Thursday, May 31, 2007

The Market for Default Rules

Is it true, as the “libertarian paternalists” claim, that the law must necessarily establish default rules for contracts and other transactions? On the one hand, yes; the law must decide what was “really” agreed to in the event of a dispute. On the other hand, numerous everyday transactions rely on default rules established by common practice, and the law traditionally just ratifies those rules. More importantly, these market-selected default rules often seem to reflect awareness of the need to correct errors of judgment.

For example, Sunstein & Thaler apparently favor legal cooling-off periods for certain consumer purchases, which would allow customers to change their minds and reverse their transactions later. Without the legal cooling-off period, would consumers lack that option? On the contrary, thousands of everyday consumer purchases include an implicit cooling-off period. How many times have you returned clothing that you realized didn’t fit after all? How many times have you returned a gift that wasn’t ideal? For a wide variety of products, the market-determined default rule is that you may return them – for either cash back or store credit – as long as you do so within a given time period and still have the receipt.

Note that the default rule is occasionally suspended, such as when a sale rack has an “all sales final!” sign. Moreover, the default rule isn’t the same for all products. As consumers, we understand that certain products carry an implicit all-sales-final clause. As Jerry says in an episode of Seinfeld, “I don’t return fruit. Fruit is a gamble. I know that going in.” And I suspect most buyers of fruit follow the same rule. Why? Because fruit is perishable, and because fruit sellers lack the ability to guarantee precise levels of quality. These factors raise the cost of providing a return option. Underwear is another mundane item that often carries an all-sales-final clause, for (I hope) obvious reasons.

For some large purchases, like cars, the default rule (except in states that have already adopted a mandatory cooling-off period) is again all-sales-final. The natural reason is that potential losses from wear-and-tear before the return are relatively large and often unobservable (how do we know this customer didn’t ride hard on the gear shift?).

It’s apparent, then, that there is a market for default rules. If the default rule were all-sales-final for every single product, we might assume (with Sunstein & Thaler) that people just aren’t thinking carefully enough, and that sellers are just taking advantage of unwary customers. But the diversity of default rules tells a different story: at least at the margin, there are enough customers who care to make the default rules responsive to their needs (as well as relevant cost factors).

And if that’s true, then newly adopted legal defaults don’t merely fill an unavoidable gap at zero cost, as would be true if one default were as good as any other. They displace existing defaults, chosen by market participants, with new defaults chosen by the paternalists. Even if you can opt out of the new defaults, the legal mandate places an additional burden, though hopefully a small one, on choosing the market default. The burden is notably higher if opt-outs are limited or banned altogether.


Anonymous said...

I learned somewhere (though I can't remember where) that the free return of retail goods was traditionally the exception rather than the rule in America, and it wasn't until the widespread adoption of the UCC (which explicitly changed the default rule) that permissive return policies became common.

I can't remember where I learned this so I might be mistaken - maybe one of your readers is knowledgable about this history.

Glen Whitman said...

Anon -- interesting, I hadn't heard that. If true, then it does weaken my argument (though the existence of systematic exceptions for certain products still demonstrates that defaults respond to market conditions). I see this post just got linked on Volokh; maybe some of the legally savvy blog readers from that site know the real history.