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Why are there hidden fees?
This new paper by David Laibson and Xavier Gabaix is one of the best of the last year...
Here is the bottom line:
Laibson and Gabaix's explanation relies on a good bit of math, too, but it can be summarized pretty simply using a hypothetical example. Imagine two hotel chains. The first, Hidden Price Inn, has a very low room rate of $80 a night, but makes liberal use of high "shrouded" fees: Three bucks for a minibar Dr Pepper, $25 for parking, $12 for eggs at breakfast. The unsophisticated traveler cheerily (if unwittingly) forks over the fees, all the while patting herself on the back for getting a cheap room.
Now imagine a second chain, Straightforward Suites. It charges much more reasonably for the extra costs ($1, say, for that Dr Pepper), but because it makes less on the extras, it has to charge slightly more for the room-$95, instead of $80. Even an unsophisticated traveler can tell $95 isn't as good as $80.
Through an aggressive ad campaign, Straightforward could try to point out how devious the approach of Hidden Price Inn is and how much less deceptive its own prices are. But Laibson and Gabaix show that there's a catch in this strategy: Hidden Price Inn actually has two key types of customers. Yes, there are the clueless consumers (the economists prefer to call them "myopic"). But there are also the sophisticated ones, who know that if they avoid the hotel restaurant, take a taxi instead of using the parking garage, and call home with a cellphone, they'll actually get a better deal at Hidden Price than at Straightforward.
Straightforward Suites's ad campaign, then, might just end up increasing the ranks of sophisticated consumers who will in turn dial up Hidden Price Inn for a cut-rate room. Rather than play this self-defeating game, Straightforward will most likely just lower its own room prices and stick it to the customers on the extras.
Here is the full story, by Christopher Shea. The pointer is from www.politicaltheory.info. Here are earlier versions of the paper.
Posted by Tyler Cowen on June 27, 2006 at 02:39 AM in Economics | Permalink
Comments
The intuition reminds me of the explanation sketched by Asubel (AER, 1991) as to why credit card interest rates are so high, i.e., there are two types of agents: (i) those who get a credit card knowing that they will not be using it or paying their balance in time every month (the sophisticates); and (ii) those who get a credit card expecing not to use it, but who still use it and fail to pay in time (the naïves). The latter group gives rise to "high" interest rates in the credit card market. A very good paper on adverse selection for anyone interested in applied contract theory.
Posted by: Marc at Jun 27, 2006 8:10:36 AM
Is this story sophisticated vs. naive or bundled vs. unbundled pricing, with some consumers willing to pay a substantial convenience premium?
Posted by: Gary at Jun 27, 2006 9:11:07 AM
Then there are also the skeptical types, who are confident that every hotel will try to gouge them somehow, and don't believe advertising campaigns.
Posted by: y at Jun 27, 2006 10:08:13 AM
There is a cost to avoiding the hotel restaurant (or minibar), taking a taxi instead of using the parking garage and calling home with a cellphone (especially if you are roaming). Presumably there is a (lower) price at which even the sophisticated user will weight these costs and consume these services thus increasing the hotel's revenue.
One of my personal benchmarks is that I will pay $10 a day for high speed internet but not $20 or more which the fanciest hotels seem to charge - although I much prefer the free internet that is almost standard in the basic business traveller hotels these days. Here's a real mystery. Why does the liklihood of free internet decrease as the hotel price increases?
Posted by: Dan Hill at Jun 27, 2006 10:14:20 AM
It's amazing that an analysis this obvious should attract admiration. Any MBA with a basic understanding of market segmentation (literally Marketing 101) could have produced it (minus the math, but where's the loss in that?).
Posted by: ZF at Jun 27, 2006 10:41:18 AM
There's a nice Ariel Rubinstein paper showing how firms can
discriminate against boundedly rational consumers in
price-setting. It turns out that everyone benefits - the
price discrimination means firms can make more attractive
offers overall, allowing more demand to be satisfied.
Posted by: David Hugh-Jones at Jun 27, 2006 10:57:27 AM
The internet question is a fun one: tons of cheap Best Western fleabag motels have free internet, but swanky downtown places (annoyingly, where most conferences tend to be) tend to do the gouge thing.
I figure most of it is whether most customers are paying for themselves versus getting their trip paid for by a third party; the "Hidden Price Inn" has a cheaper base rate, and that is what most company trip planners tend to look at.
Posted by: Foobarista at Jun 27, 2006 12:42:44 PM
I'm not sure how generally this applies (nor how widely the paper generalizes), but:
I'd guess that the hidden fees at hotels are largely set up to capture value from business travelers, essentially taking advantage of an agency problem.
Businesses have an incentive to minimize travel costs, where travelers have the incentive to maximize around quality. Because of this most companies have systems in place to put limits on employee choices in making travel – forcing the lower cost option.
“Hidden fees” allow business travelers to circumvent systems intended to control business travel costs. If this hypothesis is true, I’d expect that “hidden fees” have increased recently in response to companies implementing proactive automated IT cost control systems, rather than relying on post-trip audits that would more easily catch the $9 drink from the mini-bar.
Posted by: Dan Knup at Jun 27, 2006 1:01:45 PM
Without having the time to read the paper right now, one question suggests itself right up-front: satisfactorily can that theory satisfactorily explain Hidden Price Inn's behavior? If Straightfoward, having lowered its "frill" prices, is forced to raise its basic price (above HPI's) to meet costs, that implies that the correct/equilibrium/whatever market price for rooms must be somewhat above HPI's base price (assuming that Straightforward isn't selling its "frills" below cost).
Consequently, HPI must be making some portion of its profit on the overpriced "frills." Which means that there have to be a significant number of "myopic" customers still in the marketplace.
Does the authors' math somehow invalidate this conclusion?
Posted by: Paul Gowder at Jun 27, 2006 1:17:24 PM
I don't see what the big deal is. If one looks at actually market behavior one will see that all hotels follow the hidden cost formula. I work in a four diamond hotel. Our rack rate is 289 but our average daily rate is 155. We give away the rooms so week can have the price indecriminate customers get bent over at the bar. I live in Saint Louis and the drinks at my hotel are more expensive than the 4 seasons in Miami. 10 dollars per day for internet? SURE. 9 bucks for a cup of bad coffee? WHY NOT! Jeez sometimes it makes you wonder if economists ever look at the real world.
Posted by: RWP at Jun 27, 2006 1:37:59 PM
So hidden fees are a bit like anti-coupons?
Posted by: Gordon Mohr at Jun 27, 2006 2:13:40 PM
The original article also writes: "Yet how many people realize, when they walk out of CompUSA, a nice $99 inkjet model tucked under their arm, that it's likely they've just committed themselves to spending nearly $1,500 on ink cartridges over the next four years? (In fact, only about 3 percent realize it, according to Stanford economist Robert E. Hall.)"
Well, the last time I bought a printer I DID ask the cartridge price. But there were NO bargains: all the prices were within a couple of dollars of each other, and not especially comparable. So I bought the cheapest printer.
Posted by: Mae Sander at Jun 27, 2006 5:28:26 PM
The printers are, in a way, a counterexample to the Laibson/Gabaix claim, are they not? After all, there are few to no savvy printer users who have figured out how to save on ink cartridges (the whole refilling thing is a messy and inconvenient option, non?). So why don't we see an honest printer company enter the market?
Posted by: Paul Gowder at Jun 27, 2006 8:17:27 PM
This is an actual published paper? I'm guessing that if this question was posed to economists, 95 percent would have given the exact same answer without breaking a sweat. It would never have entered my head to try to publish an peer reviewed article on something so mundane and obvious.
Posted by: Paul at Jun 28, 2006 1:41:52 PM
Mae: buy a laser printer. Significantly higher up front cost, but much cheaper operating costs.
Paul G: how is it a counterexample? It's the same principle.
Posted by: David Nieporent at Jun 29, 2006 4:09:58 AM
David: it's a counterexample because the L/G claim is that honest pricers don't enter the market because the proportion of savvy customers who would not benefit from honest pricers is high enough that the honest pricing model wouldn't work. That explanation for the absence of honest pricers relies on a market that has savvy customers. If there are no savvy printer customers, the L/G claim fails to explain the absence of honest pricing in that market.
Posted by: Paul Gowder at Jun 30, 2006 1:36:15 PM
In response to Mae's comment on the price of ink cartridges.
Consumers have now become at least semi-aware of the cost of cartridges, so manufacturers have responded by pricing them similarly.
This doesn't mean that they are all equal - some cartridges contain smaller amounts of ink and some printers (I'm looking at you Lexmark) use FAR more ink for a given number of printed pages.
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Posted by: levan at Sep 11, 2006 2:40:28 AM
"Here's a real mystery. Why does the liklihood of free internet decrease as the hotel price increases?"
My theory: By paying $100+/night to stay at the high priced hotel vs. the budget hotel you've identified yourself as someone for which price is not a prime motivator. Therefore, you will very likely be willing to pay $10/day (only 10% of the room rate if the room is $100/night) for internet access.
The budget chains realize that for their customers, price is often a prime motivator, and so they have to offer a "perk" to get you to come to them over the next budget guy on the next block. That "perk" started out as free internet access. But once one budget hotel offered free internet, all the other budget hotels had to offer free internet lest they lose customers to the ones that offer free internet. And the result is that the likelyhood of free internet approaches 100% as the price of the room approaches zero.
Posted by: at Jun 12, 2009 12:28:39 PM
