Automatic‐renewal contracts with heterogeneous consumer inertia

• DOI: http://doi.org/10.1111/jems.12317
• Author: Johannes Johnen
• Date: 01 November 2019
• Published date: 01 November 2019

J Econ Manage Strat. 2019;28:765–786. wileyonlinelibrary.com/journal/jems © 2019 Wiley Periodicals, Inc.

|

765

Received: 25 June 2018

|

Revised: 15 April 2019

|

Accepted: 20 April 2019

DOI: 10.1111/jems.12317

ORIGINAL ARTICLE

Automatic‐renewal contracts with heterogeneous

consumer inertia

Johannes Johnen

CORE, Université catholique de Louvain,

Louvain‐la‐Neuve, Belgium

Correspondence

Johannes Johnen, Centre for Operations

Research and Econometrics, Université

catholique de Louvain ‐Voie du Roman

Pays 34 bte L1.03.01 à, 1348 Louvain‐la‐

Neuve, Belgium.

Email: johannes.johnen@uclouvain.be

Funding information

EOS, Grant/Award Number: 30544469

Abstract

Automatic contract renewals are a common feature in consumer markets. Since

these contracts renew automatically unless a consumer actively cancels, firms

can use them to exploit consumer inertia. As a source of inertia I study limited

attention and investigate how firms use contract renewal to sell to consumers

with different degrees of inattention. In monopolistic markets, adverse selection

of more‐attentive consumers limits the exploitation of naively inattentive

consumers. When signing a contract, naively inattentive consumers over-

estimate their future probability to make an active cancellation decision. To

exploit this mistake, the monopolist wants to target these consumers with large

prices after contracts renew. These back‐loaded contracts, however, adversely

attract more‐attentive consumers who cancel more often when choosing these

exploitative contracts. To mitigate adverse selection, monopolists focus less on

exploiting naively inattentive consumers. Adverse selection induces fewer

consumer mistakes and can increase efficiency. I show that competition

mitigates adverse selection, which induces firms to focus more on exploitation

with more back‐loaded pricing. I discuss implications for recently implemented

policies on automatic‐renewal contracts.

KEYWORDS

automatic contract renewal, limited attention, naiveté, present bias, price discrimination

JEL CLASSIFICATION

D03; D18; D41; D42; D82

1

|

INTRODUCTION

Contracts with automatic renewal or open‐ended subscription are widely used in consumer markets. Unless consumers

cancel, these contracts renew automatically. We observe these contracts in areas as diverse as telephone services,

utilities, gym memberships, retail banking, credit‐card services, and newspaper subscriptions.

Automatic‐renewal contracts raised concerns of academics and policymakers alike. Despite recent regulation,

policymakers continue to worry that automatic‐renewal features exploit consumer inertia and induce consumers to

forgo benefits of switching.

1

The existing literature also presents reasons to be concerned. For example, DellaVigna and

Malmendier (2004) show how firms can design contract‐renewal conditions to exploit overconfidence of present‐biased

consumers who procrastinate contract cancellation.

2

This paper goes beyond the existing literature in two ways. First,

existing work does not study how firms design offers for heterogeneous consumers, in particular when more

sophisticated consumers are also present in the market.

Second, existing papers on automatic contract renewal focus on present‐biased consumers.

3

Yet recent empirical

studies

4

suggest that limited attention or memory plays a crucial role in explaining low switching rates. Imperfectly

attentive consumers procrastinate switching because they may forget to cancel their existing contract. Also

policymakers seem to think that limited attention is crucial for consumer inertia towards contract renewal: Several

US states and the UK now oblige firms to remind consumers before contracts renew automatically—a policy targeted at

limited attention/memory rather than present bias.

5

Thus, and in contrast to the aforementioned work on automatic‐

renewal contracts, I study limited attention as a cause for consumer inertia.

Section 2 introduces the main model with automatic‐renewal contracts and limited attention. Consumers purchase a

product or service from a firm. Firms make a take‐it‐or‐leave‐it offer at the contracting Period 0. Firms can charge a

fixed price in Period 1, and a renewal price in Period 2 that consumers pay if and only if contracts renew and they

consume in Period 2. After consumption in Period 1, consumers learn their value of consuming again in Period 2. After

Period 1 contracts renew automatically unless consumers actively decide to cancel and switch to their outside option.

Without active consumer intervention, for example, in the form of a cancellation letter or phone call, contracts extend

automatically and consumers pay the renewal price.

Consumers differ in their degree of limited attention. I consider perfectly attentive consumers who always make a

decision about contract renewal, and inattentive consumers who forget to make a decision with positive probability.

Following empirical evidence by Ericson (2011) and Tasoff and Letzler (2014), inattentive consumers might be

overconfident about their future inattention, which I refer to as ‘naively inattentive.’Section 3 characterizes consumer

switching and contract choices.

Section 4 studies monopolistic contracts. Section 4.1 explores a benchmark case where a monopolist can distinguish

attentive and inattentive consumers, and targets offers accordingly. Monopolists offer efficient renewal prices to

attentive consumers and inattentive ones who correctly predict their inattention. But they design offers to exploit

mistakes of naively inattentive consumers. At the contracting stage, naively inattentive consumers mispredict their

switching behavior. They believe they will act and switch more often than they actually do. To exploit this switching

error, monopolists charge naively inattentive consumers a larger renewal price, and a lower fixed price to ensure

participation. By offering these more back‐loaded contracts, monopolists increase the switching error and earn an

exploitation rent.

Section 4.2 explores optimal contracts when the monopolist cannot distinguish attentive and inattentive consumers.

Unable to identify consumers, the monopolist faces an adverse‐selection problem. Attentive consumers take actions

about contract renewal with a higher probability and therefore benefit more from any contract. They could choose the

offer intended for naively inattentive consumers, enjoy a lower fixed price and then switch more often at the larger

renewal price. In this way, attentive consumers can take advantage of the exploitative offer and reduce profits.

Adverse selection limits the ability of monopolists to exploit inattentive consumers. The lower fixed and larger

renewal prices intended to exploit inattentive consumers adversely attract attentive consumers who can take advantage

of these exploitative offers. As a result, monopolists face a tradeoff between exploiting inattention and adverse selection

of attentive consumers. This tradeoff induces monopolists to make offers less exploitative with smaller renewal prices.

Adverse selection, by bringing renewal prices closer to marginal cost, can even increase total welfare.

Section 5 discusses policy implications. The tradeoff between exploitation and adverse selection in automatic‐

renewal contracts is the core mechanism identified in this paper. It suggests that policymakers who try to limit

exploitation should reduce overconfidence without mitigating adverse selection. I discuss implications for recently

implemented policies in the USA and the UK, namely, reminders applied just before contracts renew, and policies that

make automatic renewal more salient when consumers sign the contract. My results suggest that reminders are more

targeted at reducing overconfidence, and seem more likely to reduce exploitation.

Section 6 studies implications of the key tradeoff between exploitation and adverse selection for competitive markets.

Compared with monopolists, competitive firms intensify exploitation of inattentive consumers. Competition shifts

surplus from firms to consumers and relaxes incentive constraints. This induces attentive consumers to self‐select into

their designated offers, and mitigates adverse selection. Consequently, competitive firms are less constraint by adverse

selection, and competition intensifies exploitation of inattentive consumers. Whenever competitive equilibria exist, they

induce self‐selection, and lead to larger renewal prices, that is, more back‐loaded pricing ceteris paribus, than

monopolistic contracts.

6

Section 7 discusses the connection to previous empirical a theoretical work on back‐loaded pricing and teaser rates.

Teaser rates are small introductory prices combined with larger post‐teaser prices. In the US credit‐card industry

Ru and Schoar (2016) find that companies target less‐educated consumers with more back‐loaded offers containing

766

|

JOHNEN