Thursday, March 28, 2013
This is the eighth and final post 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. Below, Professor Bar-Gill (pictued) responds to the comments provided by Angela Littwin, Alan White and Nancy Kim.
I wish to open these comments by thanking Jeremy for organizing a great panel and for following up with this on-line symposium. I also wish to thank Angela, Alan and Nancy for their thoughtful comments and suggestions. I cannot, in this space, respond to all the valuable ideas and critiques that these experts presented in their posts. Rather, I will touch upon three sets of issues that I consider especially important or provocative.
1. The Role of Competition
Competition is often considered to be a solution to market failure. “Seduction by Contract” argues that competition is not necessarily a solution to the behavioral market failure, which is the focus of the book. In essence, if imperfectly rational consumers generate biased demand, sellers in a competitive market must respond to this biased demand by designing products, contracts and prices that exploit the consumer bias.
This does not mean, however, that competition cannot play a helpful role. It can, and it does. Consumer biases and misperceptions are dynamic and can be influenced by market forces. Specifically, sellers can educate or debias consumers through advertising. For example, until recently, imperfectly rational consumers paid little attention to late fees when shopping for a credit card. Now banks are competing over cardholders by advertising their late-fee policies. Another example, noted in Nancy’s post, concerns early termination fees (ETFs) in cellphone contracts. Until recently, ETFs were non-salient to consumers and a 2-year lock-in contract was the norm. Now many carriers are advertising No Contract options. Nancy argues that the rise of No Contract is an imperfect market solution, and I agree that it is imperfect. Nonetheless, it shows how markets can respond to changes in consumer perception (and misperception) and, in some cases, lead these changes.
2. Normative Framework
Alan asks about the appropriate normative framework. As an economist, I am a welfarist. But I should emphasize that welfarism is very different from utilitarianism. The welfarist cares about distributional effects; the utilitarian does not.
Since I focus my policy analysis on disclosure (see below), Alan infers that I care primarily about autonomy. But, as explained above, my normative framework is welfarist. My preference for disclosure regulation rests on the argument that optimally designed disclosures can enhance social welfare, by helping to overcome (or bypass) consumer biases and misperceptions.
This last point also responds to some of Alan’s critiques of my disclosure proposals. I agree with Alan that most existing disclosure mandates simply don’t work. But the fact that badly designed disclosures don’t work, doesn’t tell us very much about the potential benefits from well-designed disclosure mandates. My goal was to come up with disclosures that will be effective, given the imperfect rationality of consumers.
3. Legal Policy Response: The Role of Disclosure Regulation
The policy analysis in “Seduction by Contract” focuses on disclosure regulation. This is not because disclosure always works and it is not because disclosure, when it works, perfectly cures the behavioral market failure. I focus on disclosure, because I think it can help, when optimally designed; because often it is the most (and sometime the only) politically feasible mode of regulation; and because it avoids certain costs associated with more paternalistic modes of regulation. To be clear, I do not argue that more paternalistic intervention is never warranted. And if I had the tenacity to write a longer book, I would definitely explore other regulatory approaches beyond disclosure. Angela and Alan are disappointed by my focus on disclosure. I hope this response provides some (limited) reassurance.
The analysis of disclosure regulation in “Seduction by Contract” hopes to provide some guidance to lawmakers on how to optimally design disclosure mandates. I begin by emphasizing the importance of product use information, and product use disclosures. Second, I outline two disclosure strategies that can help imperfectly rational consumers. First, simple aggregate disclosures, like a “total cost of ownership” disclosure, can help consumers make better choices. Second, more comprehensive disclosures can be used, but these disclosures would be targeted at sophisticated intermediaries, and would not be for direct “consumption” by imperfectly rational consumers.
[Posted, on Oren Bar-Gill's behalf, by JT]
Wednesday, March 27, 2013
Online Symposium on Oren Bar-Gill's Seduction By Contract, Part IIIB: Nancy Kim on Cell Phone Contracts
This is the seventh 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 second of a two-part contribution from our own Nancy Kim of the California Western School of Law.
Bar-Gill argues that the three part design of cell phone contracts (summarized in yesterday's post) imposes welfare costs by preventing efficient switching of plans and discouraging comparison shopping and by regressively redistributing wealth from the consumers to carriers, and from lesser informed (and presumably poorer) consumers to better informed (and presumably richer) consumers. He also argues that market solutions are limited as providers must respond to the biased demands of consumers or else be driven out of the marketplace.
I tend to agree but only to a point. I do think in many markets, and the cell phone service market is one, consumers eventually wise up (i.e. after “bill shock”) and competition heats up in response to consumer dissatisfaction. The problem is that it might take a while, and by the time consumers can muster up some momentum, the existing players have gotten bigger and more entrenched – and newer companies can’t compete in terms of marketing dollars. In the cell phone space, for example, Walt Mossberg of the Wall Street Journal, recently reviewed a new upstart called Republic Wireless. The company’s offering is the exception to the standard three part contract design – they offer no contract. Furthermore, users pay for the phone in exchange for which they pay a very low monthly fee – only $19. (Users also have the option of paying less for the phone and slightly more for the monthly service). The catch? The reception itself isn’t as good because the technology isn't quite there yet – but it’s coming. I think the bigger challenge for the company isn’t that calls sometimes get dropped – I use Sprint and my calls get dropped all the time! – it's getting their name out there (Republic who?) and overcoming consumer inertia.
Bar-Gill proposes disclosure regulation as a way to deal with problematic contract design. He’s right to a certain extent – while disclosure has been knocked as ineffective, the problem is really with the type of disclosure and not the notion of disclosure. In other words, we need the right kind of information. Bar-Gill proposes that carriers be required to disclose consumer use information (both specific to the consumer based upon past use as well as use by others similar to the consumer) and total cost of ownership information which would be the total amount paid by the consumer including overage charges on a yearly basis or over the duration of the plan. He also proposes that there be real time disclosures or warning so consumers know before they make that call that they are about to exceed their plan limit.
While I like his proposals, Bar-Gill omits one very important aspect of disclosure (which I have written about in other articles, most recently this one) – and that is visual design. In other words, effective disclosure should mean both the right information as well as the right presentation of that information. You can require all the relevant information you want but if consumers don’t notice it, then they won’t read it. How the information is disclosed is just as important, in my view, as what information is disclosed. Furthermore, in some markets, regulatory action of business practices (and not just disclosure regulation) may be required.
I could go on, but I’ve already taken up too much space. Hopefully this review has sparked your interest and made you want to run out and buy your own copy. Oren Bar-Gill has written a useful and thought provoking book and I think that it’s essential reading for contracts profs (as is Margaret Jane Radin’s book, BOILERPLATE, which was also discussed on a different panel).
[Editor's note: we expect to have an online symposium on Boilerplate in May)
[Posted, on Nancy's behalf, by JT]
Tuesday, March 26, 2013
Online Symposium on Oren Bar-Gill's Seduction By Contract, Part IIIA: Nancy Kim on Cell Phone Contracts
This 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.
The 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]
Monday, March 25, 2013
Online Symposium on Oren Bar-Gill's Seduction By Contract, Part IID: Alan White, The New Law and Economics and the Subprime Mortgage Crisis
This is the fifth 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. This post is the fourth (and last) of a series within the series contributed by Professor Alan White of the CUNY School of Law (pictured at right).
Part III: Prescriptions for Future Mortgage Regulation When Information Is Not Enough
In my prior posts, I discussed two aspects of Oren Bar-Gill’s book chapter on subprime mortgages: the behavioral economics insights that describe how these disastrous contracts came to be, and the norms and values that the law should promote in regulating the mortgage market in light of the subprime fiasco. I now turn to the conclusion of the chapter, and its policy recommendations. In brief, Oren proposes two steps, an all-in loan price disclosure by means of an improved annual percentage rate (APR) formula, and requiring disclosures earlier in the mortgage shopping process. “Disclosure regulation is the right place to start . . . A disclosure mandate seems to provide . . . an effective response to the behavioral market failure in the subprime and Alt-A mortgage markets.”
Given the range of regulatory tools already adopted by Congress, the Federal Reserve and the CFPB, and the extensive damage done by the subprime mortgage market, this prescription is surprisingly timid. Oren acknowledges that Dodd-Frank includes substantive regulation of contract terms, but nevertheless adheres to a very traditional economist’s solution – fix information problems and the market will maximize welfare.
But the whole point of behavioral economics, in the context of mortgage loans, is that information isn’t enough. Even borrowers who understand risky and expensive loan terms will still choose them, and suffer welfare harms as a result. Subprime brokers were also very adept at using mandatory disclosures to mislead consumers and reframe choices. Moreover, Oren nicely summarizes the evidence that literacy and math skills of most adults are not up to the task of assessing mortgage risk and making complex price trade-offs, for example with adjustable rates and prepayment penalties, even with perfect disclosures.
Although the recommendations are not presented as exclusive, Oren implicitly comes out favoring consumer autonomy as the primary norm for mortgage regulation. To my mind this evades some more difficult choices for the law of mortgage contracts, where serious attention to welfare maximization and economic equity would call for stronger legal intervention, but where we can recognize that autonomy is a value as well.
On the question of foreclosure risk, for example, the Dodd-Frank act is paternalistic. It requires lenders to make a reasonable determination of the borrower’s repayment ability, i.e. it prohibits excessive foreclosure risk. The new law’s regulatory approach is an interesting balance between consumer autonomy and welfare maximization. The CFPB is charged with prescribing contract terms that are deemed safe, and loans with those terms are immune from legal attack. Loans outside the safe harbor contract design are legal, but may be attacked under the broad affordability standard in the statute. This is a form of nudging or choice architecture advocated by other behavioral economists.
There are also important value trade-offs in current debates around fair lending laws, such as how to apply the disparate impact test to mortgage lending, that directly confront the normative conflicts between autonomy, welfare maximization and racial justice. A prescription to begin with disclosure seems ill-suited to addressing the huge impact subprime mortgage lending had on racial wealth distribution in our country, and ill-suited to preventing future systemic mortgage contract failures and their disastrous consequences for homeowners and the economy generally.
[Posted, on Alan White's behalf, by JT]