ContractsProf Blog

Editor: Jeremy Telman
Oklahoma City University
School of Law

Tuesday, February 1, 2022

Guest post: Michael Simkovic & Meirav Furth Matzkin on Pigouvian Contracts

Pigouvian Contracts
Michael Simkovic & Meirav Furth Matzkin

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MeiravFurthMatzkinConsumer attention is a scarce common resource. It is scarce because our cognitive ability to process information is limited. When we pay attention to one thing, we inevitably deflect attention from other things. Consumer attention is also a common resource because it benefits not only the particular consumer who pays attention, but also other consumers. For example, when a consumer pays attention to a company’s “terms and conditions,” that consumer can alert others about consumer-unfriendly terms through social media channels.

Firms generate negative externalities by over-exploiting consumers’ limited attention through long and complex standardized agreements, even for transactions that are trivial in value. The use of these overly complex contracts prevents most consumers from reading and understanding the terms of their agreements.

If more consumers could comprehend contractual terms, then more consumers could shop around for better terms, negotiate, or decline to transact with a seller who failed to offer sufficiently buyer-friendly terms.  In this hypothetical world of widespread comprehension, sellers would be encouraged to offer all consumers more buyer-friendly terms. This means that comprehending consumers could generate positive externalities, improving the terms for non-reading consumers.

This Article develops an illustrative model which shows that sellers may be incentivized to make it exceedingly difficult for even a small fraction of consumers to comprehend their contracts.  As has been previously observed, even small search costs can eliminate competition with respect to contract terms.  Furthermore, sellers have incentives to encourage consumers to harbor overly optimistic views about their contracts by selectively highlighting benefits and obscuring costs.

SimkovicIndeed, empirical evidence shows that sellers increasingly make their contracts so long and complicated that most consumers do not read them, at least not until it is too late. In a world in which consumers cannot distinguish between sellers with varying contract quality, sellers have incentives to use ever more pro-seller terms because they can do so without penalty.  Indeed, we demonstrate that the extent to which sellers will offer inefficient contracts to all consumers is a function of the proportion of consumers who comprehend contracts.

If regulators had perfect information, they could simply ban inefficient contract terms that harm consumers more than they benefit sellers.  But regulators usually cannot readily observe either the benefits of a contract term to sellers or the costs to consumers.

The ideal way to determine whether a term is socially desirable is to make that term available in a market where consumers understand all contract terms.  In such a market, consumers would incorporate the implications of the contract terms into their purchasing decisions and only enter contracts that make them better off.  Informed consumer purchasing decisions would, in turn, provide feedback to sellers, who would be forced to improve their contracts to survive in a competitive market.

However, this ideal is costly because of the attention costs inherent in numerous individual consumers understanding contract terms and forming independent judgments about them. When such costs are not taken into account—as they are not under the current legal regime—sellers do not fully internalize either the costs to consumers of anti-consumer contracts or the costs to consumers of reading and understanding contracts.  This leads to an overproduction of lengthy and complicated contracts that are also typically pro-seller. 

Our Article proposes to solve this problem by changing both sellers’ incentives regarding contract drafting and consumers’ incentives regarding contract comprehension. We encourage policymakers to make sellers internalize contract comprehension costs through quasi-Pigouvian taxation of sellers’ contracts.  Because regulators typically cannot directly observe whether and to what extent a contract term is inefficient, we propose to tax sellers based on the more easily observable costs to consumers of comprehending sellers’ contracts.

We demonstrate that our proposed tax would fall more heavily on sellers using inefficient contracts than on those using efficient contracts, even though regulators may not know ex ante which contracts are efficient.  This is because the tax would be imposed upon the presentation of a contract, regardless of whether or not the consumer chooses to transact.  When sellers present an inefficient contract, consumers who comprehend the contract will be less likely to transact.  The tax would make it costly for sellers to attempt to drive down consumer comprehension levels by increasing comprehension costs.  Moreover, we propose to compensate consumer contract comprehension and information sharing efforts.

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