This post comes from Ryan Bubb of Harvard University.
This week in the Law, Economics, and Organization Seminar at Harvard Law School I presented my paper Consumer Biases and Firm Ownership (joint with Alex Kaufman). In the paper we examine the role of firm ownership in mitigating incentives of firms to exploit consumer biases. Recent work has explored the implications of behavioral biases among consumers and has documented that profit-maximizing firms exploit consumer biases in the contracts they offer consumers. This behavior can result in substantial social costs as the resulting contracts distort decision-making from the social optimum.
In the paper we show how ownership of the firm can be used as a commitment device to avoid using contracts that exploit consumer biases. In particular, if customers of the firm own the firm, as in a consumer cooperative, or if the firm has no owners, as in a nonprofit, then firm managers have less incentive to offer contracts that exploit consumer biases. We thus identify a “governance strategy” of shaping the incentives of firm management through assignment of ownership of the firm, rather than a regulatory strategy of dictating contractual terms or processes, as a way to reduce the social costs that result from consumer biases.
As a paradigmatic example, consider a bank that offers credit card services to consumers. Because of the complexity of the contractual relationship between banks and their customers, consumers have trouble understanding all of the charges, penalties, and other payments they are obliged to make to the bank under their credit card contract in various contingencies, such as the penalty interest rate that applies if they fail to make a minimum payment on time. Furthermore, many consumers have self-control problems that lead them to trigger commonly charged fees and penalties. Consequently, investor-owned for-profit banks have a strong incentive to charge high fees and penalties. The use of penalties in credit card contracts can persist even in competitive markets, since banks simply compete on the salient, easily observable and understood features of accounts (e.g., the introductory interest rate and rewards programs), and then cover their costs through penalty income.