Automatic‐renewal contracts with heterogeneous consumer inertia

Johannes Johnen

Journal of Economics & Management Strategy, 2019, vol. 28, issue 4, 765-786

Abstract: Automatic contract renewals are a common feature in consumer markets. Since these contracts renew automatically unless a consumer actively cancels, firms can use them to exploit consumer inertia. As a source of inertia I study limited attention and investigate how firms use contract renewal to sell to consumers with different degrees of inattention. In monopolistic markets, adverse selection of more‐attentive consumers limits the exploitation of naively inattentive consumers. When signing a contract, naively inattentive consumers overestimate their future probability to make an active cancellation decision. To exploit this mistake, the monopolist wants to target these consumers with large prices after contracts renew. These back‐loaded contracts, however, adversely attract more‐attentive consumers who cancel more often when choosing these exploitative contracts. To mitigate adverse selection, monopolists focus less on exploiting naively inattentive consumers. Adverse selection induces fewer consumer mistakes and can increase efficiency. I show that competition mitigates adverse selection, which induces firms to focus more on exploitation with more back‐loaded pricing. I discuss implications for recently implemented policies on automatic‐renewal contracts.

Date: 2019
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Working Paper: Automatic-renewal contracts with heterogeneous consumer inertia (2019)
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