1. The Economics of Contract Law
Summer 2015
Eric A. Posner
University of Chicago Law School

2. One more slide on economics versus behavioral economics
The economics of pricing
The psychology of pricing:

3. Disclosure

6. Disclosure The common law of disclosure
The modern law of disclosure: The Truth-in-Lending Act
Disclosure from an economic perspective
Disclosure from a behavioral perspective
Normative implications

7. Disclosure What does disclosure mean? A few types:
Seller must reveal product features
Manufacturer must reveal product risks
House seller must reveal termites, etc.
Seller must reveal contract terms
Cross-collateral clauses, etc.
Buyer must reveal intentions

8. Common law of disclosure
Termites example
Seller must disclose termites in house
Seller need not disclose conditions that can be easily discovered
Geology example
Buyer need not disclose minerals in seller’s land
But Buyer may not engage in fraud
Balance between:
Allowing people to exploit information they invested in
Protecting people from transactions that injure them

9. Tort law and disclosure
Manufacturers may be held liable for failing to warn of the risks of using products
This has led to a proliferation of (unnecessary?) warning labels
See:

10. Modern disclosure law: contract terms
Typical example is complicated form contract; what is hidden (or not clearly described) are terms, not product features
Henningsen: the warranty limitation
Walker-Thomas: the cross-collateral clause
Brower: the cost, complexity, and difficulty of arbitration
Courts typically adjudicate these disputes by asking two questions:
How clear was the provision (or how surprising it was)?
How burdensome was it?
But there is a further question: can the consumer really understand the term, even if it is clear?

11. Truth-in-Lending Act Suppose you borrow $100. Which terms are better?
“5% monthly interest rate”
Annual Percentage Rate = 80%
“70% annual interest rate”
APR = 70%
The TILA requires not just disclosure of interest rate, but disclosure in a certain form: the APR.
The key idea is that disclosure is not enough. Disclosures must be standardized so people can make comparisons.

13. TILA Problems Credit card terms are multidimensional (Bar-Gill)
Interest rate
Late fees
Cash advance rate
Minimum payment
Credit ceiling
Annual fee
Frequent flyer miles
Many other clauses
For example, one case involved an issuer’s rule that it can raise the interest rate if the customer obtains credit from another company
APR rule does not capture all these dimensions, and might cause customers to neglect all these other terms

14. Example: Rossman v. Fleet Bank (not assigned)
Fleet Bank offered customers a credit car with “no annual fee.”
Rossman applied for the card and was accepted.
A few months later, Fleet announced that it was imposing a new fee of $35, effective for the next month
Fleet cites a “change-in-terms provision” in the card holder agreement, which allowed it to change any terms as long as it provides notice.
Issue: does the change in fee violate the TILA?

15. Court’s holding:
Not a violation to state a fee of $0 in contract and then later change it if the change was not contemplated.
However, “no annual fee” implies no annual fee for more than a trivial amount of time. Court holds that it implies at least one year. So Fleet violated this provision.
Fleet also acted unlawfully if it continued to tell new customers that there is no annual fee after it changed terms for existing customers. This is “bait & switch.”

16. Economics of disclosure
Benefits of disclosure
Buyers should be informed of terms/features so they know whether to buy
Costs of disclosure
Sellers may have trouble conveying information to buyer given limited time and means of communication
This implies that “full disclosure” is not optimal (or even possible)
But won’t sellers hide relevant features and terms that buyers care about?
And if they do, won’t buyers either refuse to buy (“adverse selection”) or end up buying things they don’t want?

17. Two standard responses to these problems
The skeptical buyer
Suppose you want to buy a used car and the seller doesn’t tell you about the maintenance record of the car
If you are a skeptical buyer, you will infer that the car has a bad maintenance record (if it has a good record, the seller would tell you in order to get a better price)
So you refuse to buy.
This will force the seller either to reduce the price or to show you the record.
This argument assumes that the buyer can anticipate (all?) possible problems with a product.

18. The informed minority (Schwartz & Wilde 1979)
Suppose most consumer do not read contracts
But a significant minority does
And sellers cannot distinguish between the majority and minority
Then sellers must offer efficient terms so as not to lose the minority; the informed majority benefits from the efficient terms
Therefore, disclosure regulation is not necessary
Q: how large must the minority be?
If it’s too small, sellers might not care about losing them
Seller balances the gains from exploiting the majority and the costs of losing the minority
Schwartz & Wilde estimate 20-30%.

19. Bakos et al. Bakos et al. seek to test the informed minority argument
Specifically, they seek to test whether the informed minority is large enough to matter
How do they do this?
They get access to a dataset constructed by an online research company
92,411 households agreed to install on their computers a data collection plug- in that records the URL addresses of websites visited
This shows sequence of web pages visited and amount of time spent on each page
Sample: 78 retail and 12 freeware companies

23. Psychological limits on disclosure (Loewenstein et al.)
Limited attention and awareness
Most people do not read disclosure statements (Bakos et al.)
Inattention to missing information (re: skeptical buyer argument)
People do not infer that cold-released movies are inferior
Motivated attention
People check their portfolios after the stock market rises, not after it falls
Biased probability judgments
Smokers overestimate risks of smoking; accurate disclosure could thus encourage smoking

24. Moral licensing Panhandler effects Spotlight effect
Advisers who disclose conflicts of interest give more biased advice
Panhandler effects
Advisees informed of conflicts of interest of adviser may try to benefit advisor (e.g., client of investment adviser)
Spotlight effect
In response to nutrition disclosure requirements, restaurants improve nutrition even though consumers do not pay attention to the disclosures

25. Implications Simplification Standardization
Simple categorical labels can help: e.g., a star for energy efficiency rather than a complex rating
But simple ratings can be misleading. A red light next to high-caloric items causes people to select the fattiest within the red-light items.
Standardization
APR example
Social comparison information
Utilities tell homeowners how their energy use compares with neighbors

26. Vividness In-person disclosure
Gruesome pictures on cigarette package labels work better than text alone
In-person disclosure
Mixed evidence
Disclosure by seller of buyer’s characteristics or average buyer’s characteristics (Bar-Gill)
Cell-phone usage
Frequency of health club use

27. “Libertarian paternalism” versus hard paternalism
Sunstein and Thaler advocate “libertarian paternalism” in Nudge:
Disclosure rules
Default rules with opt-out
The theory is that sophisticated people can do what they want, while unsophisticated people would be “nudged” in the right direction
However, might regular paternalism also be justified?
Taxes on fatty foods
New York rule prohibiting the sale of soft drinks in cups larger than 16 oz.
Prohibition on cross-collateral clauses
Usury ceilings
Restrictions on smoking