No Such Thing

One simple economic principle that is all-too often ignored is the one represented by the acronym TANSTAAFL. Never mind that in order to create an easily pronounced phonetic entity the short instructive declaration behind TANSTAAFL has been often expressed as a nonstandard colloquial sentence containing a word that virtually no professional economist would ordinarily use—that underlying sentence is “There Ain’t No Such Thing As A Free Lunch.” Perhaps someone thought that the statement would be more memorable and effective as a pseudo-folksy formulation? In any case, the statement is true, in fact; there ain’t no such animal. That is, no product or service is ever provided without some cost. But that fact hasn’t stopped a massive number of entrepreneurs and their advertisers from pretending that they are providing something for nothing. They’re even spending large sums of money to convince people that that’s exactly what they’re doing. Admittedly, “free” attracts attention. At the time of this writing, according to ubiquitous advertising, consumers can get the following services without paying anything for them: Delivery of packages, personalized information about retirement homes or Medicare plans, scheduling of maintenance and repair services, help with filing income taxes, dinners with retirement advice, bank checking accounts, and analyses of the condition of their car or home HVAC system or teeth (free x-rays!).

You may have noted that there are examples that I’ve left out of the list above. I can start with one recent example. In the past decade there has been a rapid expansion in “free” stock brokerages. The most well-known of these is one attractively named after the anti-establishment hero Robin of Locksley, but there are many others. It would appear as if there’s no shortage of entrepreneurs with money and stock market connections who are ready to give away some of that to help ordinary people invest in the stock market without charging them any money for the opportunity. How generous! Magnanimous, even! It also, unfortunately, seems that there is no shortage of ordinary people willing to believe that such investment opportunities are truly free of cost. However, TANSTAAFL.

Before I go further, I’ll note that when I talk about investment cost I am referring to brokerage fees, not about what millions of day-traders and crypto investors and commodities traders have discovered; the reality that one of the most significant potential costs of investing in volatile markets is … risk. When you buy a share in something that can vary widely in value you want it’s value to increase, but you also take the chance that it can go downward rapidly. Too many small investors are attracted to speculative markets by the myth of endless and inevitable growth, and they become devastated when their life savings decline suddenly, when the markets suffer the inevitable downturn, as happened dramatically last month with crypto currencies and this month with stocks. Such personal losses can be significant, and it’s no consolation to note that when they purchased the collapsing token they weren’t directly charged a fee or commission. Risk involves a very different myth.

In general, whenever someone is offered a free service there is one important question they should ask. They should consider who, exactly, is actually paying for the activities they are supposedly getting for free, and how and why. Remember that the company that provides any service, of any kind, is paying people to do that work. In some cases their reasons for doing so are obvious. A vehicle repair garage might provide free brake checkups because they know that a certain percentage of the cars they check will need maintenance, which they can then provide, for a fee. A beauty salon that offers free makeup demonstrations knows that many of the customers will buy their recommended products, and that some will continue on as regular paying clients. The time share operation that offers a free informational dinner knows that an adequate number of their guests will accept the sales pitch and sign up for the endless string of monthly payments that keeps their business afloat. These days, in almost all of these cases, even those people who show up for the free service but who don’t accept further involvement can be monetized by selling their contact information to lists used for mass marketing. It is in fact possible that you can get something for free if you ignore such ancillary costs as wasting a couple of hours and the personal toll of irritation from aggressive salespeople and losing a certain amount of your privacy and future exposure to promotional contacts. But any company that offers a free service always has an ulterior motive—sometimes their goal is simply to encourage people to purchase things they don’t really need and wouldn’t otherwise buy, but even if the advice they provide is legitimate it is always motivated by the desire to turn a “free” service into an activity that will pay their bills. That intent is not always made obvious, but it’s always there.

In recent decades the internet has made possible another category of intermediary services that offer to provide information for free but that are subsidized by third-party providers who fold the cost of their efforts into what they charge. Examples of this are booking services that provide people with lists of other businesses, such as retirement homes or construction or maintenance services. If a customer selects one of the businesses on the list, that business generally returns what might be considered a finder’s fee to the booking service. The customer is rarely notified about that fee, but it is inevitably there and inevitably comes out of the amount that the customer is eventually charged. The same is true when someone uses a travel agency or an internet travel site to book a hotel or a flight or a rental car. In all cases, the company that provides the actual service, the hotel or airline or car rental company, will provide a kickback to the agency or the booking site. It is possible that the end provider spreads out the cost of such payments across all of their customers as a generalized business expense, raising the amount they charge to all customers. In some cases a hotel or airline will charge less, or provide more benefits, for customers who book directly with their own web site, which means it’s always good to compare the booking site results with the web site of the actual service provider. Even then, customers often never know how much they actually did pay for their own digital convenience, or for the convenience of others, but they should never doubt that that cost will be paid and that TANSTAAFL will reign. Companies that provide “free” services have to remain in business, after all, and they do prefer profitable ventures.

I return now to online stock brokerages that allow clients to purchase equities “for free,” that is, without any brokerage commission or fees. It is true, on the surface, that an ordinary investor can go to these sites and purchase equities, and that no fees will be charged directly. But those brokers, somehow, are still managing to make money. In fact, most of them have been quite profitable in recent years. That’s possible thanks in large part to an alternative method of extracting income from investors, involving the use of “off-exchange” wholesalers. In ordinary brokerage transactions an individual investor pays a broker for the stocks they want, paying a small commission for the access, and the broker buys those stocks from a registered public stock exchange. With the new no-commission brokerages, a fourth player is often added to this process. The investor pays the broker and the broker buys the equities from a wholesaler, at a raised purchase price. The wholesaler keeps the difference between that amount and the current exchange price and returns part of it as a kickback, called a Payment for Order Flow (PFOF), to the broker.

Anyone who has traveled overseas is probably familiar with a similar arrangement, in which someone who purchases a foreign currency pays a slightly inflated price and receives a lower return if they sell some of that money back. In most currency exchanges customers are provided with a list noting, for example, that they will pay $ 1.14 for each Euro they buy and will receive only $ 1.08 when they sell them back. Often the list will also note that $ 1.11 is the actual current exchange rate. Customers recognize that the extra $ 0.03 they pay for each Euro is what they pay for brokerage access. Such currency exchanges and the stock market PFOF system are quite similar, except for one thing: The currency transaction is completely transparent and PFOF is completely opaque. The individual PFOF investor is never told that they actually do pay a monetary cost in their “free” non-commission trade, a cost hidden in the inflated purchase price and the reduced amount when those stocks are resold.

The point of all this is that everyone should be suspicious whenever they are offered a free service and should give some thought to how it could be that any business making any free offer (if it is truly “free”) would manage to stay in business. In other words, we should all be aware of economic reality. We should remember the truth of TANSTAAFL and think about how we will, in reality, eventually, end up paying for any “free” offer we accept. Because, after all, in virtually all cases, we will. There’s another common phrase that should come to mind in reference to such attractive arrangements: Let the Buyer Beware.

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1 Response to No Such Thing

  1. Robert Tighe says:

    An excellent review of a number of the financial market issues mentioned in this blog entry has just appeared on line at the following site:

    https://www.motherjones.com/politics/2021/04/robinhood-gamestop-free-trades-alex-kearns/

    Two quotes stood out from this article. One warns us about the pitfalls inherent in investing, providing multiple examples about “the realities of a financial industry that at its heart places profit over principle.” The second is closer to the broader spirit of my blog arguments and the principle of TANSTAAFL itself, noting the reality of “a key lesson of the digital age: If something is free, then you’re not the customer—you’re the product being sold.” In the event that you don’t already believe this fact, there are, again, multiple examples proving the point.

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