Bait and ditch: Consumer naïveté and salesforce incentives

• Date: 01 January 2020
• Author: Antonio Rosato,Fabian Herweg
• Published date: 01 January 2020
• DOI: http://doi.org/10.1111/jems.12336

© 2019 The Authors. Journal of Economics & Management Strategy published by Wiley Periodicals, Inc.

J Econ Manage Strat. 2020;29:97–121. wileyonlinelibrary.com/journal/jems

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Received: 20 December 2018

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Revised: 8 August 2019

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Accepted: 7 November 2019

DOI: 10.1111/jems.12336

ORIGINAL ARTICLE

Bait and ditch: Consumer naïveté and salesforce incentives

Fabian Herweg

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Antonio Rosato

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1

Faculty of Law, Business, and

Economics, University of Bayreuth,

Bayreuth, Germany

2

Economics Discipline Group, University

of Technology Sydney, Sydney, NSW,

Australia

Correspondence

Fabian Herweg, Faculty of Law, Business,

and Economics, University of Bayreuth,

D‐95440 Bayreuth, Germany.

Email: fabian.herweg@uni-bayreuth.de

Funding information

Australian Research Council,

Grant/Award Number: DE180100190

Abstract

We analyze a model of price competition between a transparent retailer and a

deceptive one in a market where a fraction of consumers is naïve. The

transparent retailer is an independent shop managed by its owner. The

deceptive retailer belongs to a chain and is operated by a manager. The two

retailers sell an identical base product, but the deceptive one also offers an add‐

on. Rational consumers never consider buying the add‐on while naïve ones can

be “talked”into buying it. By offering the manager a contract that pushes him to

never sell the base good without the add‐on, the chain can induce an

equilibrium in which both retailers obtain more‐than‐competitive profits. The

equilibrium features price dispersion and market segmentation, with the

deceptive retailer targeting only naïve consumers whereas the transparent

retailer serves only rational ones.

KEYWORDS

add‐on pricing, bait and switch, consumer naïveté, incentive contracts

JEL CLASSIFICATION

D03; D18; D21; L13; M52

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INTRODUCTION

Many consumers are familiar with so‐called bait‐and‐switch strategies whereby customers are first “baited”by

merchants’advertising of products or services at a low price but, upon visiting the store, are then pressured by

salespeople to consider similar, but more expensive, items (“switching”). In a series of articles appeared in the “The

Haggler”—a column in the Sunday edition of The New York Times (NYT)—journalist David Segal describes a somewhat

different strategy employed by large retailers like Staples, BestBuy, and others, which he dubs bait‐and‐ditch: escorting

shoppers out of the store, empty‐handed, when it’s clear they have no intention of buying an expensive warranty or

some other add‐on for some steeply discounted electronic appliance—a practice that employees at Staples themselves

call “walking the customer.”He further reports that clerks and sales representatives, at Staples and elsewhere, are

under enormous pressure to sell warranties and accessories, particularly on computers. For motivation, close tabs are

kept on the amount of extras and service plans sold for each and every computer; the goal is to sell an average of $200

worth of add‐ons per machine, and a sales clerk who cannot achieve the goal is at risk of termination. Therefore, sale

representatives prefer to forgo the sale altogether, rather than selling the base good without the add‐on.

1

In the last few years there has been a dramatic increase in the sale of add‐on products such as extended warranties,

service plans, credit insurance, and financing programs like “buy now, pay later”arrangements, and it is well known

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium, provided

the original work is properly cited.

that such practices generate a substantial fraction of retailers’profits in different consumer industries. Likewise, the use

of sales quota to motivate sales representatives is not novel nor is the fact that meeting one’s quota is usually an

attractive goal as it leads to additional benefits such as promotion or job security (see Oyer, 2000). Yet, the NYT article

highlights how retail chains design compensation schemes that push their salespeople to target and exploit naïve or less

savvy consumers, concluding that such compensation schemes might backfire in the end.

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Indeed, it is well known that

often salespeople successfully “game”incentive systems by taking actions that increase their pay but hurt the objectives

of their employer, such as manipulating prices, influencing the timing of customer purchases, and varying effort over

their firms’fiscal years.

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In this paper, we look at the interplay between employees’compensation schemes and market competition when

(some) consumers are naïve. We start from the same premise as the NYT article—that firms’attempts to exploit

consumer naïveté might lead them to design somewhat perverse incentive contracts—and show that a firm, by using

these seemingly perverse incentive contracts, is able to increase its profits. In particular, our analysis shows that it may

be optimal for a retailer to design a compensation scheme that incentivizes its salesforce to exclusively target naïve

consumers. The reason is that the contract between the retailer and its salesforce acts as a credible commitment device

ensuring that the retailer will not attempt to capture the whole market. This, in turn, induces other retailers in

the market to price less aggressively, thereby softening price competition.

Our baseline model is one of price competition between a transparent retailer and a deceptive one. The transparent

retailer is an independent local shop managed by its owner. The deceptive retailer is a franchise retailer which belongs

to a chain and is operated by an agent (or manager) on behalf of the chain company. The two retailers sell an identical

base product, but the deceptive retailer also offers an add‐on. There is a unit mass of consumers with heterogeneous

willingness to pay for the base good. Consumers can be either sophisticated or naïve. A sophisticated consumer

understands that the add‐on offered by the deceptive retailer is worthless. A naïve consumer, on the other hand, can be

convinced by the agent that the add‐on increases the value of the base good; that is, s/he can be “talked”into buying the

add‐on next to the base product. Our main contribution is to show that by designing an appropriate compensation

scheme for its agent, the chain can induce a pricing equilibrium in which both retailers obtain “abnormal”profits; that

is above competitive levels. The chain can achieve this outcome by offering its agent a contract that pushes him to never

sell the base good without the add‐on. In this case, we say that the chain is engaging in “bait‐and‐ditch”by inducing the

agent not to serve those consumers who do not wish to buy the add‐on. Hence, complete market segmentation arises in

equilibrium with the deceptive retailer targeting only naïve consumers while the transparent retailer serves only

rational ones. Market segmentation softens price competition and eliminates the incentives for the retailers to undercut

each other’s price for the base good. Moreover, we also show that the transparent retailer might obtain a higher profit

than the deceptive one. Hence, our analysis implies that even transparent firms may strictly prefer not to educate naïve

consumers, even when education is costless.

The idea that contractual delegation to an agent can be profitable for firms’owners is not new. Several authors (e.g.,

Fershtman, 1985; Fershtman & Judd, 1987; Sklivas, 1987; Vickers, 1985) have shown how, by using an appropriate

incentive contract, a firm can commit to behaving more (or less) aggressively than it would without delegation. In

particular, a firm may use seemingly perverse incentive schemes. For instance, Fershtman and Judd (1987) showed how

owners can benefit by inducing their managers to keep sales low.

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Our paper differs from these previous contributions

in the assumed market structure and, more important, in how we model consumer behavior. These different underlying

assumptions generate novel results and implications. For example, in our model contractual delegation to an agent

provides the retail chain with a credible commitment device to serve only one kind of consumer; this, in turn, allows for

the existence of an equilibrium whereby the market is completely segmented. Moreover, our model predicts dispersion

in the base good’s price despite the fact that retailers supply identical products and have the same costs. Classical

models of price dispersion (e.g., Salop & Stiglitz, 1977; Varian, 1980) rely on the presence of significant search costs for

consumers and on price randomization on the part of firms. In our model, instead, consumers are all perfectly informed

about the price(s) of the base good and the pricing game’s equilibrium is in pure strategies. Nonetheless, price

dispersion arises as a byproduct of the endogenous market segmentation.

The finding that the chain can increase its profits by committing to sell only the bundle is—at first glance—

reminiscent of the leverage theory of tied sales (Whinston, 1990). According to this theory, bundling is beneficial for the

firm that offers both products but hurts the profits of the competitor who offers only one product. By contrast, in our

model, both firms obtain higher profits if the chain commits to sell the base good only together with the add‐on.

Therefore, our finding that the deceptive retailer can increase its profits by committing to serve only naïve consumers,

who buy the add‐on together with the base good, is more similar to the role of “technological bundling”as a tool to

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