An experimental analysis of overconfidence in tariff choice

Review of Managerial Science https://doi.org/10.1007/s11846-020-00425-w ORIGINAL PAPER An experimental analysis of overconfidence in tariff choice Katharina Dowling1 · Lucas Stich1 · Martin Spann1 Received: 26 January 2020 / Accepted: 16 November 2020 © The Author(s) 2020 Abstract Consumers regularly have to choose between a pay-per-use and a flat-rate option. Due to the increasing number and range of (digital) services, the frequency at which consumers have to make tariff-choice decisions to use these services has become even more prevalent. Prior work has demonstrated that consumers’ tariff choices are often systematically biased and identified overconfidence as one of the key drivers. Yet, prior research is non-experimental and focused on the so-called flat-rate bias. By contrast, we examine the effects of overconfidence on the choice between a pay-per-use and a flat-rate option using an experimental approach. We develop an incentive-compatible experiment to provide causal evidence for the effect of overconfidence on tariff-choice decisions. We find that overconfident (underconfident) consumers underestimate (overestimate) their actual usage, which leads them to choose a pay-per-use (flat-rate) option relatively more frequently. Based on the results, we discuss theoretical and managerial implications as well as avenues for future research. Keywords Overconfidence · Tariff choice · Pay-per-use · Flat-rate · Experiment JEL Classification M31 · D91 · D12 · D84 · C90 * Martin Spann Katharina Dowling Lucas Stich 1 Ludwig-Maximilians-Universität München, Geschwister‑Scholl‑Platz 1, 80539 Munich, Germany 13 Vol.:(0123456789) K. Dowling et al. 1 Introduction Consumers regularly face the decision between a pay-per-use and a flat-rate option. Owing to the increasing number and range of (digital) services, the frequency at which consumers have to make such tariff-choice decisions to use these services has also become more prevalent. For example, cloud services (e.g., computing power or storage) and various apps (e.g., for sports, media, meditation) involve the choice between a pay-per-use and a flat-rate subscription. Even ride sharing services like Uber or Lyft that started with pay-per-use pricing only, now offer monthly flat-rates for reduced-cost rides (Hempel 2018; Matousek 2018). Consequently, even small mistakes in individual tariff choices may add up to a substantial overall financial loss across all service categories. As choosing the wrong tariff can result in consumers’ dissatisfaction and eventually churn (e.g., Lambrecht and Skiera 2006), better understanding consumers’ (potentially non-optimal) tariff choices is important for both consumers and service providers. Prior research has widely documented that consumers do not always make optimal (i.e., cost-minimizing) tariff-choice decisions (e.g., DellaVigna and Malmendier 2006; Lambrecht and Skiera 2006). Such non-optimal choices can be driven either (1) by behavioral biases1 or (2) by consumers having a tariff-specific preference for the more expensive tariff. With respect to (1), belief-based biases are a leading candidate in the context of tariff-choice decisions. Belief-based biases arise when uncertainty factors into decisions. Under uncertainty, decision-makers must form beliefs regarding potential outcomes or “states of the world” (DellaVigna 2009; Rabin 2002). In tariff-choice decisions, consumers are faced with demand uncertainty at the tariff-choice stage, because of a time lag between the tariff-choice decision and later usage decisions (Nunes 2000). For example, when consumers want to sign up for a gym membership, they have to choose the tariff first, but decide only later on the individual trips to the gym. Therefore, it is likely that belief-based biases influence consumers’ usage estimations and further their tariff-choice decisions. In particular, prior research proposed overconfidence as one of the main drivers of tariff choice (e.g., DellaVigna and Malmendier 2006; Grubb 2009). These studies typically infer overconfidence from comparing contract choices to later usage by analyzing observational or survey data. Yet, causal evidence is lacking. The goal of this paper is to examine the effect of overconfidence on tariff-choice decisions. To this end, we develop an incentive-compatible online experiment. The participants are randomly assigned to one of two treatments. We follow established procedures in the literature (Dargnies et al. 2019) to first induce overconfidence (over treatment) or underconfidence (under treatment) in our participants. Using a memory game, we then model the essential parts of real-world tariff choices, including the prediction of usage, the choice of a tariff, and finally the usage/consumption of the product, to examine the effects of overconfidence/underconfidence on participants’ choice between a pay-per-use and a flat-rate option. 1 For a review of behavioral biases in marketing see Dowling et al. (2020). 13 An experimental analysis of overconfidence in tariff choice Our contribution is a novel, incentive-compatible experimental paradigm and the causal evidence that our experimental approach provides. We show that overconfidence (underconfidence) leads to an underestimation (overestimation) of actual usage, and thereby to a relatively higher pay-per-use (flat-rate) choice. This causal evidence is crucial for the theoretical and managerial implications as well as avenues for future research that we discuss based on our findings. 2 Literature review One can distinguish two broad streams of literature in tariff research. One stream of literature analyzes drivers of tariff choice (e.g., DellaVigna and Malmendier 2006; Uhrich et al. 2013). The other stream of literature studies consumer behavior given a chosen tariff (e.g., Iyengar et al. 2011; Leider and Şahin 2014). Focusing on tariff choice, several studies showed that consumers do not always select the tariff that minimizes their billing rate (e.g., DellaVigna and Malmendier 2006; Lambrecht and Skiera 2006; Train et al. 1987; Uhrich et al. 2013). The majority of these studies finds mostly flat-rate choices and documents a flat-rate bias2 (DellaVigna and Malmendier 2006; Lambrecht and Skiera 2006; Uhrich et al. 2013; Herweg and Mierendorff 2013). DellaVigna and Malmendier (2006), for example, found that consumers chose the flat-rate tariff too often in a gym setting, and Lambrecht and Skiera (2006) showed that consumers primarily had a flat-rate bias in the context of internet access. A few studies also analyzed the pay-per-use choice and pay-per-use bias (e.g., Lambrecht and Skiera 2006; Miravete 2002). For instance, Lambrecht and Skiera (2006) demonstrate that the pay-per-use bias (in contrast to the flat-rate bias) only occurs irregularly and that it seems to lead to higher churn. For both tariffs, most studies identify drivers of tariff choice based on findings from observational or survey data. T (...truncated)