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Making a Profit from Unrealistic Consumers
May, 2003 In agreeing to things like a cell phone contract or an introductory credit card interest rate, most consumers overestimate how much self control and common sense we use. The result, say researchers, is that we may make some questionable economic decisions.A quick scan of the goods and services you use every day will reveal that you're probably locked into scads of "contract" agreements. There's your cell phone, your "zero interest" introductory credit card, and your health club, to name a few. All of these things probably looked pretty good when you signed up for them. Phone minutes seemed generous; the credit card gave you a breather on that large balance transfer; a health club membership spurred you on to exercise at a low per-visit rate. But look again. How often in the last year have you actually exceeded your talking minutes? Do you know exactly when the teaser rate will expire on your credit card—and when the whopping interest rate will kick in? And how many times have you really gone to the health club in the past few months? "Some of us may have a lot of self-control when it comes to wisely using goods and services with either delayed benefits or delayed costs, but most of us overestimate our abilities in this regard," says Ulrike Malmendier, an assistant professor of finance at the Stanford Graduate School of Business. A recent study she conducted with Stefano Della Vigna, assistant professor of economics at the University of California-Berkeley, explores whether people are aware of their "time-inconsistent" behavior—and the financial repercussions of that behavior for individuals and companies. Economics literature has long posited that people's self-control problems do not have an important impact on their economic decisions. Individuals are assumed to be fully aware of these issues such that they will find ways to overcome them. Malmendier's first significant finding, however, is that self-control issues do in fact influence economic decision making and, importantly, that most people are not fully conscious of their tendencies in this regard. "And that's crucial," Malmendier says. "That's where firms can make money. They exploit the biased expectations people have about their own behavior." Looking at 67 health clubs in the Boston area, for example, Malmendier found that 85 percent of users who chose a monthly contract were paying significantly more per visit than if they had just paid on a per-use basis. In fact, they were paying a full 70 percent more and were losing $700 compared to the per-visit contract. "People take the monthly contract because they think they will be going to the club at least two times per week—or they're at least hoping the contract will motivate them to go that frequently," Malmendier says. "But they end up being totally unrealistic about how much they will actually use the club." In addition, she found that most people stayed enrolled for at least two months after they stopped using the club before they canceled the contract. "Members are making two mistakes," Malmendier explains. "Either they keep thinking, 'OK, next month I'm going to start going again,' but they never do. Or, even if they've decided to cancel, they simply drag their heels about terminating their membership. Meanwhile, they end up losing in the neighborhood of $185 in monthly fees. Firms specifically use automatic contract renewal just to take advantage of people's procrastination." Malmendier's study is one of the first to demonstrate that systematic biases in consumer behavior are not mere blips on the world market screen. Far from it: People's quirks significantly influence market dynamics. "The health-club industry relies heavily on consumers' naivete about their time-sensitive behavior to make their profits," says Malmendier. "And it's a $12 billion industry in the United States, so we're really talking about a significant market force here." The study also analyzes how consumer self-control issues are exploited in the credit card, cellular phone, and vacation timesharing industries. "Credit card teaser rates of zero percent for balance transfers, for example, similarly lead to huge profits," she says. "That's because people are basically lazy about tracking when the teaser rate ends and transferring the debt somewhere else." Cell phone contracts also take advantage of people's inability to restrain their behavior. "When you first get your cell phone, you think you're only going to use it for special situations," Malmendier says. "Before you know it, you're using it all the time. And once you have talked beyond your contracted minutes, you pay a super high price per minute. If you had been able to accurately assess how tempted you would be to talk at the beginning, you would have chosen the contract that offered a lot more minutes for just $5 more a month. Firms make a lot of profit off high marginal costs." Malmendier's study is not a plea for companies to stop exploiting consumer naivete. Rather, its implications are more subtle. Firms, she says, might want to consider using her findings to try another clever marketing strategy: namely, educating consumers about their penchant for time inconsistency and then offering hand-holding contracts specially designed to help them overcome such behavior. "There's certainly a lot of opportunity for profit in that," she says. MARGUERITE RIGOGLIOSO Citation: Additional Reading: Wertenbroch, Klaus (1998), "Consumption Self-Control by Rationing Purchase Quantities of Virtue and Vice," Marketing Science, 17 (4), 317-337 [featured in Psychology Today, July 1999] Wertenbroch, Klaus, "Firm Profits and Consumer Psychology: Consumers Pay More for Less of What They Like Too Much," U.S. Industry Today, December 1999
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Making
a Profit From Unrealistic Consumers
