Dec 29, 2008
Efficiency, Retail, Pricing Theory, Behavioral Economics

Additional Fees

I always love (hate) it when companies give a price that’s virtually meaningless to the consumer (or at least it should be). Some products and services have this concept of a “price” then “additional fees” that serves no purpose other than to confuse the consumer and make it more difficult to gather price information.

First let’s be clear that when I’m talking about “additional fees” I’m referring only to those that are applied no matter what to the price of an item, not fees that truly represent something additional that the customer can choose to purchase. In, fact many of these are good because they properly align incentives for consumption and production. For example, many people recently were irate over the fact that airlines began charging fees for checked baggage (even for one checked bag). In principle I support this concept as it separates two distinct costs of providing airfare and allows the consumer to make the choice that maximizes his utility all while properly aligning incentives. If I’m someone who likes to pack big on a short business trip simply because I can, I’m exerting an extra cost on the airline in terms of fuel and baggage handling time whether I realize it or not. When I pay the price to have the luxury of checking such a large amount of luggage, that cost is immediately apparent to me and I’m equipped with the knowledge and choice to decide whether or not carrying the cost-producing luggage is really worth $30 to me. If it isn’t, then I’ve made both myself and the airline better off by packing lighter - I saved money and the airline saved cost of fuel. Whether it’s worth it or not in my particular case is irrelevant, the point is that incentives are aligned and consumer choice increases, both noble goals of public policy. This all being said, in practice many of the additional baggage fees were not revenue-neutral for the airlines (they didn’t decrease ticket prices that on average would have kept revenue constant). Most consumers of course didn’t like that, but in general I am strongly in favor of separating prices for produces and services if doing so yields a revenue-neutral outcome.

So back to additional charges force-added to produces and services. A classic example of this are airfares. Go on to British Airways or US Airways websites and when you look up fares all you will see is some base price which is completely meaningless. You have to go the extra step to find out what your additional fees and charges are. Now I think the reason companies do this is twofold:

The initial lower price entices you to look more and the initial impression (which is very important when price shopping) is that the produce or service is inexpensive. Many consumers feel ripped-off when the believe the company is pocketing your money. By stating part of the total price as a “fee”, consumers are duped into believing that this is necessarily some direct cost incurred by the company and hence the money isn’t really “going to” the company. Of course this is rarely true but the psychology is still there. Another related example to extra fees, although not befalling 2) above, is sales tax. Prices are always quoted before sales tax because they appear to be lower. However, unlike other “fees”, sales tax really is a cost incurred by the company - it goes straight to the government. In fact it could be argued that there would be a transaction efficiency gain for companies accepting cash if sales tax were baked in to the price since the well-known price tactic of using prices on dollar boundaries minus one cent ($9.99) would reduce the need for cashiers to dispense and hold change.

Whether it’s a tax or a fee charged by a company, these extra charges impede efficiency of the price system in a capitalist economy. When taxes and extra fees become a fact of every day life, finding out really what you’re paying becomes more time consuming and hence more costly. Some companies have capitalized on this frustration by reporting the full cost. Websites abound comparing full prices (even including sales tax based on where you live) of various products. Airline comparison shopping services such as Priceline report the full price of your flight and don’t force you to waste time determining what taxes and fees are, because frankly I could care less what the price I pay for an airline ticket is comprised of (whether it’s tax or base price) - all I care about is the final price I pay.

I also have a feeling that many consumers do not completely take the full price into account, much to the benefit of companies engaging in these practices. In other words I believe that if all prices were forced to be the actual amount you pay out of pocket, including all taxes and fees, the savings rate in America would rise. It would be a very interesting economic study to analyze changes in state sales tax rates and calculate price elasticities to see if effective price changes due to sales tax are more or less elastic than prices changes not related to the sales tax rate. I think people are far less sensitive to effective price changes resulting from sales tax because they think far more about the sticker price they see than the final price they say, partially because calculating it exactly before checking out requires some thought or a calculator.

Although it won’t ever happen because of the ways companies can keep charging additional fees to their benefit, the economy as a whole would be more efficient if on every product and service you purchased you were presented with the full and entire price you are actually paying. That’s all consumers care about.

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