2023-11-11 | Loss Aversion, Sunk Cost Fallacy, and the Endowment Effect - Subscription and Why are You Paying More Than Necessary

Disclaimer: I am not professional in finance, and this should not be considered as financial advice. This is just my personal opinion. Please do your own research before making any investment decision.

If your Spotify premium subscription is about to expire, you will receive an email from Spotify, which says “Your Spotify Premium subscription is about to expire. Renew now to keep listening to your favorite music.”

The $10.99 monthly subscription fee is not a big deal, so you happily click the button and continue to enjoy your premium privilege. Although payment is not required to gain access to all albums, you still subconsciously accept that the premium subscription is a must-have.

Sure, it does provide a lot of great QoL features, such as offline listening, no ads, and organizing playlists. But is it like that you can’t live without it?

To be fair, I am not saying that Spotify Premium is not worth the money. Anyway, they have to make money to keep the service running. But this is just one of the perfect examples of the endowment effect.

P.S. The price has increased from $9.99 to $10.99 earlier this year.

Terminology

The terms feel a bit complicated, so let’s define them first.

• Loss Aversion: The tendency to prefer avoiding losses to acquiring equivalent gains. For example, you will feel more pain losing $100 than the joy of receiving $100.
• Sunk Cost Fallacy: The tendency to continue an endeavor once an investment in money, effort, or time has been made. For example, you will continue to watch a movie even though you don’t like it because you have already paid for the ticket.
• Endowment Effect: The tendency to ascribe more value to things merely because you own them. For example, you will feel that your car is worth more than the market price.

These cognitive biases are closely related to each other. To further understand them, let’s discuss some possible scenarios with the Spotify Premium subscription.

Case Study Time

Case 1: You feel like $10.99 is too little to worry about. Just a cup of coffee. And you have grown tired of the monthly renewal process, so you simply configure the auto-renewal option and forget about it.

Case 2: You feel like $10.99 is somewhat expensive. But you have already paid for the subscription, so you will continue to use it. You download as many songs as possible to make the most of it. Wireless buds are always on your ears. You even listen to music while sleeping!

Case 3: You feel like $10.99 is justifiable. You have been using Spotify free for years, with an ever expanding playlist. You can no longer bear the ads due to increased usage, so you decide to upgrade to premium. It’s finally time to enjoy the music without interruption.

Case 4: You feel like $10.99 is too expensive. You are always searching for coupons, discounts, and promotions. And the day has never arrived. You are never happy with the price, nor with the free version.

… Let’s stop here. I am sorry for being too sarcastic. But as ordinary people, you and I are always making groundless assumptions to justify our stupid decisions. We are all experts in self-deception.

Understanding the Biases

Loss Aversion

As Emily Dickinson’s poem goes, “Had I not seen the Sun, I could have borne the shade.” Loss aversion is a superset of risk aversion, which is not necessarily true for everyone. But it is an universally acknowledged truth that people are more sensitive to losses than gains.

Here, the thing you may lose or receive is “Premium privilege”. If you have never used Spotify Premium, you will never understand how convenient it is. Thus, lossing the privilege is beyond your imagination. But once you have experienced it, part of human nature will automatically draft consequences of losing it. And you will feel the pain, even if you never lose it.

And this also explains why almost every subscription service offers a free trial. Trial is literally free! Just enter your payment information and you can enjoy the premium privilege for free. For 7 or 30 days. You will receive an email before the trial ends, and you can simply cancel it without paying a penny. Or actually, you can very easily abuse the trial system by creating multiple accounts.

The original purpose of the trial is to let you experience the premium privilege. If you feel like it’s not worth the money, you can simply cancel it. But what if you have already made up your mind to subscribe? Loss aversion kicks in. You will feel the pain sourcing from premium, even without being a premium user. And it’s likely that you will end up subscribing.

A simple trick to avoid this is to cancel the subscription before the trial ends. Live without it for a month. This can be used to prove most subscriptions are simply not worth the money, but if you actually need it, you can always subscribe again.

Sunk Cost Fallacy

Sunk Cost Fallacy is a bit different from Loss Aversion, even though both biases justify why are you not willing to cancel the subscription. Here, the thing you pay for is “Subscription fee”. But, in a wider sense, this may also involve your time, effort, and emotion.

The core idea supporting the sunk cost theory is trivial - losing less is better than losing more. However, I’ve read someone arguing about its effectiveness in Behavioral Economics, that the total investment in a wider sense is not necessarily a loss.

The divergence source from the definition of value. In practice, the sunk cost fallacy should not be used to justify the termination of an endeavor. Instead, it reminds you to evaluate the investment and return in a quantitative way. Based on your own expectation, the way to evaluate the value may vary. But the key is to be rational.

We have to take another example because music is not a good fit for this bias.

Let’s say you have been playing a social game for years. You have invested a lot of time and effort in it. You have also made a lot of friends in the game. But the game is no longer fun. You are tired of the repetitive gameplay and the toxic community. You want to quit, but all the investment is holding you back.

You have also considered selling your account. Although the price is not as high as you expected, it’s still better than nothing. And you can use the money to buy a new game. Or you can simply give it away to your friends. (However, account trading is against the ToS of most games.)

The sunk cost kicks in from the very first moment you start playing the game. Games are always designed to provide enormous appeal at early stages. Progressing through the story, unlocking new features, and leveling up your character. But soon the curiosity fades away. You have to grind for hours to make any meaningful progress, or pay to win. And it’s time to reflect on the investment.

Expected Return

What do you expect from playing the game?

• To have fun? All games end up being repetitive. Some are still fun to play after hundreds of hours, but most are not. This is decided by the gameplays and the community, which, most social games are not good at.
• To make friends? You may play the game because all of your friends are sharing the same interest, or make friends thanks to in-game interactions. Personally I regard social functionality as a bonus, that does encourage a lot of people to play or continue playing the game. But core value does not come from it.
• To kill time? This is probably the most common reason people play a relatively boring game, that would take some time, but not too much.

There have always been arguments and counterarguments for each of the reasons. But it really depends on your own expectation.

Casual games are not bad. They are designed to be played for minutes on a daily basis. However, taking casual games as the main source of entertainment results in boredom. On the other hand, gameplay-oriented games may be more fun to play, but they don’t fit the needs to kill time. (And probably too hard or penalizing for casual players.)

Back to the evaluation of the return. If you decide to trade your account, you will terminate the continuous investment, and receive some money which replace the existing value. On the other hand, if you decide to continue playing, you will continue to invest time and effort, with the hope of having fun or making friends.

Shutdown Decision

Time to evaluate which one is better: resemble with the Shutdown Decision in microeconomics. If the marginal revenue (MR) is less than minimal average variable cost (AVC), you should shut down the business. In this case,

• MR = Your satisfaction from playing the game
• AVC = The investment measured in time and money
• MR - AVC = Gross Profit
• AFC = Historical investment
• MR - AVC - AFC = MR - ATC = Net Profit

Even if both decision leads to a loss, you should choose the one with less loss. Therefore, the sunk cost fallacy only holds if your gross profit is negative.

Theories are all here to help you make a rational decision. But in practice, it’s not always easy to numerically evaluate the investment and return. And that’s why we need to be aware of the Endowment Effect.

Endowment Effect

Endowment Effect highlights the irrationality of human nature that takes perceived value as a reference. In the case of Spotify Premium, the thing you own is “Premium privilege”. And you will subconsciously ascribe more value to it.

If you care about the Premium fee, you will try to convince yourself that it’s worth the money, or even worth more than the money. Or, if you can’t afford the price, you will apply the converse-negative approach to prove you don’t need it. But in both cases, you are making groundless assumptions.

If you don’t care about $10.99, you will value something else more than its price tag so that you can effortlessly justify the purchase. For example, you may value the convenience of offline listening, or the satisfaction of supporting the artists. But the truth is, you can always find a free alternative.

The nature of subscription service makes it unpriceable. The service provider earns revenue to offset the cost and generate profit. They set the price carefully, or even utilize price discrimination, set multiple prices that target different groups of customers. But the price is not necessarily the value. It’s just a reference.

Some app developers have pay-what-you-want pricing. You can pay as low as $0.99 to unlock all features, or up to $29.99 to express your appreciation. Will you pay more than the minimum price? Probably not from a rational perspective. But certainly some people will pay whatever they can afford, just to support the developers. This pricing effectively eliminates the developers’ need to set a price, and let the customers decide the value.

But sure, other services and games can’t do this. They have to set a pricing scheme to attract more customers while maximizing the revenue. And the endowment effect is the key to make you feel that the price is justifiable. Whatever you pay for, your action is always driven by the perceived value. If you simply pay $0.99 for a scientific calculator app, you will never use it unless you forget to bring your CASIO. But if you pay $29.99 for the same app, you will try to make the most of it, and even recommend it to your friends.

Back to the Spotify Premium example. Is the $10.99 monthly subscription fee justifiable? Again, it depends on your own expectation. If you are a casual listener, you will never need the premium privilege. If you are a hardcore fan, $10.99 is literally nothing compared to your spending on merch and concert tickets.

But don’t care about the price itself too much. Instead, ask yourself, how do you value the premium privilege, in terms of dollars? If you can’t answer this question, you will never be satisfied with the price.

Ask the same question to a friend who has always used free version, and another hardcore fan who has been using premium for years. You will get different answers.

Price is not the value. In microeconomics, market price is also known as Marginal Benefit (MB). In this case, MB is the perceived value of premium privilege, which is different for everyone. And Marginal Cost (MC) is a fixed value, $10.99, for everyone. If MB > MC, you will subscribe. Otherwise, you will not.

Therefore, nature of Endowment Effect is very similar to Loss Aversion. Owners all claim that their MB > MC, and others try to disprove it. But given that MB is different for everyone, it is meaningless to argue about it. The only thing you can do is to evaluate your own MB, and decide whether to subscribe or not.

More on Subscription

Price Discrimination

Price discrimination is a pricing strategy that charges customers different prices for the same product or service. It is a common practice in the subscription industry, and is also known as dynamic pricing.

There are three types of price discrimination:

• First-degree price discrimination: The seller charges the maximum price each customer is willing to pay.
• Second-degree price discrimination: The seller charges a different price for different quantities. (e.g. bulk discount)
• Third-degree price discrimination: The seller charges a different price for different groups of customers. (e.g. student discount)

Despite the name, price discrimination is not necessarily a bad thing. If properly implemented, it can benefit both the seller and the customer. For example, the seller can maximize the revenue, and the customer can enjoy the service at a lower price.

Price discrimination is utilized in many, if not all, subscription services.

In Spotify Premium,

• Third-degree price discrimination: Students can enjoy a $5.99 monthly subscription fee (combined with Hulu basic plan). Students are price sensitive, but more likely to become loyal customers. This facilitates the growth of the user base.
• Second-degree price discrimination: Family members can share a $14.99 Duo plan (for 2 accounts) or $16.99 Family plan (for 6 accounts). For the users, subscription is cheaper than individual plans. For the seller, the revenue is higher than individual plans because the users are more likely to buy an overall cheaper plan.

Price Anchoring

However, it should be noted that by price anchoring, the seller can earn even more without benefiting the customers. In this case, the price gap between different plans is not the same as the value gap, which encourages customers to change their plans to a more expensive one.

Price anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. For example, you will feel that a $1000 watch is a bargain if a $5000 luxury watch is put next to it.

Different Spotify Premium plan provides the same service regardless, so we have to take another example.

Assume a social media platform has 3 paid plans:

As you have probably guessed, this is a hypothetical Discord Nitro pricing scheme. But I have changed some values to make it sound more reasonable.

What’s the core difference and value gap between different plans?

The quantified privileges provide substantial value to the users. However, the cosmetic privileges, despite not providing any functional value, attract a lot of users to upgrade to a more expensive plan. And the seller can earn more revenue without increasing the cost.

From the most basic plan to the most expensive plan, the price gap usually increases. This encourages users to choose a better mid-to-low tier plan, instead of the cheapest plan (just like Starbucks’ pricing scheme). However, the most expensive plan usually involves overpricing, whose improvement in value is not proportional to the price increase. To resolve this, the seller can add more cosmetic privileges to the most expensive plan, or even reanchor the price like this:

• Plus: $4.99
• Pro: $17.99
• Ultimate: $19.99

It’s not hard to see that the price gap between Pro and Ultimate is smaller than the value gap. Although the seller loses a proportion of the original Pro users, other Pro users now have a reason to upgrade to Ultimate, which increases the overall revenue.

And based on loss aversion phenomenon, the seller can further increase the price after some time:

• Plus: $4.99
• Pro: $19.99
• Ultimate: $24.99

Most of the Ultimate users are not willing to downgrade to Pro, which means the seller can earn more revenue without losing too many users. The process can be repeated until the price is no longer justifiable.

Unfortunately, price anchoring introduces more variable to value evaluation. If you are not careful enough, you will end up paying more than necessary.

Subscription Fatigue

Subscription fatigue is a term used to describe the exhaustion that consumers feel when they are subscribed to too many subscription services.

Paddle divides all subscription services into 3 categories: Media, Commerce, and Software. Media is most likely to cause subscription fatigue, because it’s easy to subscribe to multiple services, and the content is usually not unique. Software is least likely to cause subscription fatigue, because the content is unique, and as long as the demand exists, the subscription will continue.

What about social games? They fall into the Media category, because of the nature of the content. Despite the unique gameplay, story, and community, different social games are still competing for your time and money.

Or, in a wider sense, if we take time as part of the subscription fee, social games cause the most subscription fatigue. It’s rather common to lose interest in a game after forgetting to log in for a day. Even though you receive in-game rewards for daily activities, you will feel that you are still falling behind, and the need to spend more time and money to catch up. Or you simply give up and move on to another game.

How does subscription fatigue affect your decision making? If you currently hold too many subscriptions, you will be more price sensitive. After terminating some subscriptions, you are likely to value the remaining subscriptions more than before, which eventually leads to the endowment effect and paying more than necessary, again.

Conclusion

Coginitive biases are everywhere, and given the nature of human decision making, it’s impossible to avoid them. But we can always be aware of them, and try to make rational decisions.

Do remember that these theories should be applied to help you make a rational decision. They are not designed to help you make a decision; the only person who can make the decision is you.

Therefore, please do your own research before making any investment decision. List down every possible option, and evaluate them in a quantitative way.

Thanks for reading. If you have any questions or suggestions, please feel free to leave a comment below.

Have a nice day!