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The Prisoner’s Dilemma of Honest Pricing

These days, clear prices have become an increasingly rare specimen driven to the edge of extinction.  Every price followed by .99 seems to be always also followed by a parade of small hidden numbers that somehow managed to sneak into your bill. For instance a hotel room advertised online to cost $99.99 per night might end up costing $120 or $150.  Pay TV companies that offer $29.99-dollars-a-month service will certainly charge you something like $50. Where do these hidden charges come from? Most of them are add-ons that were not fully advertised with the initial product ,and often the consumer becomes aware of them only after the bill arrives. As annoying as it may seem, hidden fees are here to stay. This is because companies profit by covering them. Despite that it would be more beneficial for society to have fair, clear pricing; companies have a strong incentive to enshroud their pricing policies, and thus leading society to an inefficient equilibrium of unclear pricing. This is the premise of a working paper of Xavier Gabaix and David Laibson of MIT Department of Economics.

We can understand this concept further if we analyze it from the perspective of the prisoner’s dilemma. First we construct the payoff matrix game, with the assumption that the net social welfare (referred as marketplace value in the article) is 100, and we obtain the following.

If we stare at the game for a while is easy to notice that there is only one pure Nash equilibrium (Tricky,Tricky). This is unfortunate since the strategy (Honest, Honest) would have had the greatest net welfare. This game is essentially identical to the prisoner’s dilemma, in that both prisoners could benefit by playing honest, but they decided to betray each other instead because it is the best decision given what the other is likely to choose.

Although the prisoner’s dilemma may seem too abstract and constrained to work in real life, situation like these happen all the time often resulting in catastrophic results.

A recent instance of this phenomenon is JC Penney’s 163 million lost. JC Penney launched an aggressive campaign of clear prices. No more coupons. No more confusing discount. No more hidden fees. They even took out the “.99” from their prices. However, the problem was that other companies did not use the same honest pricing policy, and thus the consumers that were unaware of hidden fees went to buy to the other companies. The result: a massive 163 million lost.

And this is why the hidden fees parade is here to stay.

Reference

MIT research paper available for free download by Social Science Research Network.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=728545

NBC news article about the JC Penney lost

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=728545

Website about game theory and personal finance that describe the JC Penney case and from which I took the image

http://mindyourdecisions.com/blog/2012/06/12/how-jc-penny-lost-163-million-losing-a-prisoners-dilemma-game/

Screen name: Near Rivet

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