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

Bar-Gill discusses some interestingfacts about the cell phone market but the focus is on the three design featuresof cell phone contracts:  three parttariffs, lock-in clauses and complexity.

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

The second feature, lock incontracts, are a market response to the imperfect rationality ofconsumers.  The lock-in contracttypically consists of a “free” fancy phone and a two or three yearcontract.  The consumer is required topay an early termination fee (although that is now greatly discounted orprorated– more on that later).  Bar-Gillargues that these lock-in contracts take advantage of consumer myopia assubscribers are lured by the fancy free phone and underestimate the likelihoodthat 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 confusingfeatures and pricing variables offered by companies – in addition to the 3 parttariff, lock in clauses and early termination fees, there are different pricesfor different times of day, rollover minutes, family plans, etc.  Boundedly or imperfectly rational consumersdo not effectively aggregate costs associated with these different plans andwill focus on a subset of salient features and prices and ignore orunderestimate other features and prices. In response, providers will increase prices or reduce the quality of non-salientfeatures.

Bar-Gill explains how carriers design theircontracts using these three design features to exacerbate the misperceptions ofconsumers.  In doing so, they reduce thenet benefit that consumers derive from their service.  He also addresses a typical rational choiceexplanation for the three part design of cell phone contracts, namely thatconsumers have heterogeneous preferences; complexity and multidimensionalitycater to those differences.  Yet, Bar-Gillconcludes that this rational choice explanation fails simply because it is toocostly for even perfectly rational consumers to ferret out thisinformation.  The cost of sorting out theinformation exceeds the benefit of finding the perfect plan, thus deterring anyshopping for terms.

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