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Tuesday, March 26, 2013

Online Symposium on Oren Bar-Gill's Seduction By Contract, Part IIIA: Nancy Kim on Cell Phone Contracts

KimThis is the sixth in a series of posts on Oren Bar-Gill's recent book, Seduction by Contract: Law Economics, and Psychology in Consumer Markets.  The contributions on the blog are written versions of presentations that were given last month at the Eighth International Conference on Contracts held in Fort Worth, Texas.  Today is the first of a two-part contribution from our own Nancy Kim of the California Western School of Law.  In this post, Nancy lays out Professor Bar-Gill's explanatory model.  In tomorrow's post, Nancy will set out her differences with Oren's approach.  Stay tuned:

Oren’s book adopts a behavioral economics approach to consumer contracts.  His thesis is that companies are intentionally using contract design to exploit the imperfect rationality of consumers – what other contracts profs like Melvin Eisenberg and Russell Korobkin  have referred to in their classic articles as “bounded rationality.”  Prof. Bar-Gill’s book adopts this basic insight regarding contract design and applies them to three types of consumer contracts:  mortgages, credit cards, and cell phones.  The chapter I discussed was on cell phone contracts (Angela and Alan deftly tackled the other two).

Bar-Gill discusses some interesting facts about the cell phone market but the focus is on the three design features of cell phone contracts:  three part tariffs, lock-in clauses and complexity.

SeductionThe three part tariff consists of a monthly charge, a number of voice minutes that the monthly charge covers, and a per-minute price for minutes beyond the plan limit.    Consumers choose calling plans based upon a forecast of future use, but consumers don’t forecast accurately.  Many underestimate and end up paying much more by exceeding their plan limit whereas other (many more others, actually) overestimate their future usage and pay too much for their service by paying for minutes they never use.

The second feature, lock in contracts, are a market response to the imperfect rationality of consumers.  The lock-in contract typically consists of a “free” fancy phone and a two or three year contract.  The consumer is required to pay an early termination fee (although that is now greatly discounted or prorated– more on that later).  Bar-Gill argues that these lock-in contracts take advantage of consumer myopia as subscribers are lured by the fancy free phone and underestimate the likelihood that switching will be beneficial down the road. 

The final feature, complexity, allows carriers to hide the true cost of the contract,  Complexity refers to all the confusing features and pricing variables offered by companies – in addition to the 3 part tariff, lock in clauses and early termination fees, there are different prices for different times of day, rollover minutes, family plans, etc.  Boundedly or imperfectly rational consumers do not effectively aggregate costs associated with these different plans and will focus on a subset of salient features and prices and ignore or underestimate other features and prices.  In response, providers will increase prices or reduce the quality of non-salient features.

Bar-Gill explains how carriers design their contracts using these three design features to exacerbate the misperceptions of consumers.  In doing so, they reduce the net benefit that consumers derive from their service.  He also addresses a typical rational choice explanation for the three part design of cell phone contracts, namely that consumers have heterogeneous preferences; complexity and multidimensionality cater to those differences.  Yet, Bar-Gill concludes that this rational choice explanation fails simply because it is too costly for even perfectly rational consumers to ferret out this information.  The cost of sorting out the information exceeds the benefit of finding the perfect plan, thus deterring any shopping for terms.

[Posted, on Nancy Kim's behalf, by JT]

 

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