Negative option contracts and consumer switching costs.

• Author: Phillips, Owen R.

1. Introduction

   A negative option contract is an agreement by which a buyer accepts a flow of goods from a vendor until the buyer notifies the vendor otherwise.(1) In the finance literature |10~, a negative option contract would probably be referred to as a negative call option. The contract gives the holder the right to refuse buying the good or service, but the holder does not have to exercise this right. The trade literature argues that negative option contracts were pioneered by the Book-of-the-Month Club more than 60 years ago |2~. Book Club members agree to accept, with the right of refusal, a selected book every month until they opt out of the Club. A similar method of marketing is common in the recording industry through tape and compact disk clubs. It is estimated that 10 million consumers in the U.S. belong to a negative option club of some sort |8~. These contracts are legally binding in all states if the consumer signs an agreement that starts the flow of deliveries. Book, recording, and video clubs have thrived with the added feature of "prenotification" for the next unit of delivery. This itself is a negative option. Just before the next delivery the consumer is given the option to refuse the good, usually by mailing a postcard. If the vendor is not notified, delivery is forthcoming. Prenotification gives the consumer control over the bundle of goods ultimately received. Consumers can self-select components of the bundle and the bundle size.(2)

   Certain negative option plans have come under public scrutiny. Recently Tele-Communications Inc. (TCI) attempted to sell its cable subscribers the Encore channel as a negative option contract. All subscribers were to receive the channel unless TCI was notified otherwise, and all subscribers would pay a monthly charge for the service unless TCI was notified otherwise to discontinue the service. The first negative option was unacceptable to most consumer advocates. State attorneys in Florida, Iowa, Pennsylvania, Texas, and Washington, to name just a few of the public opponents, brought suit against TCI. They argued the service must be initiated as a positive option; consumers must explicitly give permission to begin the service flow. Eventually TCI capitulated to this protest. The channel was supplied only upon request, but service continued thereafter as a negative option |16~.

   A less visible controversy has arisen over local Bell telephone companies providing inside wire maintenance as a negative option. For a small charge per month, usually less than $1.00, the Bell company agrees to service and repair telephone wiring within the customer's premises. These maintenance contracts were initiated as both a negative option in some regions and a positive option in others. Interestingly, under a negative option, for example in the Rocky Mountain region, about 75% of the customers did not deny the service and so received it. In the Northwest where a positive option was required to begin the service, about 75% of the telephone customers did not respond and so did not receive it. Marketers attribute this kind of behavior to consumer inertia, but there are other explanations. One being the existence of close substitutes to the service in both regional markets. Assuming there are, the full cost of responding has the same impact in both markets.

   Negative option contracts for telephone wire maintenance in the Rocky Mountain states prompted a civil antitrust suit. Gordon C. Ham, et al. vs. Mountain Bell (Colorado case No. 87CV23146) brought a class action suit against Mountain Bell. The 1987 complaint argued that Mountain Bell primarily through negative option contracts had attempted to monopolize the telephone wire maintenance market in violation of section II of the Sherman Act and Colorado antitrust laws. Mountain Bell had approximately 75% of this "market". New entrants were blocked from the market because of the already existing contracts, which had no explicit termination date. The complaint continued to argue that the telephone company had intended to erect a barrier to entry with its negative option agreements, and that entry would be much easier and maintenance contract prices lower without the negative option. This case has been settled out of court, and some compensation is being paid to the certified class |5~. Mountain Bell, though, continues to employ the negative option as a marketing device for other services. Recently they have asked customers to take one free month of call waiting service. If accepted, the service is billed to the customer after the one month until Mountain Bell is notified otherwise.

   For those agreements like the book clubs an important feature of a negative option contract is the legal right to return an unacceptable unit of the product flow. The right has a price, because there is at least a transaction cost of return that buyers must pay. This is a switching cost that is paid when consumers choose to change or reduce the components of the bundle supplied by the seller over some period of time. A second switching cost arises if the buyer decides to end the product flow. Now the buyer seeks to exit the contract with the vendor. These costs are usually transactional, but may include contract penalties. They represent a barrier to entry to potential sellers, because consumers will be reluctant to pay these switching costs if, at best, they view the product of the entrant as a close substitute to that currently provided. Both types of switching costs are studied in this paper.

   In a two good world this paper begins with a model of consumer equilibrium behavior when sales of good X are made through a negative option contract. In section II the model shows that when it comes to the buyer selecting and the seller supplying components of a product bundle, a negative option agreement can be Pareto superior to a positive option contract. Hence negative option contracts appeal to both the buyer and seller and thus explains why this method of marketing is pervasive. Next, in sections III and IV of this paper, there is a discussion of how a negative option can raise the costs of potential entrants. The argument is that if customers pay an exit or switching cost to dissolve the contract with the incumbent firm, a two-part tariff is forced upon the potential customers of the entrant. The incumbent may have control over this switching cost, so it can be endogenous. These sections show that a profit maximizing entrant will pay part of this cost for the consumer if a switch is made. Section V concludes the paper with a discussion on the public policy of negative option contracts.

2. Negative Options and the Product Bundle

   The consumer in this model agrees to accept units of a good under either a negative or positive option contract. The utility of these contracts is compared. The total quantity purchased by the consumer is not explicitly decided by either the positive or negative option contract, because the consumer may return the good at some cost under the negative option, or not request some units if the contract has a positive option. Specifically, there are two goods X and Y, where Y is a composite good, and X is sold under a negative or positive option agreement. The negative option contract is patterned after the contracts in a book or recording club. The consumer agrees to take delivery of |X.sub.S~ units (which may be specified by the buyer) with the option of returning the delivered item. The explicit return or switching cost may be quite low, because many negative option plans notify by mail the item is on the way and will be delivered unless the vendor is notified otherwise by mail.

   The model's notation is now introduced:

   |P.sub.Y~ |is equivalent to~ price of the composite good Y.

   |P.sub.X~ |is equivalent to~ price of good X.

   M |is equivalent to~ income of consumer.

   |X.sub.S~ |is equivalent to~ quantity of good X delivered under the negative option contract.

   |X.sub.R~ |is equivalent to~ quantity of good X returned under the negative option contract.

   |X.sub.T~ |is equivalent to~ |X.sub.S~ - |X.sub.R~; quantity of good X consumed.

   |P.sub.R~ |is equivalent to~ switching cost or price of returning one unit of good X. This amount is equivalent to the cost of placing an order under a positive option contract.

   The negative option contract specifies that the consumer is sent |X.sub.S~ units with the option of returning any item. The contract may specify that the consumer...