Wednesday, 29 April 2015

Two different ways to charge for a good

The conventional way to charge consumers for something is pretty simple - they pay for every unit they buy. But, there are alternatives. One is to charge an up-front fee and then refund customers for every unit they purchase below some threshold. Google's new Project Fi has an element of this built into it, as they explain - 'Let's say you go with 3GB for $30 and only use 1.4GB one month. You'll get $16 back, so you only pay for what you use'.
          It is simple to design a pay and refund pricing policy that are theoretically equivalent. For instance, suppose you regularly buy movies from an online website. Also, suppose that you would never buy more than 20 movies a month. Then the following pricing policies are equivalent:
  • Pay: You pay £5 for every movie you download.
  • Refund: You pay a monthly fee of £100 and receive £5 back, per movie, if you download less than 20 movies. 
For example, if you buy 10 movies in a month then this either costs £10 x 5 = £50 or £100 - 10 x 5 = £50.
          To say, though,  that a pay policy and refund policy are equivalent in theory does not mean they are equivalent in practice. So, which type of policy would you prefer? And which type of policy do you think would lead to most downloads?
           One way of looking at this is to say that paying money for something is coded as a loss. So, under the pay policy there would be 10 times during the month where you 'lose' £5. The abundant evidence for loss aversion tells us that losses are bad. So, 10 losses are very bad. Under the refund policy there is one big loss of £100 and then a gain of £50. Now, a big loss is clearly worse than a small loss. Evidence suggests, however, that we don't consider a big loss as bad as lots of small losses. This, in itself, does not tell us that a £100 big loss is better than 10 losses of £5. But, it does suggest that people might prefer the refund policy once we factor in the additional £50 gain. So, expect people to opt for the refund policy.
           Consider now the number of downloads. With a pay policy each download is a loss of £5. With a refund policy each download reduces the gain at the end of the month by £5. Loss aversion clearly implies that people will download less with a pay policy than a refund policy. Interestingly, this poses something of a conundrum for the company deciding on a pricing policy - the refund policy may be more popular but lead to more usage.  
           If you are not convinced by the above arguments lets churn out some numbers consistent with prospect theory. Suppose that if you lose £x you suffer a psychological cost of 2log(x). Then losing £5 costs 3.22 while losing £100 costs 9.21. This is already enough to tell us that 10 losses of £5 is worse than a one-off loss of £100 (because the 10 losses costs 32.3 compared to only 9.21). Hence, you would prefer the refund policy. Suppose that if you gain £x you experience pleasure of log(x). Then gaining £5 adds at most 1.61 to pleasure which is nothing compared to the cost of paying £5. Hence, you will download more movies under a refund policy.

Monday, 13 April 2015

Public good versus common resource dilemma: Framing in social dilemmas

In a social dilemma what is good for the group is not necessarily good for the individual. For instance, if Fred donates time and money to charity that costs Fred but benefits society. Similarly, if Fred cycles to work so as to not pollute that costs Fred but benefits society. We know in the lab that many people (typically around 50%) are willing to put the interests of the group ahead of their own. This gives hope when it comes to things like combating climate change. There is, however, an intriguing and unexplained framing effect regarding willingness to cooperate.
         Any social dilemma can be framed in two alternative ways. One can frame things in terms of Fred making a contribution to the group or in terms of Fred making a withdrawal from the group. Some things, like giving to charity, are more naturally thought of in terms of contribution. And others, like cycling to work, are more naturally thought of in terms of withdrawal. But, one can always reframe things. For instance, charities, when soliciting donations, have a wonderful way of making a donation seem already given; this means to say 'no I do not want to give' appears like a withdrawal.
        Framing effects are most pronounced in asymmetric social dilemmas. To illustrate, let us look at a simple example. Suppose four work colleagues have to do a project. For the project to be a success a total of 12 hours need to spent working on it. Fred and Fay each have 6 hours they could spend on the project while Max and Mary each have 12 hours they could spend. How should they split the workload?
        With a framing of how much should they contribute the typical outcome is that each worker contributes in proportion to the number of hours they have available. So, Fred and Fay would work 2 hours each while Max and Mary would work 4 hours each. While this may seem advantageous for Fred and Fay they still end up with less free time than Max and Mary.
         Consider now the withdrawal framing. In this case we think of Fred and Fay as provisionally working 6 hours on the project and Max and Mary as working 12 hours. This adds up to 36 hours which is clearly a lot more than necessary. The question thus becomes how many hours should they spend not working on the project. The typical outcome is that workers split equally the number of hours they save. Given that there are 24 hours to be saved they each save 6. This means that Max and Mary will work 6 hours each on the project while Fred and Fay do nothing.
         With a different framing we, therefore, get a very different outcome. So, why does framing matter? Put simply, we do not know. Some studies have looked carefully at the issue, such as one by Eric van Dijk and Henk Wilke on decision-induced focussing. Clear answers, though, have not been forthcoming. Why? The traditional approach has been to assume some 'gut instinct' effect - or system 1 processes - drive the framing effect. Choice could then be affected by whether contributing is perceived in terms of loss (of time) or gain (in free-time or success on the project). Inter-related is the issue of property rights - does Fred feel as though he 'owns' 6 hours free time or zero?
          In ongoing work with Federica Alberti we are exploring an alternative approach. One that puts the focus on more structured reasoning - system 2 processes. In particular, our approach, emphasizes that colleagues need to coordinate if the project is going to succeed and so they may be looking for focal or salient ways to coordinate. Hence, the focus becomes more 'what do I expect others to do' than 'what do I want to do'. It is well known that framing can effect focal points.
          Our work to date has primarily focussed on focal points with a contribution framing. For example, in one study we look at the effects of requiring full agreement in order for the project to work. It is relatively straightforward to extend our work to a withdrawal framing. Whether this will help solve the framing effect puzzle in social dilemmas is not yet clear. But, there is a definite sense that until we solve this puzzle our understanding of why people cooperate (or do not) in social dilemmas is worryingly incomplete!