Add-on Pricing in Retail Financial Markets and the Fallacies of Consumer Education*

Abstract

Empirical evidence from retail financial markets shows that some consumers are naive about the full costs of the products they purchase. For example, they may not consider the costs of expensive overdrafts or high fees of investment products when they open a bank account. Retail banks -and more generally firms operating in markets with naive consumers -are likely to exploit this. As shown by previous research, the equilibrium pricing strategy of firms in a situation with sufficiently many naive consumers is to compete purely on the price of a base good (bank account) and to shroud information about prices of add-ons (overdrafts, investment products). While the base good is priced below marginal costs, the price of the add-on is above marginal costs. The consequences for consumers are twofold: First, sophisticated consumers who rationally expect that addons are overpriced will search for substitution possibilities, leading to smaller firm revenues and inefficiencies if substitution costs exceed firms' costs of production. Second, naive consumers who buy the add-on at the high price subsidize the low-priced base good and thereby also sophisticated consumers, which raises consumer protection concerns. The question is if and how a regulator may intervene to increase economic welfare and protect consumers in their decision making. This paper examines the effectiveness of consumer education, which is a simple and popular form of regulatory intervention, to mitigate adverse effects for naive consumers. Intuition suggests that such initiatives -if effective -will have only positive effects on consumer protection and welfare, and may eventually lead to efficient market outcomes if only the educational boost is strong enough to make many naive consumers sophisticated. In contrast, our results show that this simple intuition is wrong. Due to firms' strategic responses welfare consequences of consumer education are more intricate and consumer education may actually cause unintended damages for consumers.Allowing for different information and pricing strategies, our first key result shows that education is unlikely to push firms to disclose prices towards all consumers, which would be socially efficient. Instead, price discrimination emerges as a new equilibrium. This is what we view as the first fallacy of consumer education in retail financial markets: It is less relevant how consumer costs and welfare change when firms are pushed into a prices equilibrium where firms disclose prices towards all consumers (since this is unlikely to happen), but how these outcomes change in a price equilibrium where firms price discriminate between sophisticated and naive consumers.The second key result of our model, and additional fallacy of consumer education, is that in contrast to common intuition, education which is good for the single educated consumer may be bad for consumers who stay naive and even for the group of consumers as a whole. Due to a strategic feedback on prices, educating some consumers may entail hidden costs for all o...

Cursed Consumers and the Effectiveness of Consumer Protection Policies*

“…Nonetheless,Kosfeld and Schüwer [2017] show that if firms in a shrouded attribute model can price discriminate between different levels of sophistication, then educating naive consumers may increase exploitation, as it does in our model.© 2023 The Editorial Board of The Journal of Industrial Economics and John Wiley & Sons Ltd.…”

Financial fraud and investor awareness

“…Our paper contributes to the growing literature of bounded rationality and its applications to industrial organization and contracting problems. First, depart from the extensive literature of shrouded attributes and add-on pricing (e.g., Gabaix and Laibson, 2006;Agarwal et al, 2017;Heidhues et al, 2017;Kosfeld and Schüwer, 2017), we consider two types of products. While the fraudulent product can be considered as having shrouded side effects, the normal product is by nature a "transparent" product, with no add-on or shrouded attribute.…”

Competition and the Regulation of Fictitious Pricing

“…The second category—regulating consumer information—includes Options 2a, consumer education, and 2b, disclosures. We believe consumer education has very little potential to be a broad-scale solution based on consistent evidence showing the limited impact of broad education efforts to train consumers to overcome decision biases (Fernandes, Lynch, and Netemeyer 2014; Kosfeld and Schuwer 2017; Staelin 1978). The final option, 2b, has, in our minds, the most potential for changing market behavior.…”