Every shroud has a silver lining: The visible benefits of hidden surcharges

Abstract

Opportunities for shrouded pricing drive down upfront price as firms compete to capture new customers. Unless the surcharge is sufficiently high, consumers are worse off if the practice is banned, assuming Cournot–Nash equilibrium and isoelastic demand.

Introduction

Instances of firms levying hidden charges abound. For example, a survey of customers of UK car rental firms found that half of the 8924 respondents “…ended up paying more for their car hire than originally quoted, thanks to fees for things like additional drivers, extra fuel and insurance being added on collection …5% of those questioned said that after returning the car, money was taken from their credit card without their knowledge to cover the additional charges”.¹ This practice is related to “drip pricing” where unanticipated charges are only revealed when a purchase is under way. This is common in online booking of airline tickets, prompting concern from the UK Office of Fair Trade (OFT). “The OFT considers that surcharging for using a credit or debit card is potentially misleading to consumers when it comes as a surprise–particularly when free payment mechanisms are only available to a small proportion of consumers, making a surcharge effectively compulsory”. “At the end of 2011 the British Government announced it would introduce a law to prohibit hidden surcharges involving credit and debit cards”.²

At first sight this policy response is correct. When consumers are misled, there must be welfare costs, and therefore a prima facie case for banning such practices. Gabaix and Laibson (2006) initiated the systematic study of these issues. Their main concern is to demonstrate the existence of an equilibrium in which a price component is deliberately hidden. Sophisticated consumers are not fooled, but if there are enough myopic types, firms choose to obfuscate. This is inefficient because the smart consumers devote resources to circumventing the trap. For example, they bring their own food on train journeys knowing they would be “ripped off” by the on-board buffet. The feature of their model that precludes efficiency enhancing shrouding is that everyone buys the basic item irrespective of the price charged. However, if demand is price sensitive and competition imperfect, price exceeds marginal cost. A shrouded price lures consumers into thinking the price is lower than it really is. It is then possible that there is an efficiency gain since consumers who value the good above marginal cost may end up buying it though they would not do so in the absence of shrouding. Even so, there may still be disquiet that any aggregate gain is at the expense of consumers. However, we show that, under relatively innocuous assumptions, prohibiting shrouding increases the upfront price by more than the shrouded surcharge.

That eliminating “rip offs” may be counterproductive is illustrated by recent events in the mobile phone market. UK telecom regulator OFCOM has reduced termination fees for incoming calls from landlines and the EU has lowered roaming fees which are charged when using mobiles abroad. The response has been for operators to raise their standard tariffs so that “The net effect of the fresh price rises is that, despite the promises of regulators, consumers are no better off”.³

The remainder of this work investigates these issues by means of a Cournot–Nash model. For simplicity, all consumers are assumed to be myopic. In Gabaix and Laibson’s terminology, the case of a surcharge, rather than that of an add-on sold at an inflated price, is considered. Costly and so socially inefficient avoidance action is thus impossible.