Why Might Firms Offer Free Services?

Those who have been following along with Economic Forces will know that I have some problems with the way that we teach economics. My complaints are not the standard complaints that you get from the mainstream of the profession (surprise!). Those complaints seem to be that principles courses are not complicated enough or that they are too “pro-market” (a good economist might ask, “relative to what?”). My problem is that we give students rules of thumb that are not always useful and sometimes wrong. I think that this is particularly true when we talk about firms and competition.

Let’s start with something basic. The discussion of firms is typically centered around the level of competition. Students are taught about perfectly competitive firms. This is then juxtaposed with monopoly, in which there is only one firm. Perfectly competitive firms have no control over the price and therefore choose a quantity of output that maximizes profit, given the prevailing market price. Monopolists, because they are the only firm producing a particular good, have control over their price. Monopolists face a downward-sloping demand curve and set the price such that the quantity they sell at that price will maximize profit. Students are therefore left with the impression that competition is associated with price-taking and the lack of competition is associated with price-setting. In fact, price-setting is sometimes colloquially referred to as “monopoly power.”

This framing is wrong. There are two types of firms: price-taking firms and price-setting firms. Both price-taking firms and price-setting firms can find themselves in competitive markets.

Economists, of course, acknowledge this. After all, economists have models of monopolistic competition. Nonetheless, most introductory textbooks do a bad job discussing monopolistic competition. It is just this vague, intermediate case between our already established alternatives.

Yet, emphasizing the competition part of monopolistic competition can be quite informative. For example, competition does not always entail competition over price. Non-price competition occurs all the time. Walk into a store and look around for the various services that you are offered and do not pay for. There are people who help you locate items. There are people who provide expertise about the product you are considering buying so that you can make a more informed decision. There are stores that allow you to return products that you decide you do not want. There are stores that allow you to try on clothing. Car dealers let you drive around their cars just to see if you like it.

In an accounting sense, you are not paying for any of these services since none of these services are added to your total when you leave the store. However, some might argue that you are paying for these services in an economics sense. In other words, you might be paying a higher price than you would in a world in which none of these services existed. If one focuses on the monopoly part of monopolistic competition, that certainly makes sense. Since the firm has control over its prices and providing these services raises the marginal cost of producing/providing the good, then naturally one would assume that the price would go up.

However, if we think about the competition aspect of monopolistic competition, this isn’t necessarily the case. These additional services might indeed be offered for free in the sense that the price would be the same in the hypothetical world without the services as it is in the observed world with the services.

But why would firms do that? These firms undoubtedly have higher costs from providing these services. Are we expected to believe that they would just eat the cost?

No.

One thing that all students learn about monopoly is that there is a deadweight loss. There are potential gains from trade that are left foregone. In other words, there are people willing to pay a higher price than the marginal cost of producing an additional unit of the good. However, that willingness to pay is below the profit-maximizing price. So, the monopolist either has to figure out how to charge that marginal consumer a lower price without changing the price for everyone else (price discrimination) or forgo what would be mutually beneficial trade.

The offer of free services might be understood as a variation of this idea, albeit one that emphasizes competition rather than market power, as in the case of price discrimination.

Imagine that there are two types of customers. There are those who get zero value from firms offering these services. For those customers, the willingness to pay for the product is independent of the services that are provided. However, there are other customers who value the services so that they can make an informed choice. In fact, the very reason that monopolistically competitive firms face downward-sloping demand curves for their products is due to informational problems. (Some people allege that its product differentiation. However, that is a sufficient, but not a necessary condition.) People don’t abandon a particular good for another good just because its price changed. People often lack information to know whether they would be happy with the alternative. Even if the goods are identical, the consumer might not know that the goods are identical and might not be willing to switch just because of the slightest possible price difference.

The services I described are ways of providing information and therefore (the firm hopes) making consumers more sensitive to changes in the price of a competitor’s product. By providing services and information, the firm can potentially increase the demand for its product. This allows the firm to sell more of its product at the same profit-maximizing price as it would for the existing consumers who do not care about these services. The firm will therefore provide these services free of charge as long as the price charged for the good is greater than or equal to the marginal cost of producing the additional quantity of output, along with the services, to meet the new demand. Under standard assumptions about marginal costs, this outcome not only benefits the new consumers, but also improves the firm’s welfare.

Despite the fact that this firm has market power, competition creates a win-win situation. The consumers who do not care about these services are no worse off than they were before and both the firm and the subset of consumers who do care are better off.

What this example reveals is that monopolistic competition is where a lot of the interesting types of competition are to be found. Emphasizing the competitive behavior of monopolistically competitive firms can often be enlightening. It is almost certainly more enlightening than focusing on the costs of market power.