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August 28, 2006

Let others pay for add-ons while you ride free


Damon Darlin's July 22, 2006 New York Times story about letting other people do your heavy lifting got my undivided attention.

Here's his piece.

    What the Naïve Consumers Don't Know, Can Help You

    When Xavier Gabaix and David Laibson open a hotel room minibar, they see among the tiny liquor bottles and European chocolates a perpetual battle between companies charging hidden fees and the sophisticated consumer trying to avoid them.

    The two economics professors -- Mr. Laibson at Harvard and Mr. Gabaix at the Massachusetts Institute of Technology and Princeton -- have looked at how companies hide fees and costs. They found that sophisticated consumers have somehow learned how to game the system by having enough naïve consumers around to subsidize them.

    The smartest strategy, they say, is for the sophisticated consumer to choose the service with the most hidden charges and highest add-on prices, but then avoid paying those added costs. ''The sophisticated consumer takes advantage of that,'' Mr. Gabaix said. ''The naïve pay all the fees.''

    Companies hide add-on costs, of course, because it is lucrative. Hewlett-Packard sells inexpensive printers and makes its profit on high-margin replacement ink cartridges that can cost half as much as the printer. The fastest-growing segment of Wells Fargo's banking business is income from fees, up 14 percent in the latest quarter.

    Consumers see fees everywhere, in their cellphone and credit card bills, mail-order invoices, mutual fund statements, car rental and hotel charges. Actually, most consumers (particularly those who do not start their Saturday mornings reading financial advice) do not see them or they spot them too late. And that myopia perplexed the two professors.

    Economic theory says shrouded fees should not happen. A competing company should come along and tell consumers just how bad its competitors are for extracting those fees. Epson should be telling the world how much Hewlett-Packard charges for ink. Marriott should be pointing out Hilton's parking fees and phone surcharges. But that rarely happens, and Mr. Laibson likens that to the dog that did not bark for Sherlock Holmes.

    ''My view of the world is that people usually make smart choices, but sometimes they make mistakes,'' Mr. Laibson said. ''Why doesn't the market fix the problem?''

    In a paper appearing in The Quarterly Journal of Economics with the academic title of ''Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets,'' the professors say that price-cutting and educational advertising do not always benefit the bargain-seeking consumer. A company would hurt itself if it described how its competitor loads on the fees, they said.

    They argue that drawing attention to the rivals' fees just alerts the sophisticated consumer that the rival is actually offering a better deal. Transparent Hotel could advertise a no-added-fees $100 room and point out that Nontransparent Hotel really charges $145 for its $70 room. If a consumer goes with Nontransparent and avoids the add-on fees, he ends up paying less, the economists said. He would advise going to the hotel with the lowest room rate and avoid any fees, assuming -- which economists love to do -- that factors like location and safety are equal.

    The result for the well-meaning company is harsh. Its advertising might hurt the rival in the sense that consumers pay fewer fees there, but it is increasing the number of sophisticated consumers and teaching them to choose the other guys. It is unlikely to draw in the sophisticates. ''That business won't make much money once you understand how the world works,'' Mr. Laibson said. ''What's the benefit to the company?''

    It is a far better business strategy to have the naïve subsidize the sophisticated. The way the market solves this problem, in other words, is not by educating consumers, but by having the sophisticated consumer exploit the opportunities. Sophisticated consumers are not really taking advantage of companies, nor are companies taking advantage of consumers, as much as companies are helping those sophisticated consumers take advantage of the less sophisticated consumer.

    For example, you see an offer for a room at Nontransparent Hotel for $75 (which costs the hotel $100 to provide). The guy checking in behind you also rents a room, but will rack up $70 in fees from the minibar, the phone and garage parking (all of which cost the hotel $20 to provide). You, on the other hand, were not tempted by the minibar, used your cellphone for calls and took public transportation to the hotel. The other guy subsidized your room.

    Smart consumers now have a strategy. They should go to the company offering the discounted product even if the company has loads of hidden fees. The sophisticated consumer then exploits the company by taking the below-cost product and shunning the fees. ''It's a perpetual battle between the firm that fools consumers into paying fees and the smart consumer who can avoid them,'' Mr. Laibson said.

    Getting cheaper goods and services subsidized by the naïve consumers works as long as you know what you could be charged. But it does not pay if too many people know the same thing.

    Shrouding of information rarely goes away because there are new generations of myopic consumers and even the sophisticated consumers are forgetful or distracted and end up paying for add-ons. The professors say that new shrouding techniques constantly evolve as companies find fresh ways to generate additional revenue. ''Now that the world is more complicated with more products, there are more opportunities for people to make mistakes,'' Mr. Gabaix admits.

    That said, outsmarting companies is hard work. Hewlett-Packard does not tell consumers the price-per-page cost of its printers on its Web site, for example. You have to hunt for the information and do the math yourself. Hotels in South Florida rarely tell you while you are making reservations or checking-in that you will face a $25 ''resort fee,'' which is ostensibly imposed to cover your use of the pool and deck chairs. A recent study of purchases on eBay showed that consumers responded to direct costs more than to shipping costs.

    Even the most sophisticated people find it hard to game the system when it comes to fees. In earlier research, Mr. Laibson and two colleagues, James Choi of Yale and Brigitte Madrian of the Wharton School at the University of Pennsylvania, learned that even the most knowledgeable people make really dumb decisions even when provided all the information.

    Wharton is a top business school and its graduates will be leading companies. The students there should be pretty smart about financial matters, right?

    The academics asked a number of the school's M.B.A. students how they would allocate $10,000 among five indexed mutual funds. Each student was given the fund prospectuses, where investment strategies and fees are outlined. The academics expected the students would put all of the money in the fund with the lowest fees since index funds invested in identical stocks. But some students went chasing the highest historic returns. Others wanted to spread risk by dividing the money among a number of funds. Only 6 percent did the expected thing.

    Then Mr. Laibson and his colleagues made the test easier. Instead of giving them just the funds' prospectuses, he gave them a sheet of paper that summarized the fees of the five funds. ''We thought that would make it more transparent,'' he said. ''We were unshrouding the information.''

    Only 19 percent got the correct result.

    Or you could say that the smart segment of the market saved money because it was subsidized by the ignorance of the others.

August 28, 2006 at 02:01 PM | Permalink


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Thanks. That was interesting.

Posted by: Jack | Aug 28, 2006 2:22:30 PM

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