Consumer Biases and Firm Ownership

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.

Ownership of the bank by its customers is a potential mechanism by which firms can commit to not exploit consumer biases. Since a mutual bank is owned and (at least nominally) controlled by its customers, it lacks an outside residual claimant with control over the firm. It will set a price schedule that is preferred by, say, the median customer, modulo agency costs between customer-owners and bank management. Mutuals thus charge lower penalties and, in a competitive market, must charge higher base prices than do for-profits to break even.

Our analysis suggests that policies that expand the share of mutual firms in markets in which consumer biases cause social costs or undesirable redistribution may be normatively attractive, even if, as some scholars believe, mutual firms tend to operate less efficiently than do for-profits. For example, policies that expand the role of credit unions in mortgage origination may reduce the opportunistic behavior of lenders vis-a-vis unsophisticated borrowers, which Bar-Gill (2008) argues has plagued the subprime mortgage market. Our analysis also provides a potential justification for regulators to disallow conversions of mutually-owned thrifts and credit unions to investor-owned banks.

In support of our theory, we present evidence that consumer contracts offered by for-profit firms differ from those offered by mutually owned firms in the markets for credit cards, deposit accounts, and mutual funds. We find the robust result that for-profit firms charge higher penalties than mutually owned firms and that their base prices are typically lower than mutuals. We also investigate whether consumers sort into for-profit, nonprofit and mutually-owed firms based on their perceptions of their biases, as our theory predicts. Using proxies for bias and proxies for perceptions of bias, we find that perceptions are a more important determinant of credit union membership than is bias itself.

While the evidence we present for our theory is confined to financial services markets, we think it is likely that firm ownership plays a similar role in attenuating the incentives of firms to exploit consumer biases in other markets, such as education and health care.

The full paper can be downloaded here.