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Monday, April 18, 2005

Zero-percent financing

Colleague Courtney LaFountain mentions an interesting twist on price discrimination that seems odd at first. Bose will finance a Bose Wave Radio for 12 months at zero interest, the price of the radio is simply divided into twelve payments. I went to check it out - The Bose Wave Radio: now only $1228, regularly $1,378. This is why I have second-hand Bose equipment.

I haven't spent too much time on this, but it does seem weird. Why? The interest should be be incorporated in the price (notwithstanding Bose's claim that the price is lower than "regular" price), and thus those who pay in one transaction are penalized relative to those who take the zero-percent financing. The penalty isn't much, on the price of the Bose radio it might be around $10 (at a savings account interest rate of 1.5%).

Typically firms want their money up front and have to be compensated for not getting it all at one time. Some consumers don't want to pay up front and are willing to pay for the right to spread the payments over time. It seems odd that there would be a penalty for paying the entire price up front and foregoing the multiple payments. Here we have the opposite, the firm is compensated for spreading the payments, but those who avoid the multiple payments pay more.

Qui bono? Bose obviously thinks it is profiting, so what gives? Maybe the (Bose) world has flipped and the demand by those who want to pay up front is less elastic than those who want to pay over time. If this is true, the higher price for those who pay in one shot is consistent with profit maximization via third-degree price discrimination. Perhaps there are enough Bose consumers with bad/no credit that it pays to stick it to the cash transaction, consistent with customer sorting schemes via second degree price discrimination; the transaction costs (12 payments vs. one) for some people might be high and they are willing to pay a premium for a single transaction.

Perhaps there is a tax issue here? Can Bose declare income in the quarter they receive money rather than the quarter in which the "make a sale" (alas, I am not an accountant). I could also see inventory/storage costs being a potential motivation.

Bose isn't the only company that offers the "zero-interest financiing" and I think I remember reading that the auto companies are trying to move away from the gimmick (although that might be tough to do in the short run). If the zero-interest strategy isn't profit maximizing (at least for some firms), it would explain why they are moving away from the concept. Bose isn't a public company, so we don't have a signal from the market as to whether this is expected to be profit enhancing. Anyone aware of an event-study model looking at zero-percent financing?

Update: To clarify, Bose charges the same price to those who take 12 months to pay and those who pay all at once. There is an implicit difference in price, which I calculated as foregone interest on the $1238 or approximately $10. Those who pay over 12 months pay $10 less if they keep the money in a savings account at a 1.5% annual interest rate. It might be possible that the Bose radio is the same price as it was before the 12 months free financing, but this would require Bose to give up the interest they were charging before. It would seem reasonable to assume that Bose raised the price of the radio by the amount of interest they would have charged on the radio and then offer zero-percent financing.

Keep in mind that with automobiles zero-interest financing is generally a substitute for a "rebate" or for more flexibility in pricing. So the purchase price, if you take the zero-interest optios is usually higher than if you take the rebate or negotiate more vigorously. This is just the opposite of what it sounds like Bose is doing.

BTW, are you sure the lower price doesn't apply to everyone, cash and over-time purchasers?
This is what I am suggesting Bose has done. They have raised the price of the radio and the radio now costs the same whether you take the financing or not. This implicitly makes the radio more expensive for the single transaction (assuming zero transaction costs) than the twelve transactions. I would have thought that Bose would have raised the price of the radio, offered zero percent financing or a rebate for those who pay in a single transaction, just like the auto companies, but it seems they are offering no benefit to the single-transaction customer.

I am assuming that the price of the radio has increased after the zero-percent financing option was put in place, but I have not direct evidence of that.
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