Naïve Consumers (Contract Economics)
Consumers are viewed as a weak contract party by both lawyers and economists, although with some distinctions. The unconscionability theory addresses consumers’ naïvety, to be intended as partial or total incapacity of understanding contract terms, as a reason for public intervention. Economists as well agree that law must protect consumers against sellers’ abuses, especially when contracts contain add-ons or are preprinted and no bargaining is allowed.
How law should intervene is still an open question. On the one hand, lawyers point out that courts should not enforce contract clauses literally but rather should replace them with terms that consumers could have reasonably expected and approved. On the other hand, economists focus on how sellers exploit naïve consumers and warn that regulation may turn out pejorative if it is not able to educate naïve consumers or if it allows the seller to raise the price up when forced to offer good terms.
The Notion of Naïvety in Law
Consumers can be viewed as a special category of buyers that has magnetized lawyers and economists’ attention in the last decades. A distinction is, however, necessary to highlight what the two disciplines have in common and nevertheless why they differ.
Starting from a legal point of view, when lawyers refer to consumers, they have in mind a weak and nonprofessional contract party with limited or no contract power, and usually uninformed of every clause or consequence of the contract signed (see Korobkin 2003). This sort of considerations has driven the legal literature to formalize a general theory of unconscionability: accordingly, it is unconscionable a contract that mentally competent people would not sign and/or that no fair and honest person would accept. Not surprisingly, consumers’ naïvety, to be intended as partial or total incapacity of understanding the contract content in each of its clauses, has been viewed as one of the main factors to support the theory of unconscionability.
Accordingly, since consumers may sign the contract without reading or understanding its content, their signature on the contract may not correspond to a meaningful consent to all its clauses. It comes out that courts should not enforce contract clauses literally, especially those so one sided to turn out vexatious, but rather should replace them with terms that consumers could have reasonably expected and approved.
The Notion of Naïvety in Economics
On the other hand, economists make a second-order distinction between two categories of uninformed consumers: those who are simply uninformed but conscious of the potential risks hidden into a contract that has been prewritten by the counterparty and those who are not only uninformed but also unconscious of such risks. Consumers in the former category are labeled “rational” or “sophisticated” and are usually assumed to be able to fill their knowledge gap by paying a positive cost to read contract terms. Consumers in the latter category are labeled “boundedly rational” or “naïve” and are assumed to never read the contract simply because they do not realize the risk of signing without reading.
Ellison and Ellison (2009) analyze how firms can exploit consumers’ in Internet transactions where price search engines make a price search more difficult and sometimes not convenient.
As pointed out by Armstrong and Chen (2009), it does not imply that naïve consumers do not care of contract clauses at all or less than sophisticated consumers. There might be also consumers who are naïvely pessimistic, that is, they do not trust the seller and believe that contracts always include unfriendly clauses. More generally, we can say that naïve consumers simply do not realize the risk involved in signing a contract without reading or they never trust the seller and never sign.
Similarly to the legal literature, there is a general consensus in the economic literature as well that court intervention is necessary to protect naïve consumers. To be more precise, economists have focused on how unregulated seller(s) exploit such consumers. The answer clearly depends on the beliefs that naïve consumers hold about the terms in preprinted contracts. Despite in some contexts a consumer might expect complex contracts to contain default terms (e.g., he might believe that the non-price terms in a complex contract address contingencies which are irrelevant to the buyer and are therefore regulated by default rules or uses), most of the literature prefers focusing on the case in which consumers are weaker and easier to exploit for a contract-drafting seller: it happens when consumers are naïvely optimistic, believing that preprinted contracts contain favorable terms.
The Effects of Regulation
A recent behavioral literature treats the infrequency of reading as indicative of buyer naïvety and argues that sellers lack an incentive to educate such buyers: cf. Gabaix and Laibson (2006) for the special case of add-on goods and D’Agostino and Seidmann (2016) in respect of contracts of adhesion. The intuition is the following: if all buyers believe that complex contracts contain favorable terms, then an unregulated seller would include the worst possible terms in preprinted contracts charging the price that buyers would be happy to pay for friendly terms according to those constraints imposed by the market structure in which they operate. Regulations may therefore benefit such naïve buyers.
Despite the general principle that parties are free to negotiate contracts, courts, legislatures, and regulators have sometimes overruled onerous terms in consumer contracts. There are two underlying and potentially conflicting rationales: Sect. 218 of the Uniform Commercial Code states that a clause is unenforceable if a buyer would not have traded had he known its contents, which suggests that naïve buyers should be protected. By contrast some courts, notably in Henningsen v. Bloomfield Motors (NJ 1960), have cited market share as an aggravating factor, which suggests that all buyers should be protected against sellers who exploit market power to offer onerous contracts.
It is also unclear whether regulations are designed to protect buyers who have already accepted onerous terms (and must necessarily gain) or to protect buyers who have yet to enter the market.
Suppose all consumers are, economically speaking, naïve in the sense that they believe that contract terms are favorable and do not take into account the risk of accepting a preprinted contract without reading its content. Sellers in a free market would therefore include onerous terms in their contracts charging the highest price that such consumers are willing to pay for favorable terms. Consumers therefore risk to get a negative payoff, to be intended as the difference between their evaluation for an onerous contract and the price they pay believing that it is rather favorable, under the supposition that they value more a favorable contract than an onerous contract.
Trivially, regulations which do not educate buyers have no effect on play: if naïve consumers remain unaware of the effect of regulation, they will not be able to call the seller in front of a court of law if terms are different from those legally acceptable. Conversely, effective regulations which either mandate terms turning out favorable to consumers or prohibit rather onerous terms induce both a monopolist and each competitive seller to offer a favorable contract, but the effect on price crucially depends on the market structure. Precisely, a monopolist will charge the highest price that consumers are willing to pay for those terms, whereas competition will lead price down to the production cost. As an effect, consumers get zero from buying and may be better off compared to a free market in which they would have been offered onerous contracts charging a price close or equal to their reservation price for a favorable contract.
Suppose now that some consumers are naïve and some others are rational. If rational consumers must pay a cost to read and understand the contract, a commitment problem arises and an unregulated seller has again no incentive to include favorable terms. Precisely, consumers cannot commit to read the contract and seller(s) cannot commit to include favorable terms. As a consequence, an unregulated seller cannot charge a price equal to consumers’ reservation price for favorable terms if he plans to trade with rationals, but under some conditions he may find it profitable to include favorable terms with positive probability if rational consumers read with positive probability. Naïve consumers are therefore protected by rational consumers if the latter category is sufficiently large in the market to force seller(s) to reduce the price and possibly to include favorable terms with positive probability. Conversely, if naïves represent a large percentage of consumers into the market, then seller(s) will ignore rationals and equilibrium conditions correspond to those found when all consumers are naïve. Focusing on the former and more interesting case, regulation will force sellers to offer favorable terms with market structure dictating the equilibrium price. The effect on naïve consumers’ payoffs is therefore ambiguous depending on what price they were charged in a free market given the probability of finding favorable terms.