonstrates that quality-contingent pricing is a useful mechanism for mitigating the negative effects of quality uncertainty in e-commerce and IT services. A contingency pricing contract specifies a sequence of possible quality levels and corresponding prices. The market estimates the firms performance at various quality levels based on historical statistics, and the firm may have additional private information with respect to its future, and true, probability distribution. Examining the monopoly case, we explicate the critical role of private information and differences in belief between the firm and market, in the choice of pricing scheme. Contingent pricing is useful when the market underestimates the firms performance; then it is optimal for the firm to offer a full-price rebate for mis-performance, with a correspondingly higher price for meeting the performance standard. In some cases, contingency pricing enables the existence of trade when standard pricing fails to bring the parties together when they have different beliefs about performance. We study the competitive value of contingency pricing in a duopoly setting where the firms differ in their probabilities of meeting the performance standard, but are identical in other respects. Each firms choice of contingency vs standard pricing scheme mirrors its choice in the monopoly setting, and each firm uses a full-price rebate when the market underestimates its own performance. However the superior firm achieves a greater increase in profits under contingency pricing. We show that contingency pricing is efficient as well, and consumer surplus increases because more consumers buy from the superior firm which uses contingency pricing to signal its superiority.