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Rebates are a marketing tool used by manufacturers to increase sales, by lowering the cost of a product in the eyes of a customer, without actually dropping the price on the shelf. The company makes available a rebate for those buying the product, let's say, $20. You buy the product, send the company the filled-out rebate form and proof of purchase, and they mail you a check for $20. Simple, right? Read on. :^)
You might (rightly) ask yourself: if a company wants to increase its sales of a product by dropping the price $20, why don't they just drop the price by $20? Isn't it the same thing? Wouldn't it be easier for the company to do than dealing with the rebate forms and mailing checks and whatnot? The answer to this question becomes obvious when you consider this: there are companies that sell items that cost $X and have an $X rebate (often seen for media such as floppy disks, or low-end components like cheap keyboards). The net cost to you is zero, yet, you almost never see companies just giving away stuff for free in the store! Clearly there is a big difference between rebates and "just dropping the price".
Some of the reasons why companies use rebates are practical in nature. If a company wants to run a temporary promotion, it's a lot easier to use a rebate than it is to drop the price and then raise it again: customers react poorly to price rises. It's also arguably less work for the retailers that sell the product. But the main reason for using rebates instead of dropping prices is that when you drop the price of something, that money is automatically and immediately lost for each and every item sold, while rebates never result in all of the money being lost to the company.
The most important reason for this is simply human nature: a surprising percentage of rebates never are redeemed. Let's say a customer goes to a store and sees a product he wants that costs $100 and has a $20 rebate. Immediately, the customer says to himself "Wow, what a deal! Only $80!". In the customer's mind the product only costs $80. He pays $100 at the checkout, and then takes the item home and starts using it. In his mind, he has only paid $80, and he feels satisfied; but in fact, he's paid $100! Most rebate forms are relatively easy to fill out, but they still take time to do, and many people forget about them, or lose the form, or wait too long to submit the claim (since they are always time-limited). I don't know the exact percentage of rebates that go unfilled, but I wouldn't be surprised if it approached or even exceeded 50%. For all of these sales, the manufacturer gets the full price while getting sales as if the price had been lowered.
Another reason is due to a concept called float: from the time that the manufacturer gets the money for the product you purchased, until the time you cash the rebate check, the rebate money is the company's. They can use it as they see fit, even for something as simple as letting it sit and earn interest. Many people take weeks to fill out and send in the rebate form, and then most companies take weeks to months to send back the check. In some cases the company gets the use of the money for close to half a year.
Combine the two factors above and you can see why companies use rebates, especially for "free" items. The worst part, unfortunately, is that there's another catch with rebates: some dishonest companies don't honor them. You send in the form, you wait the specified number of weeks, and the check never comes at all. This isn't common, but it definitely happens. Also, some rebates get lost in the mail, or are sent to the wrong address, resulting in problems even with honest firms.
Due to the hassles involved, and the risk of never getting the money, some folks eschew rebates completely. Frankly, I think that's throwing the baby out with the bathwater. Here are my suggestions for having success with rebates:
Next: Discount Coupons