Pricing strategy and behavioural economics

I've been holding onto this one for a while, until my ECON100 class covered pricing strategy. We know that firms use pricing strategy to try and extract additional profits from consumers (yesterday I blogged about two-part pricing). But firms also take advantage of consumer's quasi-rationality (consumer's departures from pure rational decision making). Back in January, Tim Harford wrote a great post which highlighted some examples:

The most egregious example — popular in the US, blessedly less so in the UK — is the mail-in rebate, where a manufacturer or retailer will offer a discount but only after the customer fills in a form, attaches a receipt and mails the paperwork off with fingers crossed. There are a number of advantages to this — it may allow the manufacturer to gain information about customers, and produces a flattering cash flow — but surely the main reason companies use mail-in rebates is that they know some people aren’t as disciplined and organised as they think.

Scott Adams, as so often, nailed the issue in a Dilbert comic strip. Dogbert offers a product for sale for $1,000,029 with a $1,000,000 rebate. And since “all we need is one person to forget to mail in the rebate forms”, Dogbert suggests targeting “the lazy rich”.

The benign argument for mail-in rebates is that the relatively wealthy are less likely to mail in the rebate, because they prefer to spend the time it takes to do so on other things (this is also the argument for why the wealthy are less likely to clip coupons). This leads the wealthy to pay a relatively higher price for the good, which is essentially what the firm wants, since rebates (and coupons) are a subtle form of price discrimination. Because the wealthy have relatively less elastic demand for goods (they are less responsive to higher prices, because goods of whatever type take up a smaller proportion of their income), the firm wants to (and can get away with) charging the wealthy a higher price.

However, Harford hits on another point with rebates. If consumers trick themselves into thinking they will mail in the rebate (so at the time they make the purchase they are thinking about the sticker price minus the rebate), but then are too disorganised to do so, the consumers are paying a higher price than they initially were willing to. Or perhaps people are just time inconsistent - the decision they make at the time of purchase (that they will mail in the rebate form) isn't the decision that they make later (that it's too much trouble to fill out the form, find a postbox, etc.). Either way, that extra money goes into the back pockets of the firm.

Harford also gives another example, which will be familiar to my ECON100 students:

More subtle still are pricing schemes that exploit consumers. In a recent analysis of overconfident consumers, economist Michael D Grubb highlights the “three-part tariff”. A one-part tariff would be, for example, 2p per minute to make phone calls. A two-part tariff might be £10 a month, plus 1p a minute to make phone calls. And a three-part tariff? A tenner a month with 200 minutes of free calls, plus 10p a minute to make phone calls after the 200 minutes have been used.

The three-part tariff will be reassuringly familiar to anyone with a mobile phone contract. But look at it there on the page. It’s ridiculous, is it not? It is hard to imagine any company deploying such a convoluted offering for a product whose consumption was obvious, such as petrol — “£10 a month to use our petrol stations, the first 50 litres of petrol to be supplied at cost price, and then £5 a litre thereafter.” There are legitimate business justifications for a three-part tariff but the likeliest story is that phone companies think we are fallible. Most of us don’t have a firm grasp either of how much we talk on average or of how variable that average is. As a result, many of us pay these punitive charges more often than we expect.

I demonstrated yesterday how the two-part tariff allows consumers to reach a higher indifference curve (thus making them better off). Again in a benign explanation, the three-part tariff does similarly. However, this relies on consumers being aware of how much they are spending, but if consumers are largely unaware then all bets are off. One aspect of behavioural economics is the illusion of knowledge - we think we know more than we do. So, when we choose a mobile phone plan, we are confident we know how many minutes we will use and that we will be able to keep track so that we avoid the expensive minutes after our free minutes have run out. But it turns out we aren't as aware of our mobile phone usage as we thought.

I encourage you to read the whole of Harford's post, as it is very good.