Saturday, February 23, 2008


The power of “free”

Thursday afternoon on All Things Considered, NPR interviewed Professor Dan Ariely of MIT’s Media Lab. Dr Ariely studies, among other things, how we value things... and he’s done some studies on how various factors affect what we’re willing to pay.

In one particularly interesting study, he determined that having something available free often overrides other factors, such that we’re willing to give up significantly greater value in order to get something for free (this is about 6 minutes into the audio):

But in this case, the kids went largely for the free one, basically giving up a better deal, a fantastic deal, just because of the allure of “free”. And, by the way, this it not just with kids. We replicated experiments with Amazon gift certificates, and products, and chocolates, with MIT students, and adults, and... everybody has the same issue: that “free” is such a hot button that many times it tempts us so much that we end up paying a high price or give up something better, just for the allure of “free”.

A perfect example of the effect that Professor Ariely describes can be seen in the common “free” car loans that came around a few years ago. There are various versions of it, and they have different aspects, but the simplest — and the one that should be the most obvious — hit a friend of mine, around 2002: buy a car and get a 0% loan! And then, in the small print... “or take $2000 cash back.”

My friend happily took the loan that he thought was free — 0% looks free, doesn’t it? — and imagined it a fabulous deal. It was obvious to him that everyone ought to take it.

But notice that they don’t say that it’s “free”, or “interest-free”. I pointed out to him that the loan had actually cost him $2000. No, he assured me, he’d read all the fine print, and it was definitely free. OK, look, I said: how much did you pay for the car? $24,000. And how much would you have paid if you’d taken the cash back? $22,000. Right, so the loan cost you the difference between those, $2000. No, he insisted, it was 0%.

And I gave up.

What we have here is a common case of collecting interest up front, much as happens when one pays “points” on a house mortgage. It’s pre-paid interest. But in this case, all the interest is paid up front, which is why the interest rate can be 0%, but the loan can still not be interest-free.

In fact, on a five-year loan of $24,000 with monthly payments, total interest of $2000 corresponds to an interest rate of about 3¼%. For a three-year loan it’s about the same as a 5¼% interest rate. Not a “free” loan at all.

But the appearance of being free makes it appealing, nearly irresistible, to the point where an otherwise intelligent person is completely hoodwinked by the offer. Add to that the complicated computation needed to come up with the effective interest rate — how many of you could have figured out the previous paragraph in your head? — and it’s perhaps not surprising that they get a lot of takers — takers who would never have taken it if they had said, “Get a loan for an extra $2000!”

On another side of Professor Ariely’s work, looking at monetary value and social interactions: my cousin, who is a lawyer, was once talking with a lawyer friend in my presence. His friend had referred someone to him, and he said he’d send her a referral fee soon. She said he shouldn’t: they’re friends, so she doesn’t expect a referral fee from him. His response was, “Hey, I’d send a referral fee to a complete stranger. I should do less for a friend?”


Julietta said...

Hunnh? Consider me hoodwinked. I even once fell for that old chestnut (why is it called an old chestnut, anyway?), "Did you know the word 'gullible' is not in the dictionary?" "It ISN'T?" I asked my son. My kids thought I was hilarious [ly dense]. Glad I'm not the only smart person to fall for the power of free. Now I can say I think like the folks at MIT! :-) said...

The effective cost on that loan is actually worse than the percentages you quote because of the time value of money, which you lose when you are forced to pay all the interest immediately up front.