Mental Transaction Costs

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Economists need to update our conceptual toolkit in order to catch up to the 21st century. One concept that I find myself frequently using is mental transaction costs. The expression was coined by Clay Shirky, and he used it as far back as 2000, to make a case against micro-payments as a tool for supporting content providers.

In theory, you could pay a penny or so to listen to a song one time on your phone. This would be inexpensive for the listener, andaggregated over many listeners it might provide decent incomes to artists. But Shirky identified the drawback.

Micropayments, like all payments, require a comparison: “Is this much of X worth that much of Y?” There is a minimum mental transaction cost created by this fact that cannot be optimized away, because the only transaction a user will be willing to approve with no thought will be one that costs them nothing, which is no transaction at all.

Thus the anxiety of buying is a permanent feature of micropayment systems, since economic decisions are made on the margin — not, “Is a drink worth a dollar?” but, “Is the next drink worth the next dollar?” Anything that requires the user to approve a transaction creates this anxiety, no matter what the mechanism for deciding or paying is.

The desired state for micropayments — “Get the user to authorize payment without creating any overhead” — can thus never be achieved, because the anxiety of decision making creates overhead. No matter how simple the interface is, there will always be transactions too small to be worth the hassle.

In short, charging you a penny to listen to a song forces you to stop and think whether listening to this song at this time is worth a penny to you or not. Your life would be much more pleasant without those mental transaction costs.

I subscribe to Spotify. My monthly subscription fee divided by the number of songs I listen to is more than a penny per song. But if a competitor were to offer me a music service that was one penny per song, I probably would stick with my Spotify subscription, in order to save mental transaction costs.

Another example of a service that attracts consumers by saving them mental transaction costs is Amazon Prime. Without Prime, each time you order you have to think about shipping. Do I want immediate delivery, or do I want free shipping? If I want free shipping, do I have to order more items to qualify? Having a Prime account means that you do not have to incur these mental transaction costs.

Health care and mental transaction costs

Economists and others who wish to reform health care often lament that patients with comprehensive health coverage are not concerned with the prices of medical services. Often, we are not even aware of what the health care provider is going to charge.

Perhaps consumers are ignorant about health care prices for a reason. When it comes to relieving pain and suffering, we do not want to take on the task of deciding between treatments based on price. Imagine having to ask yourself how much pain you would be willing to endure to save an addition $500. Or trying to choose between a high-cost treatment that is certain to work and a lower-cost treatment that has only a 75 percent chance of success.

Allowing our treatment choices to be made for us by doctors, with insurance companies in the background negotiating prices and determining what will be covered, saves us on mental transaction costs. We prefer to obtain health care without having to make cost trade-offs.

Having said this, I still believe that our health care system would work better if consumers were aware of prices and had the incentive to make cost-conscious decisions. My point is simply that health care reformers need to acknowledge the importance of mental transaction costs.

The Aggregator Model

Recently, Medium CEO Ev Williams made the case for what one might call the aggregator model. He called it the rationalization of publishing.

There’s a reason we don’t subscribe to TV shows or our favorite bands individually: 1) It would be a pain in the butt. 2) It would be a much worse deal. We pay for bundles, which give us access to lots of options. It’s great, and it will be great for published content, as well.

There won’t be a Spotify of publishing — with literally everything you want. But there will be a Netflix and Hulu and Amazon, etc. — each with a substantial amount of things you want. You might also have your superfan subscriptions (Patreon-based individuals), and your company-expensed subscriptions (The Information), but most consumers will have one or two of the big bundles.

This aggregator model saves on mental transaction costs. Subscribing to Hulu is an easier decision than subscribing individually to each program that you want to watch.

Traditional media outlets, such as TV channels, magazines, or newspapers, would prefer to remain independent, rather than have to rely on an aggregator to bring them users. But in many cases, consumers are not willing to incur the mental transaction costs that would be required to enable these content providers to obtain sufficient individual subscription revenue.

Summary

In many industries, we find that consumers want to avoid having to calculate the cost of making choices. In health care, many consumers prefer not to look at the price. When it comes to content on the Internet, they prefer subscription bundles to item-by-item pricing. And they are attracted to services such as Amazon Prime, which aggregate many services into a single price.

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