Werner's Blog — Opinion, Analysis, Commentary
How ethical are introductory offers?
Introductory Offer Advertisement

You have probably seen advertisements like the one shown here on the right on billboards and on the internet: a remarkably low offer for a service contract, for example by a cellphone provider or a cable company. It may entice you to consider switching to that provider as your current contract is more expensive. Marketing tactics that rely on low introductory offers are common. There are two good reasons for it, and one bad reason. The good reasons are perfectly ethical, but the other one not so much. The trouble is that it is not so easy for consumers to distinguish the good reasons from the bad reason.

First up, you recognize the psychological pricing that ends in digit "9". The price is, effectively, $60 per month, but consumers perceive it as less because the first significant digit is "5" rather than "6". This psychological effect is well-documented (Thomas and Morwitz, 2005) and understood to be effective in many (but not all) circumstances. The pervasiveness of "9" prices makes you wonder if that in itself is turning into a signal of "we are beholden to marketing tactics" rather than "we have a product priced competitively."

More important here, however, is the nature of the introductory offer. The consumer is receiving an incentive to switch from one provider to another. The introductory offer is meant to compensate the consumer for his or her switching cost (Klemperer 1987, 1995). Transferring your service from one provider to another takes time and effort, may entail a service appointment to swap or install hardware, and constitutes a hassle. So the good reason for providing an introductory offer is that the accumulated benefit from the price differential between the introductory price and the regular price, times the duration of the introductory offer, provides an inducement for overcoming the consumer's switching cost. So far so good.

The second good reason for introductory offers is that consumers may need to experience the higher quality of a new product in order to appreciate the value of the higher quality. That is, consumers learn from experience (Schlee 2001). A lower initial price increases consumption and thus information, and as more consumers learn about the positive aspects of the new improved service, the more they spread word about it to friends and family. The initially-low price serves as a form of quality signaling. The producer of the service again encourages switching from competitors.

What makes introductory offers problematic—and in some cases unethical—is when the consumer is left guessing about the full consequences of switching. In the ad example above the real monthly price of this 3-year contract is hidden. It may be left out entirely as in the example, or it is shown in a small font that makes it look unimportant, difficult to read, and easy to overlook. Of course, a company may not be very keen on advertising the fact that their regular price is actually much higher. If they want you to switch from a less-expensive plan to a more-expensive plan, perhaps for a somewhat improved quality, they don't want you to focus on the long-term price but on the introductory price. Rather than telling you that you will pay $99.99 per month for three years with a $480 discount in the first year, they tell you that you will pay $59.99 per month and disguise the $99.99 per month that you pay regularly. The perception difference could be large. The actual three-year cost of the contract is $3,120, whereas the perception may amount to just about $2,160, which is $960 less. The low introductory price may have fooled some people into believing that this is either the regular rate or that the regular rate is close to the introductory price. Those who are misled are stuck in a three-year contract and will only be able to break out of it with a hefty cancellation fee.

Enter the CRTC. In 2013, the Canadian Radio-television and Telecommunications Commission introduced a code of conduct that banned cellphone companies from charging customers cancellation fees after two years into a multi-year contract. As a result, most service contracts are offered only on a two-year horizon in Canada.

‘The ethics of introductory pricing is tainted when advertising is opaque.’

The ethics of introductory pricing is tainted, especially when the advertising is opaque. It may well be that companies act with good intentions when they compensate switching costs. However, they also enjoy the benefit when consumers are seduced by the low price without fully appreciating the higher price that comes into effect at the end of the introductory period. When the advertisement is meant to deceive, it is unethical.

Introductory Offer Advertisement, Revised

How can well-intentioned companies avoid misleading consumers? The answer is, of course, full disclosure. Do not obfuscate! What that means in practice is that ads should always show introductory and regular prices with clarity. The regular rate should never be hidden or disguised (for example, by showing it with a smaller font in the quintessential "small print"). This does not mean that ads will automatically become unattractive. The point is to focus on what is the essential inducement: the cumulative savings from the introductory rate. In the example above, the focus would be on the $480 saved in the first year of the three-year contract. The version of the ad shown below is more informative than the ad shown above, and no essential elements are hidden or obfuscated. (A small caveat applies here: that the regular rate is indeed the regular rate paid by non-switching (continuing) customers. Otherwise it would be easy to inflate the savings.)

If marketing experts cringe at the full-disclosure version of the ad in the second example, then they know they are in the unethical territory of advertising. Deception is the basis of unethical marketing. The Canadian Marketing Association has established a code of ethics that companies should follow in their advertisements:

Truthfulness: Marketing communications must not omit material facts and must be clear, comprehensible and truthful. Marketers must not knowingly make a representation to a consumer or business that is false or misleading.

This principle is sometimes read simply as "don't lie", i.e., making false or misleading representations. But that misses the first sentence that makes a point about not omitting material facts. The fine line here is that firms usually don't hide the regular price entirely, but make it difficult to find, or make it look small or unimportant. When you are buying a two-year or three-year service contract, the actual price is the total for the contract period, in whichever way it is broken up into monthly payments.

Many companies provide introductory offers in kind rather than money, for example by providing free or heavily-subsidized hardware. Sometimes these in-kind introductory offers are a way of overcoming liquidity constraints faced by consumers. Instead of facing high up-front fixed costs for hardware, the hardware is essentially amortized over a longer time period.

The last point raises the question about all the different methods that firms can use to provide a switching cost inducement to consumers. The in-kind method is often the most up-front and cumulative. Front-loading incentives can then take many forms. For example, the $3120 total price for the three-year contract could also be offered as: pay nothing for the first six months, then $103.99 per month afterwards; or pay $39.99 per month for the first year, then $109.99 per month afterwards. Which version is the most attractive to consumers?

In general, my sense is that consumers react more strongly to large upfront inducements rather than the equivalent amount stretched over a longer time period. This seems to imply high discount (time preference) rates on the part of consumers, a kind of consumer myopia. This type of myopia is also the basis for a related marketing practice: shrouding high-priced add-ons (Gabaix and Laibson, 2006). Sophisticated consumers eschew such add-ons, but myopic customers do not. Firms do not gain from full-disclosure advertising; full disclosure is good for consumers but bad for firms. The result is that firms exploit myopic consumers.

The same mechanism, by the way, applies to credit cards. Sophisticated credit card users gain from the convenience of the payment instrument and the various reward points and air miles, while avoiding interest charges by paying off the balance each month. Myopic credit card users buy goods they cannot afford and load up on credit card debt with high interest rates. When upfront incentives are used simply to ensnarl myopic consumers, the outcome raises questions about ethics.

Further readings:

Posted on Tuesday, April 11, 2017 at 18:50 — #Business
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