Contracts, Biases and Consumption of Access Services

Abstract

We consider a consumer consumption model that takes into account the valuation and demand uncertainties that consumers face while using access services. Typical examples of such services include extended warranties for consumer electronics, club memberships, and telecommunication services. Recent research shows that the consumer’s consumption is affected by the structure of the contract (i.e. two part vs. three part tariffs) although ex ante the contracts result in the same consumption and expected utility. This suggests that consumers experience biases while maximizing their utility from the consumption of access services. Identifying biases that derive this consumption behavior has important ramifications for marketing and optimal contract design. We study consumption models that take into account behavioral aspects of decision making and test these models with a set of laboratory experiments. We find that a majority of individuals correctly use a threshold policy, however they use their initial allotment of free units too quickly. These errors appear to be partially driven by mistaken beliefs about the value distribution that leads subjects to underestimate the value of future consumption opportunities. We also measure subjects’ willingness to pay for a contract with free access units, and we find that nearly half of subjects are willing to pay at least the full per-unit price, with a substantial fraction willing to overpay. The optimal firm strategy is therefore to offer a contract that presells access units at a very small discount; this strategy increases revenue by 8-15% compared to only offering a pay-per-use contract.