Bestiary of Behavioral Economics/Zero Price

The zero-price effect is an observed theory that decisions about free (zero price) products differ, in that people do not simply subtract costs from benefits but instead they perceive the benefits associated with free products as higher. The effect of zero price can be characterized by the tendency to regard zero as behaving as a “special” price resulting in overreaction to a free product as if zero price meant increased value as well as the effect on demand where ”free has the effect of bending the demand curve – demand shoots up in a very non-linear fashion”

Supporting Research

EXPERIMENT ONE:

Given an experimental situation, the nature of response to price changes involving zero price and positive prices was conducted. The experiment involved 60 participants who were given the choice to purchase a Hersheys bar (the low-value good), a Ferrero Rocher chocolate (the high-value good) or to buy nothing.

Three different pricing conditions were tested; two of which prices for both goods were positive were called cost conditions, and those in which the price for one good was zero were called free conditions. The two variations which featured cost conditions involved Hersheys cost 1 cent and the Ferrero cost 26 cents, and In the second cost condition, Hersheys cost 2 cents and Ferrero cost 27 cents. The free condition tested featured the Hersheys bar was free and the Ferrero was priced at 25 cents.

Results of the experiment revealed that when prices changed from the initial 2&27 cost condition to the 1&26 cost condition, the change in demand for both products was negligible. In contrast, when prices dropped from 1&26 to 0&25, there was a substantial increase in the demand for Hersheys and a large decrease in the demand for Ferrero chocolate suggesting that the inclusion of the price of Hersheys as zero increased demand for Hersheys over Ferrero despite the relative value of the products.

Traditional economic theory argues that people subtract costs from benefits when making an economic decision and choose the outcome with the highest level of utility. According to this argument, zero should be treated just like any other price. However, the results of this experiment indicate that zero is NOT just another price. In fact, the results support the existence of a zero price effect.

EXPERIMENT TWO:

In order to test the strength of the zero price effect, participants were provided with choices that involved larger incentives to not choose the product with price zero. 398 participants took place in this experiment. Each individual was given the choice to purchase a low value product (Hersheys), a high value product (a Lindt truffle), or nothing. Pricing conditions for this experiment were as follows : In condition one, Hersheys cost 1 cent and the truffle cost 15 cents, in condition two Hersheys were free and the truffle cost 14 cents, and in the last condition Hersheys were free and the truffle cost 10 cents. The purpose of having the last free condition was to investigate how drastic price reductions for the high-value product effected demand for the free low-value product.

As the price dropped from the 1&15 condition to the 0&14 condition, demand for Hersheys chocolate increased dramatically, while demand for the Lindt truffles decreased substantially, again exhibiting evidence to support the zero price effect. There was no significant demand change between the two free conditions (0&14 and 0&10) despite the lowered price of the truffles. ”The reduction of a price to zero is more powerful than a five-times larger price reduction that remains within the range of positive prices”. The difference between the cost and free conditions is quite significant, but the difference between the two free conditions is insignificant.

Possible Explanations/Causes

Social Norms

Social norms may be attributed to somehow creating a higher perceived value for the product whose price is zero. There have been several studies performed that suggest that the presence or lack of prices in a market invokes different decision-making patterns in individuals. Situations which involve prices invoke “market exchange norms” while an absence of prices (free) invokes “norms of social exchange”

Affect

Affect, being how individuals perceive decisions involving costs and benefits, is seen as a possible explanation/cause of the zero price effect. Theory states that consumption options that have only benefits create a higher affective response when compared to options that involve both benefits and costs. Shampaner and Ariely argue that the decision to take a Hersheys chocolate for free involves no explicit costs - one does not actually have to pay for the chocolate - and so a higher affective response is achieved. This is in contrast to the truffles, where, although the benefits of consuming a Lindt truffle are presumably higher (it is the higher-value product), the costs are also higher as well, and the mental transactions involved with weighing the costs and benefits cause the consumer to simply choose the free product. Situations which involve prices invoke “market exchange norms” while an absence of prices (free) invokes “norms of social exchange”

Applications

Section Description

• The purpose of this section of the article would be to provide examples of how businesses and countries have used the zero price effect to elicit desired behavior from a population.

Quotes/Ideas to Include

Google

• Google is an example of a company that has thrived off of “free”
• Google is a 20 million dollar company that gives that majority of its products (Gmail, Google Docs, spreadsheets, etc.) away for free. How can it do this?
• Google makes the majority of its profits off of advertising, so it can afford to give away products for free in order to make its products available to a large number of individuals with the hope that they will eventually purchase software from the company.

Jell-O

• When pre-packaged powdered gelatin was first produced by Peter Cooper in the late 1800s, Cooper had a difficult time selling his invention. Eventually, Cooper became so frustrated with the failed product that he sold the rights to a man by the name of Pearle Wait. Wait spent a great deal of his time and money attempting to market the packaged gelatin, with little success. Eventually Wait gave up as well and sold the rights to Frank Woodward in 1899. Woodward and his marketing chief William Humelbaugh realized that Jell-O was not selling because consumers didn’t understand the product and its benefits. In an effort to change this, Woodward distributed free cookbooks to housewives around the country - free cookbooks filled with recipes involving Jell-O. Due to Woodward’s genius marketing strategy, Jell-O would eventually become a household staple.

Congestion in Singapore

• In the mid 1970s, the government of Singapore introduced a program known as the Area Licensing Scheme in an attempt to solve the traffic congestion problem that was developing
• Under the ALS, drivers were forced to purchase special licenses to enter heavy-traffic zones during peak hours. In addition to these fees, drivers parking prices in the Central Business District were also increased. Finally, in order to encourage alternative forms of transportation, significant improvements were made to the country’s bus system.
• As predicted, visits to high-traffic zones during peak hours dropped, and usage of the bus system increased as individuals substituted away from driving.
• Implementation of the ALS had another interesting effect on the behavior of Singapore’s residents. Despite the fact that citizens were typically averse to sharing their vehicle with others, individuals began driving complete strangers to high-traffic zones. The reason behind this reaction was that carpools were exempt from the fees associated with the ALS. Thus the residents of Singapore were heavily influenced by both the raise in transportation prices and the existence of a zero price associated with carpooling.

References

Ariely, Dan. Predictably Irrational. New York: Harper Collins, 2008, Print.

Driouchi, Ahmed, Youssef Chetioui and Meryem Baddou. “How Zero Price Affects Demand?: Experimental Evidence from the Moroccan Telecommunications Market”. Institute of Economic Analysis and Prospective Studies. 3 September 2011. Accessed 31 October 2011 from <http://ahmedriouchi.com/how-zero-price-affects-demand-experimental-evidence-from-the-moroccan-telecommunication-market/>.