Study: Add-on Pricing in Retail Financial Markets and the Fallacies of Consumer Education

Michael Kosfeld and Ulrich Schüwer explore price discrimination strategies in retail financial markets and the effects of a plausible regulatory response

Empirical evidence shows that some consumers are naïve about the full costs of the products they purchase. Firms are likely to exploit this. This is especially relevant in retail financial markets where banks intensely compete for customers to open a bank account and then have enhanced market power to charge high overdraft fees or to sell high-priced investment products to naïve customers. Financial education initiatives are often considered simple and effective measures to mitigate adverse effects for naïve consumers with only positive effects on consumer protection and welfare. However, as Michael Kosfeld and Ulrich Schüwer show in a paper forthcoming in the Review of Finance, effects are more complex when banks can discriminate between naïve and sophisticated consumers.

The equilibrium pricing strategy of firms in a situation with sufficiently many naïve consumers is to compete purely on the price of a base good (bank account) and to shroud information about prices of add-ons (overdrafts, investment products). While the base good is priced below marginal costs, the price of the add-ons is above marginal costs. The consequences for consumers are twofold: First, sophisticated consumers who rationally expect that add-ons are overpriced will search for substitution possibilities, leading to smaller firm revenues and inefficiencies if substitution costs exceed firms’ costs of production. Second, naïve consumers who buy the add-on at the high price subsidize the low-priced base good and thereby also sophisticated consumers.

This raises the question if and how a regulator may intervene to protect consumers in their decision making and to increase economic welfare. Intuition suggests that effective consumer education will lead to efficient market outcomes and have only positive effects on consumer protection and welfare only if the educational boost is strong enough to make many naïve consumers sophisticated.

Price discrimination as banks’ optimal strategy

The authors approach this question in a theoretical analysis that allows banks to choose between three pricing strategies: (i) high shrouded add-on prices for all consumers, (ii) low unshrouded add-on prices for all, or (iii) high shrouded add-on prices for naïve consumers and low unshrouded add-on prices for sophisticated consumers. This last strategy considers situations where banks collect information from new customers with regard to their degree of sophistication after the purchase of the base good.

As a first result, the model shows that price discrimination is a symmetric competitive equilibrium if banks can classify consumers relatively well and the fraction of naïve consumers is neither very small nor very large. If it is very small, banks would unshroud prices for all consumers; if it is very large, they would shroud add-on prices for all. Thus, fully unshrouded prices, which would be the socially most desirable outcome, will not emerge in many situations – even if markets are competitive. This suggests that, in the light of recent technological developments (“big data”) which both ease and advance possibilities for consumer classification and price discrimination, it is less relevant how consumer costs and welfare change when firms are pushed into an equilibrium where they disclose prices towards all consumers (since this is unlikely to happen), but how these outcomes change in a price equilibrium where firms price discriminate between sophisticated and naïve consumers.

Hidden costs of consumer education

In contrast to common intuition, the authors find that educating some consumers may entail hidden costs for all other consumers, leading to increased prices and a reduction in overall welfare. Such negative effects come from substitution efforts of sophisticated and educated naïve consumers as well as banks’ strategic reactions via prices. Assuming that the ex-ante share of naïve consumers is above 33% and consumer education succeeds in educating 40% of these naïve consumers, it would result in lower costs for educated naïve consumers but higher costs for non-educated naïve and sophisticated consumers.

Overall, the analysis suggests that policymakers are advised to carefully examine consumer and bank behavior before implementing the seemingly harmless intervention of consumer education. They may not want to jump too quickly, or rely exclusively, on consumer education to solve problems of consumer protection or inefficient information and pricing strategies of banks. Consumer education is no panacea.

The paper is accepted for publication in the Review of Finance and available as SAFE Working Paper No. 47 .