The big problem with small risks

15th September, 2012

It seems some of the best economics lessons can be learnt by hiring a car

Here’s a puzzle. If it costs €500 to hire a €25,000 car, how much should you expect to pay to hire a €50 child’s car seat to go with it? Arithmetic says €1; experience suggests you will pay 50 times that.

This was just one of a series of economics posers that raised their heads during my summer vacation – indeed, within a few minutes of clearing customs in Milan. One explanation is that the apparently extortionate price reflects some unexpected cost of cleaning, fitting or insuring the seat – possible but implausible. Or perhaps parents with young families are less sensitive to price than other travellers. This, again, is possible but unconvincing. In other contexts, such as package holidays and restaurants, children with families are often given discounts on the assumption that money is tight and bargains keenly sought.

The third possibility is that the car seat is an invisible cost, inflicted on poor suckers after they have already completed their search for a bargain. This is no great news: as Tom Waits once wrote, “The large print giveth and the small print taketh away.” But it is still a puzzle: how is it possible to conceal such entirely expected extra costs? Why doesn’t some company advertise “no hidden extras”, for instance?

This kind of puzzle – call it the hotel mini-bar problem – was explored a few years ago by economists Xavier Gabaix and David Laibson. The question is, is there some more transparent pricing scheme that aims for the same level of profitability as the companies which prefer to spring surprises on their customers? The answer is: no.

The difficulty for the straight-dealing company is that it must necessarily charge higher headline rates than tricksy competitors if it wants to be equally profitable. And advertising its honest pricing may not be a great strategy: the implicit slogan of the honest company is, “if you can avoid their sneaky charges, you may get a bargain by outwitting our competitors”. A firm that blows the whistle on industry pricing scams may simply educate its rivals’ customers, rather than winning their business.

After paying through the nose for the car seat we were alerted to a risk. “If your car is damaged or stolen, you are liable for the first €1,000 of any loss.” Gosh. I hadn’t really given the matter any thought but the danger suddenly felt very real. And for just €20 a day, or something like that, I could make that danger vanish.

Normally when you buy car insurance you are protecting yourself against an almost unlimited potential loss. But here, the prospective loss was quite clear: it was €1,000. And €20 a day is an actuarially fair price to make a €1,000 loss go away only for a driver who trashes his car every 50 days. I can be a little ropey driving on the opposite side of the road, but if that really was the risk I would stay well away from the wheel.

What’s happening here? Behavioural economists have long known about “loss aversion”: we’re disproportionately anxious at the prospect of small but salient risks. The car hire clerk carefully created a very clear image of a loss, even though that loss was unlikely. I haven’t paid such fees for years and have saved enough cash to write off a couple of hire cars in future.

A final trick from the car hire company is to invite you to bring back your car with an empty fuel tank: you’ll be charged the regular pump price and you don’t need to bother filling up. Quite a bargain – assuming you feel confident driving to the airport in an unfamiliar car running on empty. But as you juggle passports, foreign currency and a map at the beginning of your holiday, you may not think this scenario through until it is too late.

This is the time of year when I receive emails from students about to begin a course in economics. Good luck to all of them – but some of the best economics lessons can be learnt outside the classroom.

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