- We observe that department stores expend loads of effort to sell credit cards.
- We hear department stores say something like "people who use our card spend more money than people who don't. Therefore, our card must cause more sales."
- We have fun pointing out that more sales could be explained by lower prices or by adverse selection.
- Implicitly, we brand all department stores who sell their own credit card as incompetent and unable to analyze data.
Some of you brought up the point that having a Macy*s logo in your wallet might actually serve as advertising. To the extent that advertising in someone's wallet is effective, this may lead to more sales. This suggestion is worth some consideration. My understanding of the evidence on advertising is that well-placed ads seem to have very real effects on a company's bottom line.
If we accept that department store credit cards are merely in-wallet advertising, this begs the question: why do department stores spend so many resources (special managers, extra pay for selling credit cards, etc.) on in-wallet advertising when it seems more cost effective to reach many people at the same time by sponsoring a performance on Dancing with the Stars?
One explanation is that in-wallet advertising is effective (though I have not seen compelling evidence). Another explanation is that the store has no idea what it is doing. Yet, another explanation is that the department store is scamming its customers, and collecting huge interest payments on the store credit card purchases. This last explanation really makes me sad. That's not because I don't believe it is part of the reason, but because it is a dangerous world if the scamming motivation is the truth.
That said, if we doubt that in-wallet advertising is effective, if we think that companies are smart, and if we want an explanation that does not make department stores appear sinister, we're still searching for an explanation.
Here's what I had in mind: the department store uses credit cards to divide its customers into two groups.
- Group 1 is credit card prone. These people are responsive to the lure of coupon offers and special discounts that come with the store credit card. Members of this group not only buy more merchandise at discounted prices, but they buy so much more merchandise that their expenditures go up. This is what economists call elastic demand.
- Group 2 is not credit card prone. These people refused to hold a credit card even though the card comes with special discounts. This fact tells the department store that Group 2 consumers will pay a premium to avoid using the store card.
After distinguishing the two groups of consumers: charge Group 2 more, and give Group 1 discounts. The special discounts to Group 1 lead to more volume, which means more revenue because Group 1 people respond to sales by buying a lot. At the same time, the higher prices for Group 2 lead to greater profit margins for those items. If department stores can successfully navigate this dual-price strategy, peddling credit cards can increase profit.
This strategy of market segmentation to offer better prices to a subset of consumers is known as price discrimination and we see it all the time. For example, students and seniors get discounts at the movies and locals get discounts at Chicago museums. According to price discrimination theory, these groups get discounts because they're the groups who are most responsive to price changes.
Is price discrimination a reason why department stores sell credit cards? Maybe. When it comes down to it, I think department stores sell their own cards for many reasons. For all I know, their motivation could be equal parts advertising, scam, and market segmentation. But, who knows? Maybe they really don't know what they're doing after all!