Latticework of Mental Models: The Zero Price Effect

Would you buy something if it were discounted from Rs. 500 to Rs. 200? May be.

What if it was discounted from Rs. 500 to Rs. 10? Possibly.

How about if it were discounted to zero? Absolutely!

Getting something for free feels good. Isn’t it?

But don’t get too excited. Although the ‘cost of free’ is zero, it’s also a source of irrational behaviour. Remember those pile of free key chains, free pencils and notepads lying at some corner of your house? Well that pile may be harmless but there are other situations where this irrational affinity for FREE stuff can cause us to make bad decisions. The Zero Price Effect says that we often pay too much when we pay nothing.

I regularly give in to this zero price effect in my day to day decisions. Amazon offers zero shipping charges if I make a minimum purchase of Rs. 499. Every time I order a book which costs less than 499, I end up buying another book (which I don’t plan to read) just to avail the free shipping offer. I just can’t let go off the free offer.

So what explains our unusual love for FREE! stuff?

Dan Ariely, in his book Predictably Irrational, writes –

Most transactions have an upside and a downside, but when something is FREE! we forget the downside. FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is. Why? I think it’s because humans are intrinsically afraid of loss. The real allure of FREE! is tied to this fear. There’s no visible possibility of loss when we choose a FREE! item (it’s free). But suppose we choose the item that’s not free. Uh-oh, now there’s a risk of having made a poor decision—the possibility of a loss. And so, given the choice, we go for what is free.

For example, when you want to buy a good quality socks (not stocks, but we’ll talk about them too) and end up buying another brand of socks (of probably an inferior or unknown quality) just because it has a ‘buy one get one free’ offer, you gave up a better deal and settled for something that was not what you wanted, just because you were lured by the FREE!

In the image above, there are two places where this power of FREE! is being exploited. One is the ‘buy 3 get 4’ and the other is zero interest EMI. I posit that the second one is even more dangerous than the first because it lures you into the trap of consumer debt.

Dealing with and thinking about money can be stressful. Thinking about whether a small item is worth a small amount of money may itself impose cognitive costs which may make people avoid thinking about and making purchases. But the moment something is prized zero, you don’t have to worry about “value” of the product. Unless the value itself is negative.

The Cost of Free

What if you find a Rs. 100 note lying on the street? There is no harm in picking it up unless someone is playing a prank on you in which case you run the risk of looking like a fool. Even Warren Buffett admits to falling for the force of FREE. He once wrote in his letter to shareholder –

I’ll be happy to accept a lottery ticket as a gift – but I’ll never buy one. Who, after all, refuses a free lottery tickets?

For that matter, if someone gives you a free lottery ticket every day, should you accept the deal? Knowing the odds (which are abysmally low) of winning a lottery, buying a lottery ticket doesn’t make economical sense. But even for a free lottery ticket there’s a hidden cost.

With a new lottery ticket in hand every morning, you’d be tempted to check the result of the lottery everyday. And then finding out everyday that you didn’t win the lottery will give you a small dose of disappointment. Imagine the distraction this will create in your life. That’s a huge cost, in terms of mental agony, which can’t be ignored.

Which means while thinking about the cost of free one shouldn’t forget about other intangible factors like time spent, efforts undertaken and mental peace. Ariely writes –

The concept of zero also applies to time. Time spent on one activity, after all, is time taken away from another. So if we spend 45 minutes in a line waiting for our turn to get a FREE! taste of ice cream, or if we spend half an hour filling out a long form for a tiny rebate, there is something else that we are not doing with our time.

Zero Triggers Social Norm

As per economics theory, when you decrease the price of a product, without compromising on its quality or features, people tend to buy more of it. There is an exception to this rule. The pricing strategy of luxury goods works on the principle that people associate high price with high value and hence increasing the price results in higher sales.

However, the equation becomes more interesting when you decrease the price all the way to zero. Zero price brings down the sales! Counterintuitive, isn’t it?

To understand this nuance, you have to learn about following two important ideas – Social Norm and Market Norm. Ariely writes –

We live simultaneously in two different worlds – one where social norms prevail, and the other where market norms make the rules…The social norms include the friendly requests that people make of one another…Social norms are wrapped up in our social nature and our need for community. They are usually warm and fuzzy. Instant paybacks are not required..

So people are under the spell of social norm when they are exchanging gifts or extending help to family and friends. Money doesn’t come in picture anywhere. Explaining market norms, Ariely writes –

The second world, the one governed by market norms, is very different. There’s nothing warm and fuzzy about it. The exchanges are sharp-edged: wages, prices, rents, interest, and costs-and-benefits. Such market relationships are not necessarily evil or mean—in fact, they also include self-reliance, inventiveness, and individualism—but they do imply comparable benefits and prompt payments. When you are in the domain of market norms, you get what you pay for—that’s just the way it is.

Coming back to zero price effect, when people are presented with products where prices are not mentioned (i.e., the price effectively is zero), they apply social norms to make decisions.

To illustrate this, Ariely and his research team did a social experiment. To one group of people they offered a candy at a cost of 1 cent per piece (which was a great deal for the actual cost of candy was much higher). The people in this first group took approximately four pieces. For the second group the price of the candy was zero. As expected, more students took the candy, but almost no one took more than one piece (i.e., decreased demand when prices are reduced).

So zero seems to trigger the force of social norm in people’s conduct. Another reason may be that people just don’t want to look too greedy. Whatever may be the reason, we see that zero price alters people’s behaviour significantly.

In Investing

These days there are quite a few stock brokerage firms that offer zero brokerage accounts. Technology has made this possible today and it’s a boon to investor community to have zero transactional cost. But it comes with its own risk of zero price effect.

Zero brokerage removes the last mental barrier that controls the natural instinct of indulging in unnecessary action. Just because it’s free, people can get nudged into making frequent transactions. Remember, the more decisions you make, higher are the odds that you’ll make bad decisions. Frequent buying and selling interrupts the long term compounding.

Similarly, many people sell their stocks just because it lets them take tax advantage for short term losses. Now that’s another manifestation of zero price effect, call it Zero Tax Effect. In an attempt to minimize the short term gain tax, we may might end up selling a good business which is temporarily depressed because of market volatility. A classic example of being penny wise and pound foolish.

A typical dividend yield in Indian stock market is much less than what you would get on a bank fixed deposit (after tax). Some investors hold on to their stocks just because it generates a tax free (zero tax) dividend income, irrespective of the fact that the underlying business is not growing and has poor future potential.

Dividend is possible byproduct of a strong moat and cash flow rich business. And if a business can’t redeploy the earnings at higher yield, it makes sense to give it back to shareholders in form of dividends. But many unscrupulous management pay dividends for wrong reasons. They take on debt and use that to distribute dividend because they know that most investors love the bait of tax free dividends.

And don’t forget that dividend isn’t really tax free. Dividend is tax free in the hands of shareholder, but it attracts a sizeable dividend distribution tax. Indirectly, the shareholder ends up paying the tax anyways.

The hype of tax free dividend income and strong pull of zero price effect can create unjustified excitement for dividend paying stocks.

Exploiting the Zero Price Effect

Behavioural biases are like two sided sword. On one hand they make us prone to irrational decisions, but on the other hand they can be intelligently exploited to install good habits and drive desired behaviour from people. Ariely argues –

…we can use FREE! to drive social policy. Want people to drive electric cars? Don’t just lower the registration and inspection fees—eliminate them, so that you have created FREE! In the same way, if health is your concern, focus on early detection as a way to eliminate the progression of severe illnesses. Want people to do the right thing—in terms of getting regular colonoscopies, mammograms, cholesterol checks, diabetes checks, and such? Don’t just decrease the cost (by decreasing the co-pay). Make these critical procedures FREE!

Conclusion

A confession is in order. Few years back I took a new credit card just because they were offering a free (and cheap) table clock to new customers. Unsurprisingly I neither needed that credit card nor I ever used it. Ultimately had to spend two days haggling with their customer care to cancel it. As for that table clock, I would have loved to keep it on my table as a reminder of my stupidity but I can’t seem to find it. I think I never took it out from its box.

I am glad I wasn’t offered a house loan with a free gym membership. I anyway have too many unused gym memberships. I would have hated to waste another gym membership, that too a free one.

So next time when you see an offer – buy two get the third one free – think again. Do you really need three or just one?

Take care and keep learning.