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B. Venkatesh

CONSIDER this. You decide to choose between two hotels for your three-week stay at the Himalayas. One charges Rs 5,000 per day without any hidden costs. The other offers a room at Rs 4,750 per day but does not tell you that it charges separately for using the Internet and phone facility. Being an informed customer, you figure out that these add-on services will push the total cost to Rs 5,200 per day. Which hotel will you choose?

The one with the lower total cost? In a paper titled "Shrouded attributes and information suppression in competitive markets", Economists Xavier Gabaix and David Laibson argue that you will be better off choosing the one that quotes lower room rental and not the one that has lower total cost. Why?

Suppose you can find substitutes for the add-on services. You could, for instance, carry a mobile phone instead of using the hotel phone. Similarly, you could use a web café that offers Internet facility for a lower price.

Firms typically sell their basic service at or just above cost and place a higher mark-up for their add-on services. By using cheaper substitutes for the add-on services, you can reduce your total cost.

But why do firms disguise their actual prices? It is because the market consists of two kinds of customers — ones that are sophisticated and the ones that are naïve.

The naïve customers choose products based on the advertised prices. In the above example, these customers choose the hotel with lower room rental. Such customers end up paying higher price for the add-on services. The hotel, therefore, generates what economists call "normal profits". This happens because the naïve customers subsidise the sophisticated ones. What the hotel loses from below-cost rentals, it may generate from higher add-on services.

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