02 July 2005

Freakier Than Steven Levitt

Posted by Jameson Penn
The regular wsj series, Econoblog, has it's most recent edition available. This blog-formatted discussion tends to be an economic debate between two opposing bloggers. However, this week's offering is a dialogue between two GMU econ profs, Bryan Caplan and Alex Tabarrok concerning just how freaky they are, a la Freakonomics.

While their discussion hits upon plenty of interesting areas just begging for extended analysis, here is one that struck me as the most unique:

Rental Cars Pricing
While rental car companies advertise low rates, the actual cost is always much higher, once taxes and hidden fees such as added insurance and gas fill-ups are taken into account. Entrepreneurial thinking would have you believe this is a ripe opportunity for a competitor to break out of the mold and run with a marketing approach similar to: "We Have No Hidden Fees, Unlike Our Competitors!" So why doesn't this occur?

A paper written by Xavier Gabaix and David Laibson suggests that there are generally two types of consumers: the smart and the naive. Profit margins are made by luring naive consumers to the party and having them eat as many added costs as possible. Sophisticated consumers don't want to buy at cost, and they don't need to so long as their naive counterparts are there to subsidize them.

Consider the opposing sales strategy applied by CarMax, a large used/new car dealer. CarMax advertises haggle-free prices fixed at or marginally lower than MSRP. This is not an attractive deal for sophisticated car buyers who do not see an even trade in the haggle-free approach, which is essentially surrendering your buyer's right to negotiate for an arbitrary price, that you are expected to believe is a deal. Don't get me wrong: haggle-free has its place, it just happens to not be an across-the-board deal as such vendors would have you believe.

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