What's The Cost of "Free" Options?

April 6, 2020 | Leadership & Management | Written by Mohamed Soliman

Food delivery became the new norm for eating during our COVID-19 stay-home order in NYC. Thankfully, one of the restaurant chains -- which I will call “Yummy” -- waived their $2 food delivery fees this month. Their meals cost on average $10, my mind thought of the actual total payment as “I’m saving $2.” Another popular restaurant in the area – which I will call “Carta” – offers slightly lower quality meals at an average price of $7. Instead of making their delivery free, they decided to cut it down their delivery fees from $3 to $1. In that sense, rationally speaking, I should have chosen Carta’s deal; I will pay a total of $8 including delivery and the slight difference in quality will be compensated by the money I will save. I - yet - fell for the “free” delivery of the Yummy’s offer. This made me wonder about “free” that makes it disproportionally more attractive than its actual value.

Reading the principles of behavioral economics and decision-making theories revealed an amusing answer which amounts to the zero-price effect. It is an intriguing biased decision-making process where our demand for goods or services is disproportionally greater when the price equals exactly zero compared to a price even slightly greater than zero1. In other words, reducing the price from $2 to $0 – free shipping - is perceived much more positively than a reduction from $3 to $1 despite that the absolute difference between the numbers is the same ($2). The effect tends to be more pronounced in hedonic products which we buy to get pleasure, fun, and enjoyment, such as reading for leisure2. Our bounded rationality makes us perceive “free” options as better opportunities even when we clearly prefer and can afford an alternative option at an additional small cost.

One of the most entertaining real-life examples of zero price utilization is the one used by the online giant Amazon. When it launched its buy-a-second book-and-get-free-shipping promotion, they gained a big jump in their sales in almost all countries with one notable exception: France. The Amazon marketers thought that perhaps the French are more rational than the rest of the planet not to spend money on a second book that they might not necessarily need now in order to save the shipping cost. To their disappointment, the French are as irrational as the rest of us. Instead of zero shipping, the French Amazon decided to charge an equivalent of twenty-cents shipping cost instead of zero. This what caused the discrepancy in sales. The 20 cents are not much different from zero cents for someone who will buy a book that costs almost a hundred times of this shipping cost. Yet, a mere 20 cents shipping cost was not zero and made customers hesitate before taking advantage of the promotion. Sufficient. Interestingly, when the 20 cents were waived, Amazon started to see increased sales3.

Is there evidence behind the disproportional effect of zero price? a group at Duke University conducted an experiment to answer this question4. They offered ~ 400 participants the choice to purchase a low-value product (Hershey’s), a high-value product (a Lindt truffle), or nothing in three consecutive conditions. First, participants must choose between Hershey’s that costs 1 cent and the truffle cost 15 cents. In the second condition, Hershey's cost was dropped 1 cent from 1 to zero (free), and the truffle cost was also dropped by 1 cent and sold for 14 cents. In the last station, Hershey’s were again offered for free while the truffle cost was reduced from the original 15 cents to 10 cents.

Interestingly, if we take those whom we coded as nothing out of the analysis, the share of the low-value product increased from ~25% to ~70% when Hershey’s was offered for free. In other words, the reduction of price for the low-value product from 1 cent to zero was more powerful than a five-times larger price reduction for the high-value product. Additionally, there was no significant demand change between the two free conditions despite the lowered price of the truffles from 14 to 10 cents!

A plausible psychological for the zero-price effect is our affect bias. The decision to choose the low-value product for free involves no explicit costs. This contrasts with the truffles; choosing a higher value product that involves minimal cost involves both higher benefits and higher cost. Our decision shortcuts overlook the costs and benefits, causing us to choose the option that has no cost and we might not like it...In the end, it is “free.”

References:

1- Shampanier, K., Mazar, N., & Ariely, D. Zero as a special price: The true value of free products. Marketing science, 26(6), 742-757.

2- Hossain, M. T., & Saini, R. Free indulgences: Enhanced zero-price effect for hedonic options. International Journal of Research in Marketing, 32(4), 457-460.

3- Romell, D. Is Loss Aversion Causing" FREE!" to Flourish?

4- Shampaner, K., & Ariely, D. How small is zero price? The true value of free products (No. 06-16). Working Papers.


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