Whether it’s cable TV, a gym membership, or computer software, many of us prepay for products and services. Prepayment is based on the dual logic that as consumers, we will have one less thing to worry about in our busy, chore-filled lives, and we will enjoy the product more if we have already paid for it in advance. And in some cases, our decision to prepay is based on the fact that the marketer has offered us a nice-sized discount in exchange for cash upfront .
Despite potential benefits, consumers should be cautious about prepaying for products. In an earlier blog post, I described the downsides of subscriptions. Even though consumers enjoy purchasing subscriptions, they often do more harm than good. Consumer researchers have found that paying in advance, too, can hurt consumers’ wallets and produce unintended negative consequences. These effects range from the consumer's incorrect assessment of the product’s real value, to how much of the prepaid-for good or service they consume afterwards, and how much they enjoy the consumption.
Here's the bottom line: Most of the time, paying in advance just isn’t a good deal for consumers. One example of an academic study from 2006 (and there are many more) illustrates this point perfectly. Economists Stefano DellaVigna and Ulrike Malmendier wanted to understand how consumers decide when they are given a variety of pricing options. Over three years, they studied the purchase decisions and attendance rates of over 7,700 members belonging to different health clubs. These consumers had the choice of either prepaying around $70 per month for membership and then enjoying unlimited use of the gym’s facilities or paying $10 for each visit. What did the researchers find? Members who prepaid the $70 monthly fee visited an average of about 4.3 times per month over the three year period. Effectively, they were paying $17 each time they went to the gym, 70% more than they would have paid by simply paying $10 on each visit. Or differently, they could have been paying $43, but prepayment increased their bill to $70. This is the alchemy of prepayment. Why does this happen?
There are two reasons that I want to examine here. The first reason is that consumers see lump-sum prepayments as being smaller than they really are, an error of perception. And second, they over-estimate how much they will consume the paid-for product or service in the future, which is an error of prediction. These two decision errors often lead people to make bad decisions about prepayment and then suffer poor outcomes. Let’s look at each one in greater detail.
When consumers prepay, the seller clearly benefits. In turn, when a seller provides an option to prepay, consumers often assume that they are being given a better deal in exchange for paying in advance. Someone paying for a month’s mobile phone service or a health club membership, for example, will believe they are getting a discount. But this need not be the case. Consumer psychologists Roger Heeler, Adam Nguyen and Cheryl Buff explain this phenomenon as follows in the case of bundles where the seller combines multiple items and charges one price:
“A simple explanation of bundle effects relates to consumers’ prior beliefs arising from their experiences with bundles. Since most bundles in the marketplace are priced less than their individual components, it has become a popular belief on the part of the consumer that bundles typically involve a discount.”
The very same logic applies to prepayment. In fact, prepayment is often a type of price bundle. What is the upshot of applying this flawed logic? When prepaying, consumers automatically expect to save money, even when the seller provides no explicit information this will be the case. And because of this mistaken inference, they are more likely to choose the prepayment option instead of the pay-as-you-go option when they buy a product or a service. Naturally, many sellers will take advantage and charge equivalent or higher fees for prepayment.
As if this error of perception weren’t bad enough, prepayment by consumers has another pernicious effect. It reduces actual use of the purchased and paid-for product. Consumer psychologists call this phenomenon “transaction decoupling.” It happens because with advance payment, there is a disconnect between experiencing the pain of paying and the reward of consuming. Because the sting of shelling out money has faded, the consumer does not experience the sunk cost effect that is normally so powerful. So he or she is not impelled to consume the product with the same motivation, and the product is less likely to be used. Psychologists Dilip Soman and John Gourville provide an interesting example of buying tickets for a Shakespearean summer festival that had a series of four plays. Play-goers could either buy single play tickets, or season tickets for the series. In their own words:
“What we found was that the no-show rate for people who had bought tickets to a single play was 0.6 percent, indicating that almost all ticket holders showed up. But the no-show rate for those purchasing tickets to two plays was 3.5 percent; for three plays, 13.1 percent; and for four plays, 21.5 percent. As the bundling of tickets increased from one to four plays, the likelihood of a person not showing up for one of the plays rose 35-fold.”
Prepayment for products hurts consumers’ wallets in two significant ways, first by creating the illusion of getting a deal, and later on, by reducing the consumption of the product they have already paid for. But there is one case when prepayment does make sense.
That is when the seller is offering a genuine, significant discount of 10 percent, 15 percent, or even higher in exchange for paying upfront. In such cases, prepayment may be at least worth considering. A great example of this type of situation is when many restaurants and other retailers sell their gift cards during the holiday season for a 20 percent or 25 percent discount to their face value. Buying a restaurant gift card is essentially the same thing as making a prepayment. And the hefty discount offered by the seller makes any potential risk worthwhile.
I want to make one final point. This discussion about the dangers of prepayment applies to the purchase of products and services. But it doesn’t apply to borrowed money. As many financial experts will tell you, prepaying money on a mortgage or student loans to get out of debt faster is often a smart thing to do. But this is the topic for another day.