Competition may not protect consumers but simple market statistics tell us when policy can, writes Michael D. Grub

Grubb, Michael D.

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2/24/2016Firms write contracts to exploit consumer overconfidenceblogs.lse.ac.uk /businessreview/2016/02/24/firms-write-contracts-to-exploit-consumer-overconfidence/Overconfidence is a common error that can lead people to make poor choices because they misforecast futureproduct usage and overestimate their abilities to navigate contract terms. The value of a gym membership dependson how often you think you will go to the gym, and the value of a mobile phone contract depends on how much datayou think you will use. Your willingness to enter into a contract depends on whether you are confident that you canavoid late fees or other penalties, or whether you worry that such fees will prove difficult to avoid and expensive.In their aptly titled study of a New England health club, “ Paying Not to Go to the Gym ”, DellaVigna and Malmendierargue that individuals overpay for gym memberships because they overestimate their own powers of self-control—they expect to regularly get off the couch to go to the gym, but in fact rarely do. Another common mistake of theoverconfident is to overestimate how quickly they will repay credit-card debt. These overconfident borrowers mayignore the interest rates that credit-card companies charge after introductory rates expire because they wronglyexpect to pay-off balances within the introductory period—a prediction supported by Ausubel’s study of consumerresponses to credit card offers.In another example from my own research, I find that overconfidence explains why individuals systematicallychoose the wrong monthly mobile-phone plans. Consumers mistakenly believe that they can choose a calling planthat is, as Goldilocks would say, “just right”, having neither too large an allowance of data that goes wasted, nor toosmall an allowance that leads to expensive overage charges. In fact, as an industry executive once told me (and isalso borne out in the data), “people absolutely think they know how much they will use and it’s pretty surprising howwrong they are.”Poor choices in gym memberships, credit cards, and mobile-phone plans all result from mistaken beliefs aboutfuture usage of the products. Yet perhaps an even more common error is overestimating one’s ability to navigatecontract terms. For instance, experiments conducted by Silk and Ericson suggest that although people recognizethat they may not follow through to collect mail-in rebates, they still underestimate the extent of the problem.Similarly, people are often unconcerned by offers that include costly terms such as high late fees, over-limit fees, orautomatic renewal clauses because they think they will be the exception and avoid such penalties and pitfalls. They1/3usually aren’t. As a result, overconfident consumers overestimate the benefits and underestimate to costs ofcontracts that include these terms.In each setting described above, overconfidence leads consumers to make bad decisions that cost them money. Yetthis is only the beginning of the story. In a recent article, I focus on further consequences of overconfidence. The firstinsight I highlight is that many contractual terms, like mail-in rebates, and late-fees—the very terms that commonlytrip people up—may be included in contracts precisely because people often overestimate their benefits orunderestimate their costs. Absent overconfidence, contracts might be much more straight forward. Why after all dofirms commonly offer mail-in rebates? As Scott Adams’ Dilbert cartoon humorously suggests, firms may offer rebatesto exploit the overconfident who forget to collect them.A second insight is that competition among firms may fail to protect people from their own mistakes, and we mayneed to rely on consumer protection policy instead. However, policies designed to prevent firms from exploitingoverconfidence do not necessarily help consumers. For instance, Matt Osborne and I predict that requiring cellularcarriers to alert customers when they exceed usage allowances (as U.S. carriers must now do) would helpconsumers avoid unwanted overage charges. However, we also predict that firms would offset the lost overage feerevenue by raising monthly fees and making other price changes that actually leave many consumers worse off. Inother cases, however, consumer protection policy can be tremendously successful. Agarwal and co-authors find nooffsetting price response by banks when the 2009 Credit Card Accountability Responsibility and Disclosure (CARD)Act curtailed U.S. credit-card late fees and over-limit fees—instead the entire $12 billion yearly reduction in feesdirectly benefits U.S. credit-card holders as intended.Happily, there is a way forward for regulators hoping to know when to try to help. My analysis shows that twoconcrete, measurable statistics—consumers’ sensitivity to prices and the willingness of firms to pass on costincreases to consumers in the form of higher prices—impact the potential effectiveness of proposed regulations.Distinguishing markets in which regulation may have limited benefit (as in cellular services) from those in whichregulation may substantially help consumers (as in credit cards) can enable policy makers to intervene wheneffective and avoid unnecessary regulation otherwise. ♣♣♣Notes:This post is based on the author’s paper Overconfident Consumers in theMarketplace, Journal of Economic Perspectives—Volume 29, Number 4, Fall 2015, Pages 9–36.This post gives the views of its author, not the position of LSE Business Review or the London School ofEconomics.Featured image credit: edar, Pixabay – Public DomainMichael D. Grubb is an Associate Professor of Economics at Boston College. He is an expert inbehavioural industrial organisation whose recent research has focused on overconfidence, bill-shock regulation, and consumer inattention. His research interests include applied microeconomictheory, industrial organisation, online advertising and market design. He is an associate editor ofthe Journal of Industrial Economics, and is on the advisory board of the Rubicon Project. He waspreviously an Assistant Professor of Applied Economics at MIT Sloan School of Management, aVisiting Scholar at Harvard University, and a consulting researcher at Microsoft Research. Heholds a B.S. in Engineering & B.S. in Economics from the University of Pennsylvania, an M.Phil. inEconomics from the University of Oxford and a Ph.D. in Business Administration from Stanford University.Copyright © 2015 London School of Economics2/33/3

Firms write contracts to exploit consumer overconfidence

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