Consumer Expectations and Loss-Leader Pricing In Retail Stores

In this paper we analyze the price and advertising strategies for firms competing for the demand of an assortment of goods in an environment with imperfect information. We obtain advertising and loss-leader pricing as an equilibrium outcome. Moreover, we show that even though both firms make a loss on the loss-leader, they are better-off selling both goods rather than specializing in one good. By extending the analysis to the case where different goods have different reservation prices, we demonstrate that in all equilibria, firms make exactly the same profits and have identical store traffic regardless of whether or not they offer a loss-leader. Thus our results are consistent with the “surprising findings” in Walters and McKenzie (1988).