The Option Value of Contract Terms
Giuseppe Dari-Mattiacci is Professor of Law and Economics at the University of Amsterdam. Florencia Marotta-Wurgler is the Boxer Family Professor of Law at the N.Y.U. This post is based on their recent article Learning in Standard-Form Contracts: Theory and Evidence, published in the Journal of Legal Analysis (2023).
When a firm offers a warranty on its products, it may turn out that consumers claim it more often or in ways that are different than the firm expected, and that the firm may have to backtrack and remove the warranty from its standard form contract. This apparent failure, we claim, has a positive side. The firm has in fact experimented with the warranty and, as a result, has learned its true costs and can now take a better-informed decision on whether to keep offering or terminate the warranty. In 2018, LL. Bean announced to its customers that it had realized that its famous lifetime warranty was being abused and cost too much to the firm, and hence would be terminated, although it had been in place for a century.
Firms that offer the warranty are, in fact, buying what it is called a “real option”: the option to decide anew after learning. Crucially, if the firm had not offered the warranty to start with, no learning would have taken place and hence the decision to revise or continue with the existing warranty would have been based on the same information in its original choice. The firm would have had no reason to revise it.
The option value of offering the warranty arises because the firm learns asymmetrically: it only learns if it offers the warranty. This option may push the firm to choose the “learning modality” of the term—offering rather than not offering the warranty—more often than short-term considerations would suggest. By doing so, the firm exposes itself to the possibility that the term will have to be revised at a later time, thus paving the way for a change in contract terms.
Asymmetric learning is not a general feature of all contract terms. Some terms only result in symmetric learning: firm learns regardless of whether it offers the term. There is no option value in those terms. For instance, a term in an End User License Agreement (EULA) that allows the licensor to transfer the licensee’s information to third parties is likely to yield the same information in the future as a term that does not allow the licensor to do so. In this case, the firm chooses which modality of the term to implement based on the expected costs and benefits without considering the value of acquiring information.
As a result, all else equal, symmetric-learning terms are equally likely to be revised later, irrespective of the modality selected initially. In contrast, asymmetric terms are more likely to be revised at a later stage if the firm chose to offer the term in its learning modality. Our theory explains both why firms revise some terms more than others, and why some terms are sticky, and others change often. Our predictions are consistent with an empirical analysis of a large sample of changes in business and consumer standard-form contracts over a period of seven years, and with interviews we had with the in-house council of several large and small firms.
Cite as: Giuseppe Dari-Mattiacci & Florencia Marotta-Wurgler, The option value of contract terms, LAW AS SCIENCE: LEGAL METHOD LAB (Sept. 30, 2023), www.lawasscience.org/legal-method-lab/the-option-value-of-contract-terms.
