A mother I know was looking into a week of golf camp for her son. She was quoted a price and it sounded reasonable to her but the fact is she doesn’t really know what a reasonable price is for golf camp. Think about your own experience in a situation like this. Somehow, whether this is rational or not, the price itself tells you what a reasonable price is. Once you hear the price you are anchored to it. For sure anything more than that would be unreasonable.
Now back to the mother who is the subject of this story. Having been quoted a reasonable price she is inclined to go for it. But first, she has some further inquiries. What happens if it rains? Will there be a refund for that day?
There is some checking with higher ups and a return phone call with the answer in the negative. Camp is rain or shine. In the event of rain the children will play board games in the clubhouse.
Now the pro-rated daily fee is, by basic arithmetic, a reasonable price for a day of golf camp but not a reasonable price to pay for day care. Thus, given the non-negligible probability of rain, the value of golf camp has just dropped by a non-negligible amount. And indeed this price which was a reasonable price for 5 days of golf camp is not reasonable for an expected 4.25 days of golf camp.
No golf camp for junior.
Here is the lesson for optimal pricing policies. A fully informed, risk-neutral expected utility maximizer sees two equivalent ways of pricing golf camp. Way #1: Price is fixed and set at the value of the expected number of non-rain days. Way #2: A higher price but with refunds on rain days.
But given the inherent reference-dependence that comes from the natural tendency to interpret any price as just on the threshold of reasonable, Way #2 is clearly superior. This has many implications. Think shipping costs, all-inclusive holidays, etc.
Cheap Talk 
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June 29, 2011 at 2:13 am
itovertakesme
This is an interesting go at explaining the advantage of refund pricing without relying on the argument of moral hazard. But even this case has potential for moral hazard because rain is not strictly on or off and how much rain a person can play golf in will depend on the person. (Here in Japan we play even in the midst of downpours because courses are far away in the mountains, it almost always rains at some point, and well, we are diehards.) The golf camp might shy away from rainy days too easily if they do not have to issue a refund.
However, this is still a nice example for not relying on an argument for asymmetric information. Everyone knows when it rains. What they don’t know is the probability of a brand new car being a lemon.
June 29, 2011 at 2:15 am
itovertakesme
Then again, do you want to put your son in a golf camp that has an obligation to refund when it rains? They might coerce the kids to play even golf is unpleasant or worse yet dangerous.