Obfuscating Contracts
In the UK, prices for broadband contracts are generally quoted in terms of an introductory rate and a post-introductory rate. For example, the twelve-month version of BT’s “Option 1” costs 12.99 for the first three months and 17.99 thereafter. This structure is notable because it pertains to FIXED TERM CONTRACTS. Most of the economics literature on behavioral contract theory, stemming from the brilliant paper of Stefano Dellavigna and Ulrike Malmendier, has focussed on cases where consumers have post-adoption choices about service use. For example, credit card adopters can decide how much to borrow; cell phone adopters can decide how many minutes to talk; gym members can decided how often to work out. In the UK broadband case, subsequent prices are unconditional on use: They are merely the way the firms partition the annual contract price into installments.
BT is not unusual in quoting its contracts in these terms. AOL UK, Tiscali, and Virgin are included in its company (though not TalkTalk and Orange). The quotes generally have a few features:
- The introductory period tends to be 3 months for 12 month contracts and 6 months for 18 month contracts.
- The introductory monthly rate is 20-50% less than the post-introductory monthly rate.
- Firms generally require that early termination results in responsibility for payment of all the contract’s remaining installments.
As I see it, there are two main reasons firms may offer contracts structured this way. First, consumers may be more liquidity constrained at the time of adoption than later during the contract term. However, it seems implausible that differences of a few pounds from month to month, within a given year, would make a difference for the typical consumer.
The second reason strikes me as the correct one: firms want to confuse consumers about the true price of the offered contracts. Firms often advertise the introductory rate, and many of the price-comparison websites report this rate despite its irrelevance.
Two questions come to mind. First, given the way (boundedly rational) consumers make decisions about contracts, how should monopolists and competitive firms design their installments? For example, why is it that we don’t see offers like “FIRST MONTH FREE! Next three months only 4.99! Last 69 weeks 39.21.” Maybe then termination rates would rise, and enough consumers would get irritated to decrease brand karma. Also, too much complexity could cause consumers to throw up their hands and turn to a competitor. (Some consumers might also notice a rip-off when confronted with one.)
The second question I find interesting is how regulators should act in these markets. For example, should there be limits on how long a non-renegotiable contract consumers can sign to? Should firms be required to quote their contract offers’ total annual costs? (Certainly, extended agreements shouldn’t be prohibited entirely, because firms face fixed costs of signing up new customers, which must be recouped over time.)
My feeling on the second question is that regulators should require the most prominent advertised price to be the total price for the duration of the contract. If the firm wants to offer financing (an installment loan), I suppose it’s fine to let them arrange that offer however they wish– though I would probably end up advising everyone to pay up-front if possible, since installment credit is usually very expensive. Alternatively, (and almost equivalently) regulators could prohibit contracts that ex ante specify varying payments for materially identical services, forcing the broadband providers to advertise only the weighted averages of their streams of monthly prices.
