Why are there hidden fees?

by on June 27, 2006 at 2:39 am in Economics | Permalink

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.

Marc June 27, 2006 at 8:10 am

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.

y June 27, 2006 at 10:08 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.

ZF June 27, 2006 at 10:41 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?).

Foobarista June 27, 2006 at 12:42 pm

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.

Paul Gowder June 27, 2006 at 1:17 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?

Gordon Mohr June 27, 2006 at 2:13 pm

So hidden fees are a bit like anti-coupons?

Paul Gowder June 27, 2006 at 8:17 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?

David Nieporent June 29, 2006 at 4:09 am

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.

Jimmy Harris July 5, 2006 at 3:35 am

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.

Comments on this entry are closed.

Previous post:

Next post: