Using a game theoretic framework, we show that not only can pay-what-you-want (PWYW) pricing generate positive profits, but it can also be more profitable than charging a fixed price to all consumers. Further, whenever it is more profitable, it is also Pareto-improving. We derive conditions in terms of two parameters, namely the marginal cost of production and the psychological cost of the consumer for paying too little compared to her reference price.

The paper makes the following contributions to the existing literature. First, we endogenize the choice of pricing strategies—PWYW vs. fixed price. Thus rather than solely focusing on the profitability of PWYW pricing, we evaluate its profitability vis-a-vis uniform pricing. To the best of our knowledge this has not been done so far theoretically. Second, we specify consumer utility to account for both economic and behavioral considerations. We show that when marginal cost is low and behavioral considerations are strong, then PWYW pricing can exploit the deadweight loss present under the uniform price to gain additional profit at the cost of serving some free riders. Therefore, PWYW pricing can be more profitable than charging a fixed price especially when the marginal cost is low and the deadweight loss is high. Third, we demonstrate PWYW pricing is more attractive when the cost of price setting is considerable or the market size is small.