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Sunday, July 23, 2006

"The Naïve Pay All the Fees"

Would you like the extended warranty, window VIN etching, undercoating, fabric protection, paint sealant, and rust proofing? And of course, we have to add ADM and advertising fees, dealer prep, carrying costs, destination charges, documentation fees, port prep fees, registration fees, and the drive off deposit:

What the Naïve Consumers Don’t Know, Can Help You, by Damon Darlin, NY Times: When Xavier Gabaix and David Laibson open a hotel room minibar, they see ... a perpetual battle between companies charging hidden fees and the sophisticated consumer trying to avoid them. The two economics professors ... 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. ... 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 ... 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. ... Marriott should be pointing out Hilton’s parking fees and phone surcharges. But that rarely happens... 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... He would advise going to the hotel with the lowest room rate and avoid any fees...

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...

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...

The sophisticated consumer ... 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. ...

That said, outsmarting companies is hard work. ... You have to hunt for the information .... 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. ...

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 ... and Brigitte Madrian ..., 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. ...

    Posted by on Sunday, July 23, 2006 at 12:33 AM in Economics, Market Failure | Permalink  TrackBack (0)  Comments (25)


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