Low cost is better than free

I blame Jack Bogle.

His ‘cost matters’ message was honed so finely to a simple effective point that it dominated the fund industry for decades. Fund costs fell relentlessly.

So we hit the logical conclusion: nothing is lower cost than ‘free’! We now have free trades, free index funds, and ‘free’ financial advice.

Yet, ‘free’ can be a poison wrapped in chocolate. When something is ‘free’ the incentives for both the consumer and provider change dramatically, often in ways that are invisibly worse for consumers.

And ‘free’ changes how consumers behave too.

Once you go free, it is very very hard to go back (ask the Red Cross). And we might be stuck in cul-de-sacs because of that. I’ll try to explain why, and suggest alternatives.

Your brain on ‘free’

Let’s start with something most people appreciate, chocolate:

In the first scenario, people were offered a choice in buying deliciously decadent Lindt truffles at 15 cents per piece or less-tasty Hershey’s Kisses at 1 cent per piece. A 73% majority chose the yummy Lindt truffles.

But in a second scenario, things went off the rails of logic. When the price of the Lindt truffles was reduced to 14 cents and the Hershey kisses were offered up free of charge, 69% of people chose the Hershey’s Kisses. The price difference between the two chocolates didn’t change!

What happened here?

1. Free is easy: Our brain has to put in effort when decisions involve tradeoffs… and our brain prefers to be lazy. A decision that involves paying anything feels worse because you have to ask ‘is this worth it’ in money terms.

A parallel: you’ll prefer a font that is easier to read, but you’ll retain and understand more if the font is hard to read.

2. Prices are easy to compare, quality is not. You know that $1 is less than $2. Supposing that two things are similar, you know that the lower price one is a better deal.

In contrast, it’s hard to differentiate the quality of goods or services in advance. We can’t tell red from white wine by taste, much less the quality of the wine. In fact, we often use the price of wine to infer it’s quality, inverting the relationship. In expertise services like medical or financial advice, it’s impossible for us to discern quality – it’s the very thing we’re trying to buy.

In any market where it’s hard to discern differences in quality we will either use price as a signal of quality (I’m looking at you luxury goods), or as the basis for buying the lower cost version.

Those are the exact opposite, I know. I didn’t design the human mind.

So ‘free’ things are usually over-consumed relative to their actual value, and yet undervalued relative to what they do for us.