A TOTALLY AWESOME economics paper

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(Wait, wait, don’t leave just yet. I know I just said “totally awesome” and “economics paper” in the same headline, as if those two terms were not matter and anti-matter, as they so obviously are, doomed to explode on contact. I know you think your RSS reader must be broken, that link you followed must have hijacked your browser and sent you into some twilight zone of people who find economics totally awesome. But wait — don’t leave. I promise I’ll make this worth your while.)

Last year, Xavier Gabaix and David Laibson published a paper entitled Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets, on why two companies competing for customers in a market with lots of fees and add-on charges have no incentive to educate those customers on how to get a better deal. They give an example of two hotel chains, Hilton and “Transparent,” where Transparent is a made-up firm that is trying to take Hilton’s customers:

[…C]onsider a hotel room that costs Hilton $100 to supply. Suppose that all consumers are initially myopic (i.e., they do not think about add-ons when they plan a hotel visit). When such a customer stays at Hilton, she ends up paying $20 to purchase add-ons like parking, telecommunications, room service, etc. Without loss of generality, assume that these add-ons cost Hilton nothing to provide. In a competitive market, Hilton will then advertise “Hilton’s rooms cost only $80,” neglecting to mention the costly add-ons that effectively raise its revenue. In competitive equilibrium, Hilton’s costs ($100) equal Hilton’s total revenues ($80+$20).

Sounds familiar, right? We talk about this here all the time — how to avoid “fee revenue” and add-ons that wind up costing you far more than the advertised price of a service. So could someone compete with Hilton by not charging fees?

Now consider another hotel chain, called Transparent, that is picking a business strategy. Transparent could tell consumers about the shrouded add-ons that consumers pay for at Hilton. Transparent could advertise, “Watch out for add-on prices at our competitors. Tranparents’s add-ons are all free.” Naturally, if Transparent did this, they could not subsidize their room fees with add-on revenue. An aggressive transparency strategy would be to charge $100 for rooms and nothing for add-ons.

The authors argue that what Transparent will wind up doing is not educating consumers to take a more transparent, less fee-laden deal, but rather educating consumers on how to avoid Hilton’s mark-up fees. As result, Transparent wouldn’t get any customers from marketing against Hilton’s hidden costs — instead, consumers would lose their “myopia” about Hilton’s add-ons, and learn to avoid those add-ons while staying at the lower-priced Hilton hotel. Consumers are better off, but both hotels suffer. They go on:

In essence, we show that there are two kinds of exploitation. Firms exploit myopic consumers. In turn, when consumers become sophisticated, they take advantage of these exploitative firms. Finally, when sophisticated consumers exist, firms cannot rid themselves of them. In equilibrium, nobody has an incentive to deviate except the myopic consumers. But the myopes do not know any better and often nobody has an incentive to show them the error of their ways. Educating a myopic consumer turns him into a (less profitable) sophisticated consumer who prefers to go to firms with loss-leader base good pricing and high-priced (but avoidable) add-ons. Hence, education does not help the educating firm.

This mechanism applies to a wide range of markets. An educated banking customer gets the benefit of a $50 gift for opening an account and avoids paying some of the fees that snare myopic consumers. An educated credit card holder gets convenience, float, and miles and avoids paying interest charges and late payment fees. An educated home printer buyer gets a loss-leader price and avoids paying for frequent cartridge replacements (by printing in black and white instead of color, printing in draft mode, or printing fewer large jobs at home). In such markets educated consumers prefer to stick with the firms that feature high add-on prices, since these firms have loss-leader base-good prices, and the educated consumer can partially substitute away from the overpriced add-ons.

Credit card companies have a name for this kind of educated, sophisticated consumer, one who avoids all the fees credit card companies normally charge. They call consumers like that “deadbeats.” Sounds like someone who doesn’t pay their bills, right? But no — it’s exactly the opposite. A deadbeat is someone who does pay their bills, and thereby avoids late charges and overlimit fees. I want to be a deadbeat!

So why is this economics paper so totally awesome? It is teaching you, as a consumer, how to get the best deal in a huge number of circumstances. Namely:

  1. look for a company with a low base cost and tons of add-on fees; and
  2. avoid the fees.

Done. (See, I told you it would pay off to read this post. You got to skip the other 34 pages of the paper!)

Now, I should say, the authors say that no one has an incentive to help consumers become more knowledgable about their money — none of the companies in a fee-loaded market will get anything out of it, and third parties are either non-profit and therefore fighting a losing battle (they give Consumer Reports as an example), or for-profit but biased (like investment brokerages). I think they’re wrong on that point. The people who have an incentive to educate consumers about getting better deals are other consumers. By pooling our data, we all have better information to draw from, and better tools for getting great deals. (This is, in fact, exactly how the credit reporting system works, in reverse.) This is the model we’re pursuing at Wesabe. Don’t try to run a business telling people what the best deals are. Instead, give people a way to show each other what the best deals are, where the best values are, and how to understand different offers in a market. We’ll see what happens, but I have a strong belief that we can do it, and that everyone who joins can be the “sophisticated consumers” Gabaix and Laibson talk about in their paper.

And hey, it’s definitely worth a shot. Better than reading economics papers!

4 Responses to “A TOTALLY AWESOME economics paper”

  1. Ed Fenster Says:

    I would add that financial companies are very sophisticated at exploiting the add-on strategy in non-obvious ways: for instance, take BofA’s recent offer to provide free strock trades in its brokerage accounts to customers who keep a large amount of money (>$25k?) in demand accounts… Drawn in by the lack of trading fees, customers miss out on interest income they might have otherwise earned by keeping their cash in a competitor’s high-yielding money market instead. So, all but the heaviest of stock traders lose.

  2. Patrick Says:

    Still, wouldn’t this be a good long term stategy for the Transparent company to break into the market?

    As mentioned, when the consumer finds out about the extra costs, they will continue staying at the Hilton and find ways to avoid the extras. Thus, the consumer would be paying $80 for a room which is costing Hilton $100 (a $20 loss for Hilton). If enough consumers were informed about Hilton’s extra costs Hilton would be forced to raise their fees to $100 – matching Transparent’s fee.

    In the situation outlined above, Transparent would have leveled the playing field with Hilton (they now charge the same amount for a stay at the hotel) and maybe even reduced profits at Hilton by the consumers who they lose $20 on.

    In any case, your point is taken; the better educated we are, the more cost effective we can be, regardless of where we get our information from.

  3. Jane Says:

    Thanks, great find.

  4. Prophetess Says:

    The scenario you describe here gives companies every reason to pose as consumers in order to “muddy the waters” of the consumer opinion landscape in an effort to give themselves an advantage. How does Wesabe plan to detect and deal with consumers who are shilling for some corporation or other?

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