Mandating Information Disclosure vs. Banning Deceptive Contract Terms

Economists are very into the idea of mutually beneficial exchange. The standard argument is that if two parties voluntarily agree to a deal, then they must be better off with the deal than without it, otherwise they wouldn’t have agreed. And if the terms of that deal don’t harm any third parties,* then the deal must be welfare-improving, and any regulatory restrictions on making it must be bad.

One objection to this argument is that it’s not always clear what is and what is not “voluntary.” I once has a well-published economist friend argue that there are no gradations of voluntariness: either a deal was made under some kind of compulsion or it wasn’t. I asked him if he would be OK letting his then pre-adolescent son make any schoolyard deal he wanted as long as it was not made under any overt threat, and I think (but am not totally sure) that he has since backed off this position. So there is an argument for purely paternalistic restrictions on freedom of contract.

Another objection, one which economists tend to take more seriously, relates to information. Specifically, there is the idea that maybe one party to the contract is not fully informed about its terms. For this reason, many economists are willing to entertain policies by which firms are required to disclose certain information, and to do so in a way that is comprehensible to consumers. So for example we now have “Schumer boxes” that govern the ways in which credit card companies present certain information in promotional materials. This seems to many people to be a reasonable remedy: if the problem was that one side of the transaction was ignorant, then a regulation that eliminates that ignorance, while at the same time not interfering with their freedom to engage in mutually beneficial exchange, must be a good thing.

I think this reasonable-sounding position is largely wrong. The standard asymmetric information stories with rational agents are stories in which the uniformed party knows that it is uninformed, which influences the contract terms that it is willing to accept, which in turn either causes beneficial exchange not to happen (the “lemons” problem) or causes contract terms to be distorted away from the efficient ones. They are generally not stories about uninformed consumers not understanding that they are uninformed and blithely marching into traps as a result. But this is what we actually see all the time, one party tricks the other party into unfavorable terms. Indeed, very often this is the real-world problem to which providing better information is supposed to be the solution! But for trickery to be the problem, you usually need a model in which some agents suffer from some limitation on their rationality, such as myopia.** And if you have that, then you have a different problem from the problem of asymmetric information, and there is no particular reason for a different problem to have the same solution. If the problem is that people are getting tricked, then providing more information is only going to help if it is going to cause them not to be tricked, and it is not at all obvious whether and when this will be the case.

But there is a bigger problem with the standard way that economists usually think about these problems, which is that they completely ignore the fact that when people are being tricked, the virtues of voluntary exchange are absent and so there is no reason for a strong presumption against interfering with it in the first place. And sometimes the very existence of certain contract terms is an indication that the contract is a trick. Think about the controversial terms often found in credit card contracts, such as provisions by which being one day late with a payment or being one dollar over your credit limit jumps your interest rate to 29.99% forever, or in which cards with multiple balances at different interest rates pay off the low rate balance first. What should be inferred from the fact that these terms exist? Is it at all plausible that there is some subtle but very important reason why these terms must be present, and that if they were banned lots of mutually beneficial deals would not be made? Is it not much more likely that that these terms exist precisely because many consumers don’t understand them and will be tricked by them? Have you ever heard of such terms being in contracts negotiated between sophisticated parties? Shouldn’t this cause you to be much less worried about the consequences of simply banning them?

There is a very good paper by Gabaix & Laibson (2006) that provides a formal model in which firms “shroud” relevant information in order to trick myopic agents. The neat thing about their paper is that they show that this persists in equilibrium: competing firms turn out to have no incentive to march in and expose the shrouding and offer transparent pricing instead. But you don’t need a fancy (and recent) paper to have known that the aforementioned terms in credit card contracts are only there to trick people. And if that’s true, then what you really want is to get rid of contracts with those terms. Mandating information disclosure is only a good remedy insofar as it causes those terms to disappear. Gone is the economist’s notion that the right solution is to make sure everyone knows the score and then to step out of the way. If you mandated disclosure and then saw those contracts continuing to exist, the conclusion you should draw was that the disclosure was ineffective, not that the terms were efficient.

One could object to heavy-handed regulation on the basis of a slippery-slope argument. While there are some clear-cut cases like the credit card contracts, a government with lots of regulatory power, even a well-intentioned one, may end up getting overzealous and interfering in ways that will have unintended and negative consequences for efficiency. And Gabaix & Laibson take pains to point out that they are not advocating lots of regulation. Whatever the merits of this argument (I understand the fear of regulatory overreach but worry about it less than a lot of other people do), the main point of this post remains. There are important instances in the world we live in where the unaware simply get tricked and screwed. That is not, at root, a problem of asymmetric information among rational agents, and there is no reason to think that the appropriate remedy is the same as if it were. More importantly, in this world the virtues of voluntary exchange are absent, and so the economists’ deference to it is misplaced.

There has been an important real-world development on this front. It seems that the Federal Reserve did a bunch of consumer testing to see how well people understood various terms in credit card contracts under different disclosure requirements, and concluded that they were simply too complicated for most people to understand. They therefore decided to go ahead and simply prohibit certain practices. Which I say is good news for the good guys.

*A weaker version of this condition is that any third parties that are hurt are hurt less than the contracting parties are helped.

**I say “usually” because there are a few special models in which fully rational agents can nevertheless be tricked.