The Cost of Zero Cost

Maastricht University School of Business and Economics Maastricht, 23January 2012 -Koch, Maximilian: -Linden, Laura: ID number: i6031068; Study: International Business ID number: i6036154; Study: Economics

-Schugardt, Marc-Alexis: ID number: i6039140; Study: International Business -Yao, Ting: Course code: EBS1506 Group number: 07 Tutor name: Joyce Vonken Writing Assignment: Paper in Reflections on Academic Discourse Number of words: 1987 ID number: i6003383; Study: Economics

Table of contents
Table of contents.................................................................................................... 2 1. Introduction.........................................................................................................3 2. Why is Zero Price Special?...................................................................................4 3. The Experiment..................................................................................................5 4. The Halloween experiment..................................................................................7 5. Conclusion.......................................................................................................... 8 References..............................................................................................................9

1. Introduction Economists assumed, and still do so to some extent, that individuals will make rational choices or decisions when presented with full information. This is the traditional view on which economic models such as utility functions and the demand curve are built upon. In contrast, there is a new field rising which is called behavioral economics. The Business Dictionary (2012) gives an adequate definition of this new field. It is a theory stating that there are important psychological and behavioral variables involved in the economic decisions of consumers, which means that behavioral economists question whether humans are rational. When making buying or consumption decisions, people consciously or subconsciously make a cost benefit analysis before deciding on a specific product or service. This means that the cost of a product or service is weighted against its benefits. For example, buying a high-quality product probably involves higher costs but also higher benefits than getting a low-quality product for free. Therefore, buying the high-quality product might be the better choice than taking the inferior product for free. Economists use the word opportunity costs to explain the value of the next best alternative activity. This value is forgone and therefore becomes an economic cost. Economic costs are unequal to accounting costs and are therefore often forgotten by customers. Let us take the example of a free lunch since it displays the principle of hidden opportunity costs very well. Although, the lunch is paid by someone else, the time spent could have also been used to do something different to add value to oneself, such as working or studying. Therefore, many research studies have been conducted to either proof or reject this hypothesis about humans making rational choices. Results of some of these studies show irrational consumer behavior. This paper deals with a research study done by Shampaner and Ariely in 2006 on the topic of zero costs. It explains the nine different steps of the empirical cycle, how these steps were applied in the study and what the results of it were. It also explains how the study fits into the context of irrationality in consumer behavior.

2. Why is Zero Price Special? One of the most powerful techniques available for customer acquisition is giving away a free product or service. Companies like Google and Facebook have sweeping success on this account. In addition to the above, even small businesses like supermarkets and phone stores are taking advantage of the hardening price of zero. The familiar buy one- get one for free -bargain in supermarket shelves is one example. The illusive offer to get a brand new PlayStation 3 for free, just by signing up a 24-month mobile contract is also an obvious example. All in all, individuals will trade-up and pay more just to be able to get a free gift or bonus. This particular behavior can be described as irrational, because consumers overemphasize the value of free products; in order to get a free product, they are willing to abandon an opportunity that they should find preferable. In the following paragraphs, the paper investigates the psychological explanation behind this source of irrational excitement, the so called zero-price effect. The zero price effect is a phenomenon in which the demand for a product or service is considerably smaller when a price is greater than zero compared to when the price is exactly zero. One rational explanation for the zero price effect is that the purchase of a good or service involves the exchange of money which imposes transaction costs. As an illustration of this approach, Shampaner and Ariely (2006) point out that most normal transactions have an upside (benefit) and a downside (cost). When a product or service is free, consumers forget the downside and perceive the intrinsic value of what is being offered immensely more than it really is. 2.1 Definition of Irrationality in the Context of Consumer Behavior Bullinaria (2008) gives irrational behavior a sufficient definition. It is the performance in a manner which goes against ones objectives, which can range from minor but persistent miscalculation of probabilities resulting in poor decisions, through to apparently totally random actions.

3. The Experiment 3.1 Real-life Examples The two researchers Shampaner and Ariely (2006) tested in their first surveys whether the price of zero has an effect on consumer behavior with special regards to any possible irrational choices and its validity. First, sixty randomly selected participants had to simulate a decision making process between two candies, namely a Hersheys and a more expensive Ferrero Rocher. Three different selling strategies were examined. Hersheys were sold for 1 cent and Ferrero were sold for 26 cents, then the prices changed to 0 cent and 25 cents and afterwards the prices were changed to 2 cents and 27 cents. Second, the experiment was conducted in reality with 398 participants. 3.2 Analysis of the Examples 3.2.1 Induction Theory Shampaner and Ariely used the scientific method to examine the results from the experiments. They made the observation that decisions about free products are different than simply subtracting costs from benefits (Shampaner and Ariely, 2006). This statement is based on inductive reasoning, since some individual observations are being generalized to the whole society. With the purpose of completing the test, the observation compares the demand of two products under the circumstance of keeping the price differentiation unchanged, however, prices are differed in order that the price with lower-cost good can be set at a low positive or a zero price. Having concluded that under this condition, participants are more likely to choose the zero price products, and there is only a small amount of participants choosing the low positive ones (Shampaner and Ariely, 2006). The only way this seems reasonable is that a zero price product will not increase the peoples costs and add additional value to their profit, in comparison with a low positive one. 3.2.2 The Variables In order to explain this phenomenon, price can be identified as the independent variable, while the consumer behavior is the dependent variable which is influenced by the products price. The hypothesis of the zero price model is then established, which states that once a products price falls to zero, the buyer adds an additional value to it, causing a rise in demand for the particular product. The following experiments are based on this research hypothesis and can be seen as step four of the scientific method; the evaluation of the prediction by making systematic, planned observations (Muysken, Gijselaers, Hommes and Pauwels, 2010).
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3.2.3 Applied Research The experiments conducted by Shampaner and Ariely revealed in the hypothetical test as well as in the experiment that the demand of the product that became free (the Hersheys) raised substantially, while the other products demand fell considerably. Therefore, applied research has been drawn attention to the ways how those research studies make a difference to explain how consumers behave irrationally. 3.2.4 Qualitative Data During the experiments the researchers collected qualitative and non-numerical data which makes the observation more implicit. When the researchers evaluate irrationality in consumer behavior by proportions of individuals choosing among the small or large candy bar, they are trying to measure such a qualitative measurement. 3.3 How the Chosen Examples Fit in the Empirical Cycle The experiment of people given a choice between two products of which one is for free fits well in the empirical cycle. First, an observation is made about consumers behaving irrational. Second, a research hypothesis is established in order to give a possible explanation for the observed phenomenon. Afterwards, further experiments can provide the researchers with assured scientific information about the phenomenon and lead to new conclusions or a proven hypothesis. In this case, the established hypothesis of a zero price model proved to be correct. Finally, new theories might be established and lead to further research potential. A second possible psychological mechanism that might explain the overreaction on free options suggested by the findings of Shampaner and Ariely (2006), assumes that individuals have difficulty assigning (mapping) the utility they expect to get from hedonic consumption into monetary terms. Especially, if a person is faced with a few really similar cost options for a product or service, it is not clear which option offers a higher benefit. On the other hand, the same person, when facing a costly option and a free option, could easily see that the free option would offer a benefit.

4. The Halloween experiment The goal of the following experiment was to test whether mapping difficulty could cause the zero price effect by using inductive reasoning. Shampaner and Ariely predicted that mapping difficulty as a driver of the zero price effect would be diminished when the two sides of the transaction, namely cost and benefit, were the same type and measurable. On Halloween, 34 trick-ortreaters were given three pieces of chocolate (each 5g) and each child has additionally a choice between a small (25g) and a large candy bar (50g). The experiment was conducted under two different conditions: in the free condition (0&1) the children were offered that they could have the small candy bar or exchange one of their chocolate pieces for a large candy bar. In the cost condition (1&2), the children were told that they could exchange one piece of their chocolate for a small candy bar or have two for the large candy bar. The results are pictured in the bar diagram below: As can be seen the zero price effect has remained even when trade-offs involved in commensurate products.

Figure 1: Proportions of individuals choosing among the small or large candy bar across the two experimental conditions Source: Adapted from Kristina Shampaner and Dan Ariely, How Small is Zero Price? The True Value of Free Products (2006).

In the free condition (0&2) the demand for the small candy bar increased from 7 to 70 percentages significantly while the large candy bar decreased from 93 to 7 percentages. Shampaner and Ariely established several empirical generalizations after their observations, which truly apply to the wheel of science by Walter Wallace. This wheel of science was also adapted in Muysken, Gijselaers, Hommes and Pauwels (2010). First, the researchers demonstrate that the attractiveness of zero cost is not limited to monetary transactions. Second, the trading of candies on Halloween is very common, which is why this experiment is a real life example. And foremost, the results hold when products and currency are commensurate (Shampaner & Ariely, 2006). 4.1 How the Examples Fit in the Context of Irrationality in Consumer Behavior Many people do not realize how irrational they behave as consumers. There are numerous examples of situations, in which buyers cannot explain why they made a certain purchase at a specific time. One example of this irrationality is the fact that a typical consumer will always take a product with a price of zero, regardless of the fact that he or she might not even need or want the product. This behavior cannot be explained logically with the regular cost-benefit principle. Instead, examples of experiments like the ones described above can give a better insight for researchers in order to find out why consumer behavior is often ostensibly irrational.

5. Conclusion Undoubtedly there is much evidence that there is an effect of zero and that it has not only a large impact on the demand for a product or service, but also leads to irrationality in consumer behavior. In many cases, this irrationality in behavior has a certain cost for consumers. For example, if people wait in line for a long time only to get a free product then they did not use their time sufficiently which can have negative effects on their lives. Research studies on the topic of the cost of zero cost such as the one done by Shampaner and Ariely helps consumers to learn about their unconscious behavior and can lead to a better choices not only when it comes to free offers.

References

Ariely, D. & Shampan'er, K. (2007). Zero as a special price: The true value of free products. Retrieved from MIT: http://web.mit.edu/ariely/www/MIT/Papers/zero.pdf Becker, G. (1962). Irrational behavior and economic theory. The journal of Political Economy, Volume LXX (Vol.70), pp.pp. 1-13. Bullinaria, J. (2008) On the evolution of irrational behaviour. Retrieved from School of Computer Science, The University of Birmingham: http://www.cs.bham.ac.uk/~jxb/PUBS/NCPW8.pdf Business Dictionary. (2012). Definition of behavioral economics. Retrieved from http://www.businessdictionary.com/definition/behavioral-economics.html Dubelaar, C., Gan, S., Morrison, M., & Oppewal, H. (2011). In-store music and aroma influences on shopper behavior and satisfaction. Journal of Business Research, pp. 558564 Forzano, L.B. & Gravetter, F. J. (2009). Research Methods for the Behavioral Sciences, Third Edition. Wadsworth: Belmont Jacoby, J. (2011, November 23). Is it rational to assume consumer rationality? Some consumer psychological perspectives on rational choice theory. Retrieved from Leonard N. Stern Graduate School of Business - New York University: http://w4.stern.nyu.edu/emplibrary/00_009.PDF Tribus, M. (1969). Rational Descriptions, Decisions and Designs. New York, NY: Pergamon