Dr
Albert Sanchez Graells comments in one of his academic works “The economic analysis of law rests on the
position that behaviour will be desirable if it promotes social welfare in the
long run”.1 This
can well be related to lock-in v free exit contracts. With consumers moving
away from lock-in contracts to free exit contracts, it can be construed that
lock-in contracts have failed to provide consumer satisfaction which has
affected its desirability amidst social welfare in the long run. In this essay,
I aim to draw a clear distinction between the implications of lock-in and free
exit contracts, establish the optimal preference from the perspective of consumer
welfare and conclude by arguing whether a default rule can help get consumers
the best deal.

 

Contracts
are an integral part of the seller-consumer relationship as they have the
capability of moulding the relationship to a potentially long-term one. Exit
from such relationships has an ex post2
consumer protection risk which has not received adequate attention3,
however, efforts are being taken to curb abuses in the industry such as “In the Matter of Verizon Wireless Data Usage
Charges4”
and enactment of Credit Card Accountability Responsibility and Disclosure
(CARD) Act5
and the Dodd-Frank Wall Street Reform and Consumer Protection Act6.

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On the one
hand ‘lock-in with sticks’7
contracts have started losing consumer support, whilst, on the other side ‘lock-in
with carrots’8
type of contracts still manages to sustain abundant consumer engagement
regardless of exit penalties or early termination fees (ETFs)9 it
renders on consumers. “A salient
characteristic of attitudes to changes in welfare is that losses loom larger
than gains.”10
This quote gives a very competent argument for why consumers have lost their
support for ‘lock-in with sticks’ contracts but still manage to see ‘lock-in
with carrots’ contracts as a rewarding relationship due to the loyalty programs11 it
offers.

Consumers without
a perfect foresight fail to understand the ex-ante12 value
of exit. Rationally educated consumers comprehend the back-end high costs of exiting
the lock-in contracts, thus leaving themselves the flexibility and ability to
adjust to the new market conditions by not entering such contracts.
Unfortunately, some consumers get lured to the initial discounts that are
offered in the lock-in contracts and they fail to contemplate the rigidity and
exit costs that can deter their freedom to seek better deals. On the other
hand, perfectly informed consumers will be able to anticipate the total loss of
transaction via lock-in contracts as they reduce the ex-ante value of the
contracts.

It will be
right to say that the aim of lock-in with sticks contracts is to retain consumers
by the threat of exit penalties. Lured by discounts at first, consumers face
high bills and a quality drop as they proceed further on in the duration of the
contract. In order to explain it clearly, let us consider a hypothetical
contract example: Internet service provider company “A” offers a contract for
one year with first term payment being $80 and the payment for following term being
$120 with an exit penalty of $250 during the term time. Now, there is another
internet service provider company “B” offering same payments in both the terms of
$100 with no exit penalty (i.e., free exit contract).

Consumers
who do not have a perfect foresight into the ‘exit penalties’ will be allured to
enter into a contract with the company A due to the first term discount as the
only thing that will matter to them is cash-flow arrangement. For the consumer,
first term will be seen as a beneficial and a ‘good deal’ term, however, proceeding
to the next term, consumer may observe the quality drop and high bills. The
consumer may not be able to exit the contract due to over-compensatory exit
cost of $250 thus, rendering the freedom to receive better deals. This leads to
consumer dissatisfaction in the lock-in contracts.

Company
B, on the other hand, manages to retain consumers with free exit contracts by providing
high quality service and great consumer satisfaction. Free-exit contracts also
referred to as ‘No Contract’13
have thus enabled the consumers to terminate the services without suffering any
penalty charges according to their wish. The ‘No Contract’ policy is often
highlighted during advertisement by many entertainment companies such as
Netflix and NowTV. Free exit contracts have gained more consumer interest by
providing better services and no hidden fees or price rises. Consumers have
learned lessons from their experiences and are responding to the lock-in inefficiencies
in the market by entering into free exit contracts instead.

 

Sellers
have discarded the aim of ETFs which is to compensate them for the reasonable
loss they suffered due to an early exit. Sellers see exit penalties as a weapon
of incurring more profit rather than as a tool of compensating the loss of the
business suffered thereof. E.g.- In re
Cellphone Termination Fee Cases, 193 Cal App 4th 29814,
courts have called the ETFs an ‘over-compensatory liquidated damage’ and have
not supported the provision. Exit penalties are not the only tactics that are
played by sellers trying to deceive naïve consumers into entering the contract.
Where discounts are highlighted in the advertisements and on billboards,
important unattractive contractual terms such as exit penalties are written in
extremely small print letters that consumers miss to read. Courts have taken
measures against such practices in cases like Cheshire Mortgage Service v Montes et al. 15

 

An
important part of the economic theory is the theory of ‘switching costs’ that is
also related to ‘inertia’16.
Lock-in contracts become inefficient not due to the contractual switching costs
but due to the non-contractual switching costs. Switching costs only makes the competition
less effective17 because
it deters entry by new sellers. Consumers often underestimate the switching
costs and overestimate the rewards they receive. Non-contractual switching
costs makes the consumer welfare inefficient in lock-in contracts because it
takes away the flexibility of consumers to adapt to technology and learn the ‘learning
costs and switching time’18

On
average, consumers in free-exit contracts and lock-in contracts pay the same.
For instance, looking back at the example, consumer pays $80 + $120 = $ 200 in
the lock-in contract and $100 + $100 = $200 in free exit contract. This means
that in terms of finance, both the contracts are same to the consumer. This is
referred to as a “invariance”19 result.
Regardless of the invariance result, lock-in contracts affect the consumers
ability to choose the service provider. They will have to stick to one provider
for the contractual duration if they do not want to pay the exit penalty. Due
to inflation, the seller will keep increasing the price of the payments and
consumer will have no way out. Consumers fail to notice such provisions in the
contract as sellers often write it in a complicated equation so as to deceive
the consumers in a ‘clean manner’. If consumers did not enter a ‘lock-in’
contract, they would potentially have acquired the opportunity to switch to
another seller without incurring any exit penalties in term two. Consumer
welfare is rendered inefficient due to the inflating prices and rigidity in the
contract to switch to another provider.

1 A Sanchez-Graells, “Economic Analysis of Law, or
Economically-Informed Legal Research”, in D Watkins and M Burton (eds), Research
Methods in Law, 2nd edn (Routledge, 2017) ch 8, p 7, Available at SSRN: http://ssrn.com/abstract=2798193
(accessed 11 August 2017)

2 Robert B. Cooter Jr., Thomas Ulen, Law and Economics, 6th Edn,
51

3 Oren Bar-Gill, Omri Ben-Shahar, ‘Journal of Legal
Analysis’, Vol 6, Issue 1 ,152

4 Federal Communications Commission File No.
EB-09-TC-458, DA 10- 2068 (Consent Decree). The example has also been used in Above,
n.3, 151.

5 (123 Stat. 1734). The example has also been used in
Above, n.3, 151.

6 (124 Stat. 1376). The example has also been used in
Above, n.3, 151.

7 Above, n.3, 152

8 Above, n.3, 152

9 Above, n.3, 152. The short form ‘ETFs’ will be
frequently used in the essay.

10 Kahneman, Daniel & Amos Tversky, 1979, Prospect
Theory: An Analysis of Decision under Risk, Econometrica,
Vol 47, 279.

11 Loyalty programs include discounts, cash back and
other rewarding facilities for consumers. These are used in various industries
such as- ‘Frequent Flyer’ with an airline,

12 Above, n.2, 51

13 Above, n.3, 153

14 122 Cal Rptr 3d 726 (2011), rehg denied (March 24,
2011), review denied (June 15, 2011), cert denied, 132 S Ct 555, 181 L Ed 2d
397 (2011)

15 233 Conn. 80 (1992)

16 Ashvini Saxena, ‘Customer Inertia and its effect on
business’ (Thoughts on Entrepreneurship, Leadership and Motivation)

accessed August 8, 2011

17
Farrell, Joseph & Paul Klemperer 2007,
Coordination and Lock in: Competition with Switching Costs and Network Effects,
In Mark Armstrong & Robert H. Porter (eds.),
Handbooks of Industrial Organisation, vol.
3, ch. 31, Amsterdam Netherlands: North Holland, 2055

18 Above, n.3, 150-162

19 Above, n.3, 161