The Market for Surprises: Selling Substitute Goods through Lotteries

Abstract

In recent years online retailers have been experimenting with novel business strategies. One notable example of such innovation is the design and sale of opaque goods. A good is opaque when at the moment of sale its characteristics, e.g. the exact name and location of the hotel, are purposely not (fully) revealed by the seller to the buyer. Opaque goods are especially popular in the travelling and hospitality industry for selling hotels, plane tickets and car rentals, with hotwire.com and priceline.com being the top two adopters of such strategies. We can explain the emergence of opaque goods sales as the outcome of the industry search for the optimal selling scheme. First, we fully characterize the optimal selling mechanism for a two-product monopolist in a Hotelling model. Products are substitute-goods and buyers’ utility depends on a base-consumption value (common to both goods) and a distance cost. We show that for high enough base consumption value the optimal mechanism involves selling lotteries. Depending on the shape of the distance costs, there can be only one simple lottery (50-50) offered for the case of linear or concave costs, or a continuum of lotteries for the case of convex or concave costs. Non sure prize lotteries can also be part of the optimal mechanism. Second, we model the interaction between the two sellers and an intermediary and show that similar patterns of lotteries can emerge as competitive outcomes. Third, to analyze industries with more than two products we offer a new model of spatial competition. We show that it is possible that social welfare increases in a market with intermediaries (and lotteries) relative to the one without them, and that firms may become worse off.