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«Bachelor thesis ERASMUS UNIVERSITY ROTTERDAM Erasmus School of Economics Department of Behavioral Economics Julia Müller C.W. Messelink 321454 ...»

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The Power of Free

literature study to the zero price effect

Bachelor thesis

ERASMUS UNIVERSITY ROTTERDAM

Erasmus School of Economics

Department of Behavioral Economics

Julia Müller

C.W. Messelink

321454

321454cm@student.eur.nl

Table of content

Introduction

1

Purpose

1.1

Structure

1.2

Theoretical Framework

2

Standard Cost Benefit Model

2.1

One co mponent model

2.1.1

Two co mponent model

2.1.2 Summary standard cost benefit model

2.1.3 2.2 Zero Price Model

2.2.1 One co mponent model

Two co mponent model

2.2.2 2.3 Definition zero p rice model

3 Co mparing the research and the results

3.1 One co mponent models

Two co mponent models

3.2 3.3 Vio lation of transitiv ity axio m

Critics

4 4.1 Experiments vs. surveys

Buy nothing

4.2 Products

4.3 Participants

4.4 Free-free condition

4.5 Exp lanations to the zero price effect

5 Transaction costs

5.1 5.2 Social norms

Mapping difficu lty

5.3 5.4 Affect

Zero risk bias

5.4.1 Mental transaction costs

5.4.2 Loss aversion

5.5 5.6 Exp lanations

6 Conclusion

Nudge

6.1 Limitations

6.2 Future research

6.3 Bibliography

–  –  –

In prices, zero can be quite interesting. By giving away products for free producers hope they can affect the behaviour of the consumers. The question is if they can affect consumers behaviour.

There is a movie theatre in the Netherlands that awarded a year of free visits to the theatre to everyone who would place a tattoo of the logo of the theatre somewhere on their skin. (NOS, 2012) Six persons showed up and one of them declared that he only did it for the free movies. He seemed to forget that there is a permanent mark on his skin to remind him of these “free” movies.

It is clear that a zero price, or a free offer, attracts people. People sometimes drive miles to go to a free concert or to a free trip to the zoo. On 7th November 2011 the zoo Blijdorp in Rotterdam had an free entrance for a day. There was a visitor record that day, more than 46.500 visitors came to the zoo (AD, 2010).

How is it possible that free attracts so many people? Is there a so called power of free?

2 The first research done on the topic of the power of free or the zero price effect is done by Shampanier et all. (2007). Their results states that consumers have an overreaction to a product when it is for free. When consumers can choose between a product they like which is cheap, but not for free and a product they do not like that much, but is for free, they tend to choose for the product they like less, because it is for free.

Dan Ariely described all the experiments and the background in his book “Predictably Irrationality” (Ariely, Predictably irrational, 2009).

1.1 Purpose The purpose of this thesis is to find if there is a zero price effect among the literature taken into account and to determine what can cause this zero price effect.

1.2 Structure In the first section the theoretical framework is formed. In the second section there is going to be a look upon the results from different researches to determine whether or not there is a zero price effect. The third section will discuss these findings. In the next section the given explanations for the zero price effect will be reviewed and discussed. The fifth section conclusions will be drawn and limitations are described.

At last some recommendations for future research will be provided.

3 2 Theoretical Framework The research taken into account can be divided into two groups. One group did the same as Shampanier et all. (2007) and tested different combinations of two products, a non-free combination in which for both the high value and the low value product had to be paid and a free combination in which the low value product was for free.

The other group of researches was based on buying a product and get a second product for free. For example Nicolau and Sellers (2012) do an experimental approach if the zero price effect also occurs when the breakfast in the low value hotel is for free. The biggest difference between the first and the second group is that in the experiments of the second group nothing was entirely for free. Some part of the deal had be paid, in the example case the hotel.

To find whether or not there is a zero price effect it is important to determine what according to standard economic theory should happen with demand when the price of a product goes down to zero. So first there will be a summary about the standard cost benefit model before explaining the zero price model.

2.1 Standard Cost Benefit Model The standard cost benefit model assumes that consumers are rational and make their decisions based on maximising their utility.

–  –  –

The standard cost benefit model states that consumers will buy a product if the value (V) of the product exceeds the price (P) of the product.

2.1.1 One component model In a two product (product X and product Y) choice situation a consumer will buy a product if the value of the product exceeds the price of the product and if the value and price combined will exceed the value and price of the other product.





The value of the product will be assumed to be positive. (Shampanier, Mazar, & Ariely, 2007) So, the consumer will buy product X if the value of the product will exceed its price.

VX PX and VX - PX VY - PY (Shampanier, Mazar, & Ariely, 2007) And will buy product Y if the value of this product will exceed its price VY PY and VY – PY VX – PX And finally, the consumer will buy nothing if the prices of the products exceeds their value.

VX PX and VY PY The standard cost benefit model states that a discount on the products does not affect the valuation of the products.

For product X this means that if VX PX and the discount α is positive, then P X PX – α, so VX PX PX – α so that means that VX PX – α The same explanation goes for product Y. If VY PY and the discount α is positive, then PY PY – α, so VY PY PY – α so that means that VY PY – α

–  –  –

The buy nothing option will also change. The price of the products will go down after the discount, making it more likely than the consumer will buy any of the products.

The consumer will buy nothing if VX PX – α and VY PY – α Due to the price reduction the demand for both the products will rise.

Some of the consumers who first bought nothing, will now buy the cheaper product or if the discount is high enough even the more expensive product, because the price might be lower than the value of the product, VX PX – α.

Consumers who first bought the cheaper product might now be able to buy the more expensive product, because the price might be lower than the value of the product, VY PY – α.

There will be less consumers who buy nothing.

amount of product bought

–  –  –

Figure 1: Schematic view of the quantity consumers buy at the original price and after discounts according to the standard cost model (Shampanier, Mazar, & Ariely, 2007) 6 Figure 1 shows in the left part the demand from consumers for both products X and Y when they have their original prices, PX and PY.

The middle part shows the demand for both products when the discount α is smaller than the original price of product Y. The demand for both product will rise.

The right part of the figure show the demand for both products when the discount α is equal to the original price of product Y, P Y, making product Y for free. The demand for both product will rise more. Still assuming that the value of the product is always positive, there will be no consumers buying nothing, because the value of product Y will be bigger than the price of the product, VY PY 2.1.2 Two component model In the two component model every product exist of two components. For example booking a hotel room with breakfast, or buying coffee with cake.

In a two component product the valuation of the product will depend on the value and the price of both components. This means that a product will be bought if the value of both components exceeds the price of both components. The consumer will buy the high value product if the value minus the price of both components will exceed the value minus the price of both components of the low value product.

Both components together form a product, so for example the hotel including breakfast at hotel M is the high value product, and the hotel including breakfast at hotel B is the low value product.

The consumer will buy product M which exist of two components R and B instead of product O which exist of the same two components if (Nicolau & Seller, 2012) VR,M + VB,M PR,M + PB,M and; (VR,M + VB,M) – (PR,M + PB,M) (VR,O + VB,O) – (PR,O + PB,O) The consumer will buy product O which exist of two components R and B if VR,O + VB,O PR,O + PB,O and; (VR,O + VB,O) – (PR,O + PB,O) (VR,M + VB,M) – (PR,M + PB,M)

–  –  –

Assuming again that the discount α is positive, and the value exceed the price, (VR,M + VB,M) (PR,M + PB,M). This means after the discount (PR,M + PB,M) (PR,M + PB,M α) and so that (VR,M + VB,M) (PR,M + PB, M - α).

If the price of component B from both products are reduced by the same amount (discount α), consumers will buy product M if (VR,M + VB,M) (PR,M + PB, M - α) And; (VR,M + VB,M) – (PR,M + PB,M - α) (VR,O + VB,O) – (PR,O + PB,O - α) If the price of component B from both products are reduced by discount α, consumers will buy product O if (VR,O + VB,O) (PR,O + PB,O - α) And; (VR,O + VB,O) – (PR,O + PB,O - α) (VR,M + VB,M) – (PR,M + PB,M - α) The consumers are less likely to but nothing, because the price of the products is lower.

Consumers will buy nothing, after the discount if the price exceeds the value.

VR,M + VB,M PR,M + PB,M - α and; VR,O + VB,O PR,O + PB,O – α 2.1.3 Summary standard cost benefit model Concluding for the standard cost model it is clear that the valuation of the product does not depend on the price of the product, but taken together the value and the price of the product let a consumer decide whether or not he is going to buy the product.

–  –  –

According to this cost benefit model consumers will make a rational choice between the products. Making one of the products for free will not cause a switch from the high value product to the low value product.

–  –  –

So the zero price model states that zero is not just a number as stated by the standard cost benefit model, but that a zero price is special.

To test for a zero price effect it is important to determine which of the choices in objects given to the consumers has the highest value to them.

The low value product will get a lower price than the high value product, otherwise no one would buy the low value product because price will exceed the value.

As both product have a price above zero, the consumers will choose the product they want according to the equations and statements made in previous chapter.

Like stated before this equation claims that nothing special will happen to the demands of the goods. There might be some small changes from consumers who first bought nothing to buying the low value product and a small switch from the low value product to the high value product.

2.2.1 One component model The results on the other hand claim different. See figure 2. This figure is taken from research done by Shampanier et all (2007), but the results from the other research shows the same. The research done will be discussed in the next chapter.

–  –  –

Figure 2 shows in the left part the demand from consumers for both products X and Y when they have their original prices, PX and PY.

The middle part shows the demand for both products when the discount α is smaller than the price of product Y, P Y. The demand for both product will rise.

The right part of the figure show the demand for both products when the discount α is equal to the original price of product Y, P Y, making product Y for free. The demand for product Y increases while the demand for product X decreases.

So these results indicate that there is a strong reaction to the free product Y.

This strong reaction toward the free product shows that consumers do not act according to the standard cost benefit model.

It seems like consumers attach a special extra value (β) to the free product Y.

For the one component model this means that (Shampanier, Mazar, & Ariely, 2007) Assuming that the value consumers give to product Y is positive, so VY 0 And that there is an extra positive value β added to this value.

VY + β 0

–  –  –

So, adding this to the equation made in the previous chapter in combination with the results that shows that more consumers choose product Y when it is for free, so when it has a discount, over product X, it indicates that VY + β – (PY – α) VX – PX – α Noting that the discount α given is equal to P Y, making product Y for free.

VY + β VX – PX – PY For product X the assumption is made that the value consumers give to the product does not change.

This means that the valuation of product X is still the same way. The consumer will buy product X if VX PX – α and; VX – PX – α VY + β – (PY – α) or VX – PX – PY VY + β The consumer will buy nothing if the price of the product exceeds its value.

This is not the case when the low value product is for free, because the assumption was made that the value for a product is always positive, and in the case the price of the product is zero.

VY PY, when PY is zero.

2.2.2 Two component model The same thing goes for the two component products. (Nicolau & Seller, 2012) The only difference is, that the product does not become for free, but that one component of the product is for free. Consumers still need to pay for the other half of the complete product.



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