Seduction by contract: do we understand the documents we sign?

By Oren Bar-Gill

We are all consumers. As consumers we routinely enter into contracts with providers of goods and services — from credit cards, mortgages, cell phones, cable TV, and internet services to household appliances, theater and sports events, health clubs, magazine subscriptions, and more.

But do we understand the contracts that we sign? Do we really know how much we will end up paying for the privilege of using a cellphone or a credit card? Many consumer contracts feature complex, multidimensional pricing schemes. Think of the common cellular service contract with its three-part tariff pricing—a fixed monthly fee, a number of included minutes, and an overage fee for minutes used beyond the plan limit—further complicated by distinctions between peak minutes, night and weekend minutes, in-network and out-of-network minutes, minutes used to call a pre-set list of “friends,” and minutes used to call everyone else. Then add the equally complex pricing structures for messaging and data services. With such complex pricing, how many consumers can accurately anticipate their annual wireless bill?

Beyond complexity, sellers and service providers often backload costs onto long-term price dimensions that are underestimated by consumers. Think of low “teaser” interest rates on credit cards, which then reset to much higher rates at the end of the introductory period. Or think of the many cell phones that are given away for free, so long as the consumer signs a two-year service contract. Why do consumer contracts bestow short-term perks and then hit us with long-term costs?

The design of consumer contracts, and specifically the common complexity and deferred-cost features, can be explained as the result of the interaction between market forces and consumer psychology. We consumers are imperfectly rational, our decisions and choices influenced by bias and misperception. Moreover, the mistakes we make are systematic and predictable. Sellers respond to those mistakes. They design products, contracts and pricing schemes to maximize not the true (net) benefit from their product, but the (net) benefit as perceived by the imperfectly rational consumer. The result: a behavioral market failure.

The interaction between market forces and consumer psychology explains many of the complex design features so common in consumer contracts. The temporal ordering of costs and benefits — with benefits accelerated and costs deferred — is linked to consumer myopia and optimism. Complexity responds to bounded rationality, to the challenge of remembering and then aggregating multiple dimensions of costs and benefits. These two features — complexity and cost-deferral — serve one ultimate purpose: to maximize the (net) benefit from the product, as perceived by the imperfectly rational consumer.

This behavioral market failure hurts consumers and undermines efficiency. Policymakers are paying increasing attention to these problems, and they are responding with increasingly sophisticated regulatory tools. The idea is to empower consumers by giving them information that they can use to make better product-choice and product-use decisions. In the UK, the Cabinet Office published the Consumer Empowerment Strategy, featuring the “mydata” initiative, which “will enable consumers to access, control and use data currently held about them by businesses.” In the USA, Cass Sunstein, Administrator of the Office of Information and Regulatory Affairs at the White House, and co-author of Nudge, is promoting “Smart Disclosure” policies, designed to help “provide consumers with greater access to the information they need to make informed choices.”

These policies are not just about disclosing more information. Sellers already provide heaps of information that most consumers cannot read or understand. The challenge is to design disclosures that can really empower consumers and solve the behavioral market failure. To accomplish this goal, disclosure regulation must adopt one of the following two strategies:

1. Simple disclosures target consumers. The idea is to design aggregate, one-dimensional disclosures that facilitate comparison between competing products. For example, cell phone companies could be required to disclose the total annual cost of using a cell phone. The disclosure would combine both product-attribute information and product-use information. The annual cost of cellular service would combine rate information with the consumer’s use-pattern information. Such simple, aggregate disclosures would help imperfectly rational consumers make better choices.
2. Re-conceptualized disclosure is aimed not at imperfectly rational consumers, but at sophisticated intermediaries. Accordingly, this disclosure could be more comprehensive and complex. Consider a consumer who is considering switching from her current cell phone company to a competing provider. Consider also an intermediary who wishes to help the consumer identify the best plan for her needs. The intermediary has information on the different plans offered by all cell phone companies. The intermediary, however, has little information on how the specific consumer uses her cell phone. Since different plans can be optimal for different consumers, depending on their use patterns, not having product-use information substantially reduces the ability of the intermediary to offer the most valuable advice. Now, the consumer’s current cell phone company has a lot of information on the consumer’s use patterns. It could be required to disclose this information in electronic form so that the consumer could forward it to the intermediary. The intermediary could then combine the product use information with the information it has on different plans and provide the consumer with valuable advice.

Consumer contracts are ubiquitous. They produce substantial benefits, but can also cause substantial harm. Policymakers can help by mandating, or encouraging, disclosure of information that would empower consumers to make better choices. The challenge is to design effective disclosure policies.

Oren Bar-Gill is Professor of Law and co-Director of the Center for Law, Economics and Organization at the New York University School of Law. He is the author of Seduction by Contract: Law, Economics, and Psychology in Consumer Markets. For his work on consumer contracts, Bar-Gill received the inaugural Young Scholar Medal from the American Law Institute.

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