Tuesday, November 16, 2010

Do Consumers Prefer 1% interest over 0% Interest or is Zero Simply Confusing?

Why would someone choose a credit card with a one percent interest rate over another with a zero percent rate? A new study in the Journal of Consumer Research finds that consumers are often flummoxed when it comes to zero.

“A reasonable assumption is that a product will be more attractive when it offers more of a good thing, such as free pictures (with a digital camera purchase), or less of a bad thing, like interest rates on a credit card,” writes author Mauricio Palmeira (Monash University, Australia). But Palmeira’s research found that consumer comparison methods tend to get confused when one of the comparison terms has a zero value.
For example, a consumer interested in a new credit card may need to choose between one with a $45 annual fee and a one percent interest rate and another with a $15 fee and a 20 percent interest rate. “One could view this decision as a choice between an extra $30 annually for a 19 percent reduction in interest rate. Alternately, it can be viewed in relative terms. In this sense, a $30 difference between $15 and $45 appears much bigger than the same difference between $115 and $145,” writes Palmeira. Consumers tend to be more sensitive to relative rather than absolute differences, which is why a one percent interest rate looks good, since its interest rate is 20 times less than 20 percent.
But what if consumers compare a 20 percent interest rate to a zero percent one? “I argue that whereas a 20 percent interest rate may look very large compared to one percent (it is 20 times larger!), it may not look as large compared to zero percent. Zero eliminates the reference point we use to assess the size of things,” Palmeira explains.

“This leads to a counterintuitive situation, in which a credit card can increase its likelihood of being selected when it has a small but non-zero interest rate,” writes Palmeira. The same is true of other attributes that consumers want to minimize, like interest rates and fat content.
The inverse is true when consumers desire an attribute. For example, if a digital camera offers a promotion that adds 200 free pictures to a purchase, a competitor may be better off offering nothing rather than just a few free pictures. “This is because 200 will look larger compared to 10 or 20 than compared to zero,” Palmeira writes.