COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1563

Optimal Pricing with Recommender Systems

Dirk Bergemann and Deran Ozmen

March 2006

We study optimal pricing in the presence of recommender systems. A recommender system affects the market in two ways: (i) it creates value by reducing product uncertainty for the customers and hence (ii) its recommendations can be offered as add-ons which generate informational externalities. The quality of the recommendation add-on is endogenously determined by sales. We investigate the impact of these factors on the optimal pricing by a seller with a recommender system against a competitive fringe without such a system.

If the recommender system is sufficiently effective in reducing uncertainty, then the seller prices otherwise symmetric products differently to have some products experienced more aggressively. Moreover, the seller segments the market so that customers with more inflexible tastes pay higher prices to get better recommendations.

Keywords: Recommender system, Collaborative filtering, Add-ons, Pricing, Information externality

JEL Classification: D42, D83, D85