Don't underestimate the impact of fees on consumer behaviour

Imagine you are at an ATM withdrawing cash. Before you do, a message comes up reminding you that there will be a $2 fee for accessing your money through an ATM that is not part of your bank's network.  Do you proceed or do you cancel the transaction?

If you were an economist with the Reserve Bank of Australia (RBA), you would have predicted that most would proceed with the transaction. After all, it's only $2.  We lose that behind the couch.

Well, much to the chagrin of RBA financial wizards, they didn't count on the impact of consumer 'irrationality'.  Instead of consumers banking like they had in the past, when the fee for a foreign ATM withdrawal was buried in terms and conditions and you only found out when you looked at your account statement, consumers have turned away from using these ATMs. 

What can you learn from the behavioural economics of ATM fees?

Red rag to a bull
People are more likely to adapt to a new price if they are not constantly reminded of it - it's like a red rag to a bull.  In this case, there was no choice for the ATM owners - the communication of the fee was mandatory, but in your business you may have more flexibility.  If you can, parcel the fee in with the price point and/or change once and not every time the customer pays.

I'm buying the good not the service
In previous posts I've talked about delivery fees.  For instance, order through Amazon and you pay less for the book but get hit with shipping.  Order through Book Depository and you pay more for the book but shipping is 'free' (ie included).  

People hate service fees so much because they decouple the value of the good from the service in getting it to them. Why? Because you retain the product not the service. Your opportunity is to gain  advantage by offering to wipe the cost of service (ie offer "free delivery" or "free installation") because 'free' is extremely persuasive and 'free' on a hated cost of service even more so.

Choose your number 
Was the fact that the fee is $2 the issue?  I think it did have something to do with it.  A lower fee structure, say 50 cents or 90 cents and more customers would have proceeded with their transactions  because dollars and cents are psychologically different.  If I told you that you are entitled to a $2 discount after you've purchased $30 worth of groceries does that hold more or less appeal than me offering you 4 cents off a litre of petrol (which works out about $2 a tank if you are lucky)?  Judging by our slavish devotion to petrol vouchers, 4 cents is extremely persuasive.  As a business you therefore need to consider the number context of the fee or discount you are using.

The big lesson out of the RBA experience is that people's irrationality should not be underestimated. Where something looks inconsequential on paper, it can have dramatic behavioural impacts. Your job is to make sure irrationality works in your favour, and behavioural economics is your guide to knowing how. 

To find out more about what happened with $2 ATM fees, read Peter Martin's article "Banks' $2 fee has big effect"in The Age. 

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(Image from http://www.bikyamasr.com/69294/india-launches-first-talking-atm-for-blind/)

Why free delivery can beat % off discount

Walking past a bedding retailer the other day and the sign on the pathway caught my attention as a nice little example of applied Behavioural Economics.  "Today only.  Free delivery".  Delivery costs around $40, so offering it as a free service is the equivalent of around a 10% discount on  a queen size mattress retailing for $400, but they chose to advertise the free service rather than reduced price.  Why?  Because 'free!' is much more behaviourally persuasive than a mere discount.

The online behemoth Amazon was one of the first to use this technique online.  Amazon offer free shipping for books over a certain value ($25), and what they find is people prefer to spend more to qualify for the free shipping than pay for the service.  In other words, people buy two books and spend more than $25 just to avoid paying a few dollars for shipping.

The behaviour behind this is loss aversion. We hate to lose and paying for a service like postage from which you gain little, is simply painful to our psyche.

Whilst the Amazon model is great for customers in the US, not so for us internationals!

Enter The Book Depository UK that offers free shipping anywhere in the world for any book.  Whilst the list price for the item is usually higher than Amazon, shipping is free.  By way of example, "Disrupt! Think the Unthinkable to Spark Transformation in Your Business" by Luke Williams is available on Amazon for $16.79 plus $9.81 shipping so the total is $26.31.  On The Book Depository the book is $24.74 inclusive of shipping.

The Book Depository has hooked into a key behavioural element here; we don't like to feel that we are paying for services related to the product.  Whilst I know that the higher listed price must cover the cost of shipping, to me the value of the purchase is in the book - the thing I am seeking to buy.  I feel better paying more for the item than I do for services that really have nothing to do with the product itself.  I will retain the book, I don't retain the delivery service.

And this is the genius of the free mattress delivery. I keep the mattress, I don't keep the delivery. Discount the element of your offer in which I see no ongoing benefit and I'll be a happy shopper.  So when you are next seeking to attract buyers to your shop, consider which elements of the product you are best to discount.  Scrapping annoying services costs might be a great place to start.

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How to introduce a charge for a free service

SmartCompany's exploration the other week week of News Limited's introduction of a paywall included my thoughts on how the newspaper giant could use behavioural economics to transition their service from free to paid.

To round out this discussion, I thought it was worth looking at what makes "free" so alluring in the first place, so that you can consider whether and how to give away products or services without charge.

So let's start by looking at chocolate.

The persuasive power of "free"

In an experiment outlined in Dan Ariely's Predictably Irrational, participants were given the choice of two chocolates: higher quality Lindt or Hersheys.

Through the course of various experiments, the price of each brand was manipulated to see how consumer rationality was affected. In other words, what was the point at which price changed our judgment of what we were willing to experience from our consumption of chocolate. When the Lindt was 15 cents and Hersheys one cent, 73% chose Lindt. Makes sense. We are willing to pay more when we receive a quality experience.

But then life got interesting. Prices were dropped by on cent. Lindt was therefore 14 cents and Hersheys, free. Suddenly Hersheys gobbled up 69% of the custom, reversing the earlier trend. Was it the one cent price drop? No. It was the impact of "free". The majority of participants were now willing to act in spite of the lower level of anticipated pleasure just because the chocolate was free.

It seems that "free" dramatically impacts our assessment of what we are willing to experience.

Ariely goes on to speculate that the reason we are so swayed by "free" is that there is no downside. In most transactions, we weigh up the pros and cons, rewards and risks, but when something is "free", there is only upside.

This is the behavioural principle of loss aversion, where we are wired to avoid loss more than seek gain. In the case of chocolates, participants were unwilling to trade Hersheys for Lindt even when they had only to pay one cent for the lower quality brand. The risk was still too great. Take away that risk by making Hersheys free, and the game changed.

Introducing a charge for a free service

That's fine for chocolate, but what does it have to do with a paywall where News Limited are trying to introduce a fee? After all, it's a bit like charging for Hersheys when we are used to pigging out for free.

It shows how difficult a task News Limited have ahead of them because "free" is one of the most persuasive of forces. So here are some thoughts on how to reverse engineer free in order to transition to a paid service:

1. Differentiate the product – if a brand wants to charge for something that they have previously given away for free, they need to change the product. For chocolate, it may mean changing the ingredients or packaging, or emphasising something new about the product that people didn't know (eg. now from sustainably managed cocoa suppliers). For News Limited, it means re-skinning the online experience, introducing new content and/or features, and new marquee journalists.

2. Reframe the pricing – News Limited customers will be paying between $2.95 and $7.95 instead of zero. These are small amounts relative to most things, but not relative to free, so News Limited needs to contextualise the price for its customers. For example, less than a gym membership, less than a zone two train ticket, less than what you spend on lunch per day to get 24/7 access to real-time Australian news.

3. Introduce decoys – Pricing decoys are a very effective behavioural technique because we assess prices relative to others. At the moment on News Limited's subscription page for The Australian they are offering a digital pass for $2.95/week, digital plus weekend papers for $4.50 or digital plus Monday-Saturday papers for $7.95. Here it would have been helpful for them to also offer a "decoy" seven day print subscription on the same sign up page. Why? It sets a value for the print subscription that makes the print and digital bundles look more attractive. (On The Australian's offers page which is buried a few clicks in they have moved in this direction but made the mistake of making print look the better deal at $2/week).

4. Get it over quickly – the behavioural principle of adaptation means we get over bad news more quickly if we are not reminded of it. News Limited will have to be careful how it treats its customers throughout the sign-up, sign-in and billing process, with the aim to have the pricing recede in the customer's consciousness. They are currently offering a digital pass three month trial. My suggestion would be that the pass defaults to payment as part of the terms and conditions rather than reminding people at the end of that period that they have to pay up.

5. Demarcate the process – anyone who has used iTunes may have noticed that the payment is confirmed a few days after your purchase. Apple are effectively disconnecting the process (purchasing music) from the pain (payment), which means we are less likely to remember that our downloads have cost us. News Limited should likewise consider how it finalises the payment process with the customer.

6. Guilt – don't underestimate how guilt can turn freeloaders into paying customers. Of course there will always be some people who take without giving, but most of us are susceptible to contra-free loading. This is our innate desire to work for reward rather than just get rewarded. Don't scoff. A recent move by the Indiana Museum of Art to move to free entry resulted in a 3% increase in paid memberships.

The key lesson to take away from this discussion of chocolates and paywalls is this; offering something for "free" changes the game. It comes with significant behavioural implications that can work well for your business to stimulate volume, but can also change how your product is perceived. While not impossible to reengineer a free service as paid, it is extremely tricky and therefore should be used with due consideration to your longer-term and competitive goals.

This article was originally published by Smartcompany, 

http://www.smartcompany.com.au/behavioural-economics/20111031-how-to-introduce-a-charge-for-a-free-service.html

Image from http://cdn.besttechie.net/wp-content/uploads/2010/07/paywall.jpeg

Smartcompany interview on News Limited's introduction of a paywall

Last week I was interviewed by Smartcompany on News Limited's introduction of a paywall for The Australian news service.  To put it simply, charging for a service that was previously free is problematic because it requires behavioural change.

Here is the interview and my tips for businesses seeking to change the game.

http://www.smartcompany.com.au/media/20111025-can-you-get-people-to-pay-for-something-they-used-to-get-for-free-behavioural-economics-expert-explains-challenge-of-news-limited-s-paywall.html

I will be following this piece up with a discussion on why 'free' is so persuasive, so stay tuned.