Behavioral Economics Explanation for Sensitivity on Service Fees

After puzzling over why people are overly sensitive to service fees, I read this good article by New York Times columnist Ron Lieber 5 Ways to Think About Nuisance Fees. Ron posits that people judge service fees by a fairness score so-to-speak. Factors feeding into the fairness score include:

  1. the size of the fee compared to the cost of service
  2. whether the consumer already dislikes the service provider
  3. how the service provider justifies the fee
  4. the value of the service

This points me to find answers to why people seem to be irrationally sensitive to service price increases from behavioral economics. I came up with a new theory.

If consumers can get away with it, they want the service to be free, regardless how much it costs. Some will pay voluntarily, but most won’t. When they must pay, consumers want a bundled price for services considered as the core package. If there is an additional fee for some add-on not terribly crucial to the core, it’s usually not a problem. The tricky part of course is what’s considered as core. Different people will have a different view. Those views also change over time.

What happens when a service previously included in the core package now moves out of the core? People complain, because now they have to pay twice instead of one bundled price. Behavioral economics says people associate paying with a pain. Paying $5 twice inflicts more pain than paying $10 once.

Debit card usage fee falls into this category. The price of a free, no-interest checking account is the foregone interest. It was actually much higher when savings accounts paid 5% than it is now. If you kept $2,000 average balance in a checking account, you were paying $100 a year for checking services a few years ago. Now you are paying only $20. The price came down dramatically but people don’t realize it. When they hear a core service (debit card) is coming out of the bundle as an itemized charge, they protest.

Airline baggage fee is another example. I disagree with Ron Lieber’s argument that the baggage fee is unjustified. Just because airlines are not weighing passengers and their carry-ons does not mean charging for bags isn’t fair. It’s a better alignment between the price paid and the cost to provide a service than not charging for bags at all. Compared with shipping the bags by UPS or FedEx, the baggage fee charged by the airlines is a bargain.

Consumers hate the baggage fee because the service was previously included in the core package but now it moved out of the core. Checkin bags had never been really free — they were just bundled into the ticket price. People don’t have a problem with $50 higher fare when fares change all the time but they complain about baggage fees.

In both these cases, it has nothing to do with whether the fee is hidden. Consumers know about these fees. They still don’t like them.

Bank wire transfer fee doesn’t get much protest because it’s never part of the core checking account service. If you want a wire transfer, you pay the fee, even though banks charge up to $30 for a wire when Federal Reserve charges the banks only 30 cents.

What happens when a service previously considered as an add-on is now demanded as part of the core? People complain. Internet connection in hotel rooms is an example of this.

Internet access from hotel rooms used to be an extra charge. Now most lower-end hotels include WiFi as part of the room rate. Remember WiFi isn’t free. It’s just bundled. Some higher-end hotels still charge for WiFi separately. Consumers complain even though they don’t mind paying if it’s just bundled into a higher room rate. They complain because it’s now expected as part of the core package. The separate charge for Internet connection has become a "nuisance fee" even though it clearly provides value.

Lessons for consumers? Don’t get too hung up on whether the fee is bundled or not. Consider the total price you are paying. In general it’s better to have unbundled prices because you won’t pay for services you don’t use.

Lessons for businesses? Bundle the items most people use into one price and call those services free. People like to hear the word "free." The take rate will be higher when you ask consumers to make just one purchase decision instead of two or many.

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  1. David says

    I don’t mind paying a fee for WiFi access. I DO mind paying $10 or even $20 a day for a service that costs the Hotels pennies to deliver.

    When a service is moved out of the core, it is often simply a way to make the price of the remaining core seem artificially low. If I make a profit of $9.90 per day on internet service from many if not all customers, I can post a room price that is lower. This helps me compete on the internet travel sites, where posted price has a huge effect on market share.

    Another factor is at play, and this helps explain why low-end hotels include WiFi in the room charge, and higher-end hotels do not. That is the mix of vacationers vs. business people in the hotel. Business people usually don’t care about the WiFi fee because it is reimbursed by their companies.

  2. tanksfurnutin says

    I’m puzzled over your obsession with this subject but here is my complaint. Over the summer one of my parents became ill so I had to fly on short notice. They live in the middle of nowhere so I knew I would be paying more for the flight since i had a choice of only one airline. I book the flight and then go to choose my seat. There are only three seats available and two of them are locked for “premium” customers. I click on the only seat available to me and am told this “choice” seat will cost me $19 more. Now it is not costing them $19 more to fly me so why am I being charged an extra fee for this last seat. And why not just include it in the price at the beginning? This is just plain annoying and I will avoid this airline in the future.

  3. Harry Sit says

    @David – When the price of the core service is set artificially low, it creates opportunity for the more rational and flexible customers to save money on the core service. Abstain from the Internet for one night and you will save $10-20. It’s worth it. Customers should thank the hotel and the other travelers for subsidizing the room rate. Instead, they are mad at the hotel for price gouging on WiFi.

    @tanksfurnutin – My obsession: I wish people look at the whole picture of what they are getting and what they are paying. Leave Bank of America because the total cost including the forgone interest is too high, not because of its price on a specific service you may or may not use.

    As to the extra cost for the choice seat, here’s the deal: if you don’t choose a seat, you won’t pay the extra $19 and you will still have that seat, or maybe even a better one. If you have a ticket, you will have a seat. If they sold more tickets than they have seats, they will ask for volunteers at the airport to give up their seats for an incentive: take the next flight and get a $400 travel voucher for example. Chances are someone will volunteer when the incentive is high enough.

  4. Todd says

    How can you consider that in the past, baggage was bundled with the fare, when fares didn’t decrease when the baggage charge was invented? Maybe a better unbundling is to give a discount when you don’t use a service, rather than a charge when you do.

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