Contractual structures and consumer misperceptions

• DOI: http://doi.org/10.1111/jems.12237
• Author: Christian Michel
• Date: 01 June 2018
• Published date: 01 June 2018

Received: 3 October 2016 Revised: 26 September 2017 Accepted: 10 October 2017

DOI: 10.1111/jems.12237

ORIGINAL ARTICLE

Contractual structures and consumer misperceptions

Christian Michel

Universitat PompeuFabra and

Barcelona GSE, Barcelona, Spain

(Email: christian.michel@upf.edu)

Abstract

We analyze how firms can design contracts to strategically induce consumer misper-

ceptions. A fraction of consumers is naive and underestimates the costs of claiming a

warranty payment in the event of product breakdown. This leads to an inferenceer ror

that makes consumers prone to overpredict product quality, which a firm can prof-

itably exploit. The channel persists under different market structures and can reduce

the quality provision to sophisticated consumers. Weargue that our results apply more

generally to cases in which consumers are inattentive or illiterate with respect to con-

tract fine print, and provide supporting evidence from TV infomercials.

1INTRODUCTION

In many situations, consumers do not observe the quality of a product before purchase. One common option for firms to signal

high quality is to offer contract guarantees that apply in the event of product failure. However, consumers are often unable to

fully understand all contract terms or do not pay attention to them.1A growing body of research studies how firms can design

structures to profitably exploit existing consumer misperceptions, such as myopiawith respect to add-on fees or time-inconsistent

preferences (see, e.g., Bar-Gill, 2007; DellaVigna & Malmendier,2004; Gabaix & Laibson, 2006). A different question emerges

in the quality context: why do consumers in some cases systematically overestimate the quality of certain products and even

become susceptible to scams?2

In this paper, we argue that firms can design contracts not only to profitably exploitexisting consumer misperceptions but also

to strategically induce new misperceptions. We identify cases in which a firm can establish and exploit false consumer beliefs

regarding product qualities by offering warranties that seldom apply or are costly to claim. This increases the consumers' overall

willingness to pay for products and services, which makes them prone to overpay. The model predictions find support from the

case of a knife set manufacturer that offers “lifetimewarranties” and “30-day money back” policies to advertise its main product

on televised infomercials while heavily devaluing these policies in the contract fine print.

Section 2 introduces our baseline model in which a manufacturing firm offers its products together with warranties that grant

consumers a payment in the event of product breakdown. The firm can choose product quality in terms of reliability, which is

unobservable to consumers and increasing in production costs. The firm can thus use a sufficiently high warranty to signal high

product quality. Claiming a warranty payment is costly for consumers. These costs can be both internal and external. Examples

of internal costs are opportunity costs of time and the mental costs of securing the warranty reimbursement. Examples of external

costs are shipping costs and the additional service fees that a firm charges in event of a return. We introduce a specific form of

consumer naivete: some consumers underestimate the costs of returning a faulty product to claim a warranty payment. Given

their cost assessments and the warranties offered, these consumers make inferences with respect to product quality, that is, they

use a correct inference mechanism based on false return cost premises. This provides the firm with a novel channelfor increasing

I thank Larbi Alaoui, Jose Apesteguia, Susanna Esteban, Rosa Ferrer, Jana Friedrichsen, Michael Grubb, Paul Heidhues, Volker Nocke, Marco Ottaviani,

Sandro Shelegia, André Stenzel, two anonymousreferees, as well as seminar participants and conference audiences for helpful comments. The paper is based on

my thesis chapter “Contractual Structures and Consumer Misperceptions – Warranties as an Exploitation Device.” I gratefully acknowledgefinancial support

from the Marie Curie Intra-European Fellowship FP7-PEOPLE-2013-IEF-623912, and from the Spanish Ministry of Economy and Competitiveness Grant

ECO2013-43011.

188 © 2017 Wiley Periodicals, Inc. J Econ Manage Strat. 2018;27:188–205.wileyonlinelibrary.com/journal/jems

MICHEL 189

its profits: at relatively low warranty levels,at which the firm optimally produces a low-quality product, naive consumers falsely

infer that the product is of high quality and are thus prone to overpay for it.

The following intuition applies. For any warranty offered, consumers ask themselveswhether it is more profitable for the firm

to produce a high- or low-quality product. Producing a high-quality product leads to higher production costs, while producing a

low-quality product leads to higher warranty costs as a result of more frequent product breakdowns. Naive consumers' misper-

ceptions of the return cost lead them to overestimate both the probability of returning a product after a breakdown and the firm's

warranty claim costs. Consequently, there existwarranty levels for which the trade-off in costs still makes the firm prefer to pro-

duce a low-quality product, whereas naive consumers believethat it is better for the firm to produce a high-quality product. These

consumers are willing to pay high-quality prices for low-quality products, which the firm can in some cases profitably exploit.

Our model provides an explanation for why naiveconsumers overpredict the quality of products and services in the presence

of warranty or product return options. In particular, we contribute to the existing literature by showing how firms can use

specific contract features as deceptive signaling devices to establish endogenous quality misperceptions in consumers whereas

both the product price and quality are salient items for them.3A firm can establish false consumer beliefs about product quality

through warranty signaling to profitably exploit these beliefs rather than only exploitingtime-inconsistent preferences via pricing

schemes. Thus, a relatively small deviation from full consumer rationality can already lead to endogenous consumer quality

misperceptions in a behavioral contracting setting. Specifically,our model implies that although some consumers underestimate

their return costs, they nevertheless rely on inferring the underlying product quality given the warranties offered in the event

of product breakdown. We see this as a weaker form of naivete compared to consumers always having full faith in a firm's

claims or advice. We find our main channel to be particularly applicable to manufacturers that directly sell their products to

consumers without the use of retailers and substantially advertise guarantees to signal high product quality. This applies to many

products sold via infomercials on TV, where the effects of reputation via repeated purchases play only a minor role. The model

relates more generally to cases of consumer illiteracy or neglect with respect to contract fine print.4

To support our main modeling assumptions, we provide detailed information on the contract structure of a knife set manu-

facturer that offers “lifetime warranties” and “30-day money back” policies via infomercials. The return policies are associated

with strong exclusion restrictions shown in fine print on the product web site: as a result of these restrictions, less than 50%of

the initial price is paid back to the consumer if a return claim arises. The warranty fine print states that a consumer has to pay

a fee per knife plus shipping costs for replacing faulty knifes. An underestimation of return costs in our model translates into

nonsalience of the additional costs or of the reduced benefits. Pairing the data on the firm's contract structure with customer

reviews for this product, we find that many reviewers anticipate neither the return costs nor the warranty and return exclusion

terms. Reviewers who do not anticipate warranty and money return exclusionter ms are likely to mention being surprised about

the low product quality and often perceive the product to be a “scam.” The effects are consistent with our quality-misperception

case. We further highlight how the observed patterns differ from the predictions in situations in which consumers are loss-averse

and thus pay relatively high insurance premiums relative to the exposed risk, see, forexample, Chen, Kalra, and Sun (2009) and

Sydnor (2010).

Section 3 presents our theoretical results by deriving the firm's optimal contracts for different market structures and by ana-

lyzing the consequences for consumer surplus. We first provide an analysis of the case in which a firm can only offer a single

product for the isolated case that only involves naive consumers. When the savings in production costs outweigh the firm's gains

in warranty revenues from selling a high-quality product with a high warranty level, the firm sells a low-quality product at a

high-quality price to naive consumers. In the opposite case, the firm makes use of naive consumers' return cost misperceptions

and sells a high-quality product together with a large and overpriced warranty.5In both cases, the firm fully extracts naive

consumers' predicted utility, which is higher than their expected consumption utility, thus leading to “exploitative” outcomes.

Consequently, the firm's profits are higher than when facing only “sophisticated” consumers who correctly assess return costs.

To understand how the profitability of the different profit channels is affected by the presence of sophisticated consumers who

correctly assess the market fundamentals, we proceed by characterizing a firm's contract choices when it faces both consumer

types and is able to offer multiple products and qualities. When the firm targets a high-quality product to sophisticated consumers,

this reduces the option to also profitably sell exploitative contracts to naive consumers. In particular, it only sells a high-quality

product to sophisticated consumers if the additional quality markup per sophisticated consumer reduces the lost exploitative

markup per naive consumer, which prevents naive consumers from becoming exploited. In any other case, sophisticated con-

sumers are only provided a low-quality product, which prevents the firm from having to pay “virtual rents” to naive consumers.

In Section 4, we show that although retail competition among multiproduct firms alwaysleads to zero firm profits, it cannot pre-

vent cases of consumer quality misperceptions and in some cases still leads to a negative expected consumption utility fornaive

consumers. Such a situation occurs if these consumers falsely infer high qualityfrom a competitively priced low-quality product

due to a sufficiently high warranty, whereas their willingness to pay for a low-quality product is lower than the product price.