Thursday, July 19, 2012

Pricing transparency does not always pay!

Clothes retailer JC Penney is apparently doing very badly following the embrace of a massive, creative and aggressive new advertising and pricing campaign that promises simplified prices. Logically it would appear that, in a world where pricing information is "shrouded", a more transparent up-front full price revealing strategy would be much appreciated by consumers and increase revenues.

The practice of concealing the real price of a product or service by "shrouding" the prices of "add-on" components from the displayed price tag is rampant in many product markets. They include the high service or consumables cost for certain products which are priced cheap (like the cartridges and printers) and high cost complementary services that are attached with cheaper hotel rooms, stadium and theatre seats (pop corn in cinemas effect). Such shrouding helps the firm make money out of myopic consumers (who either do not have the knowledge or patience or inclination to sift through information) whereas the sophisticated consumers (who process all information and make the cheapest option) get greater value for their money. In simple terms, the former subsidizes the latter. 

In this context, a working paper by Xavier Gabaix and David Laibson found that in competitive markets where shrouding is rampant, it may not be possible for firms to make money by opting for transparency. They write about their study of products with add-ons, 
In competitive markets with costless communication, Bayesian consumers infer that hidden prices are likely to be high prices. Hence, firms choose not to shroud information. However, information shrouding may occur in an economy with some myopic consumers. Such shrouding creates an inefficiency. Sometimes firms have an incentive to eliminate this inefficiency by educating their competitors’ myopic consumers. However, if add-ons have close substitutes, a “curse of debiasing” arises, and firms will not be able to profitably debias consumers by unshrouding add-ons. In equilibrium, two kinds of exploitation coexist. Optimizing firms exploit myopic consumers through marketing schemes that shroud high-priced add-ons. In turn, sophisticated consumers exploit these marketing schemes. It is not profitable to lure either myopes or sophisticates to non-exploitative firms. We show that informational shrouding flourishes even in highly competitive markets, even in markets with costless advertising, and even when the shrouding generates allocational inefficiencies. 
In other words, advertising the real price upfront and disclosing low or no add-on or markups, and thereby educating consumers does not fetch revenues. In competitive markets, where "low-ball" pricing is rampant, such firms end up with the worst of all worlds. The sophisticated consumers anyways prefer the "shrouded" markets because they get good deals from them. The myopic consumers tend to be taken in the by the "low-ball" prices and other offers of competitors and also put off by the relatively higher prices of the transparent firm. Therefore a firm that unshrouds its add-on prices will lower its profits, implying a “curse of debiasing.”

There two important policy take-aways from the study.

1. Competitive markets will not necessarily debias markets and bridge information asymmetry. Certain categories of consumers, the sophisticates, will always prefer the"shrouded" markets. Myopic customers will be put off by the relatively higher prices of the transparent firm. There are others who would be indifferent to small price variations. All this will conspire to favor an equilibrium that involves "shrouding".

2. If it is in public interest to bring in greater pricing transparency to certain markets (like say financial products), this cannot be left to free-markets or voluntary unshrouding. Regulators may have to make unshrouding mandatory for all firms. This carries great relevance to the financial services sector, where finacial illiteracy will conspire with cognitive biases to generate undesirable outcomes.

Conventional wisdom has been that lower search costs and transparency in pricing in all markets will result in better outcomes. Accordingly, policy makers have preferred to adopt this strategy to increase efficiency in financial markets like that for insurance policies and savings instruments. However, if the aforementioned study is any indicator, a more effective strategy would be mandatory unshrouding with clear defintion of what constitutes such shrouding.    

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