Transaction cost economics and privacy: looking at Hoofnagle and Whittington’s “Free”
by Sebastian Benthall
As I’ve been reading about transaction cost economics (TCE) and independently scrutinizing the business model of search engines, it stands to reason that I should look to the key paper holding down the connection between TCE and privacy, Hoofnagle and Whittinton’s “Free: Accounting for the Costs of the Internet’s Most Popular Price” (2014).
I want to preface the topic by saying I stand by what I wrote earlier: that at the heart of what’s going on with search engines, you have a trade of attention; it requires imagining the user has have attention-time as a scarce resource. The user has a query and has the option to find material relevant to the query in a variety of ways (like going to a library). Often (!) they will do so in a way that costs them as little attention as possible: they use a search engine, which gives an almost instant and often high-quality response; they are also shown advertisements which consume some small amount of their attention, but less than they would expend searching through other means. Advertisers pay the search engine for this exposure to the user’s attention, which funds the service that is “free”, in dollars (but not in attention) to the users.
Hoofnagle and Whittington make a very different argument about what’s going on with “free” web services, which includes free search engines. They argue that the claim that these web services are “free” is deceptive because the user may incur costs after the transaction on account of potential uses of their personal data. An example:
The freemium business model Anderson refers to is popular among industries online. Among them, online games provide examples of free services with hidden costs. By prefacing play with the disclosure of personal identification, the firms that own and operate games can contact and monitor each person in ways that are difficult for the consumer to realize or foresee. This is the case for many games, including Disney’s “Club Penguin,” an entertainment website for children. After providing personal information to the firm, consumers of Club Penguin receive limited exposure to basic game features and can see numerous opportunities to enrich their play with additional features. In order to enrich the free service, consumers must buy all sort of enhancements, such as an upgraded igloo or pets for one’s penguin. Disney, like others in the industry, places financial value on the number of consumers it identifies, the personal information they provide, and the extent to which Disney can track consumer activity in order to modify the game and thus increase the rate of conversion of consumers from free players to paying customers.
There are a number of claims here. Let’s enumerate them:
- This is an example of a ‘free’ service with hidden costs to users.
- The consumer doesn’t know what the game company will do with their personal information.
- In fact, the game will use the personal information to personalize pitches for in-game purchases that ‘enrich’ the free service.
- The goal of the company is to convert free players to paying customers.
Working backwards, claim (4) is totally true. The company wants to make money by getting their customers to pay, and they will use personal information to make paying attractive to the customers (3). But this does not mean that the customer is always unwitting. Maybe children don’t understand the business model when they begin playing Penguin Club, but especially today parents certainly do. App Stores, for example, now label apps when they have “in-app purchases”, which is a pretty strong signal. Perhaps this is a recent change due to some saber rattling by the FTC, which to be fair would be attributable as a triumph to the authors if this article had influence on getting that to happen. On the other hand, this is a very simple form of customer notice.
I am not totally confident that even if (2), (3), and (4) are true, that that entails (1), that there are “hidden costs” to free services. Elsewhere, Hoofnagle and Whittington raise more convincing examples of “costs” to release of PII, including being denied a job and resolving identity theft. But being convincingly sold an upgraded igloo for your digital penguin seems so trivial. Even if it’s personalized, how could it be a hidden cost? It’s a separate transaction, no? Do you or do you not buy the igloo?
Parsing this through requires, perhaps, a deeper look at TCE. According to TCE, agents are boundedly rational (they can’t know everything) and opportunistic (they will make an advantageous decision in the moment). Meanwhile, the world is complicated. These conditions imply that there’s a lot of uncertainty about future behavior, as agents will act strategically in ways that they can’t themselves predict. Nevertheless, agents engage in contracts with some kinds of obligations in them in the course of a transaction. TCE’s point is that these contracts are always incomplete, meaning that there are always uncertainties left unresolved in contracts that will need to be negotiated in certain contingent cases. All these costs of drafting, negotiating, and safeguarding the agreement are transaction costs.
Take an example of software contracting, which I happen to know about from personal experience. A software vendor gets a contract from a client to do some customization. The client and the vendor negotiated some sort of scope of work ex ante. But always(!), the client doesn’t actually know what they want, and if the vendor delivers on the specification literally the client doesn’t like it. Then begins the ex post negotiation as the client tries to get the vendor to tweak the system into something more usable.
Software contracting often resolves this by getting off the fixed cost contracting model and onto a cost-and-materials contact that allows billing by hours of developer time. Alternatively, the vendor can internalize the costs into the contract by inflating the cost “estimates” to cover for contingencies. In general, this all amounts to having more contract and a stronger relationship between the client and vendor, a “bilateral dependency” which TCE sees as a natural evolution of the incomplete contract under several common conditions, like “asset specificity”, which means that the asset is specialized to a particular transaction (or the two agents involved in it). Another term for this is lock-in, or the presence of high switching costs, though this way of thinking about it reintroduces the idea of a classical market for essentially comparable goods and services that TCE is designed to mitigate against. This explains how technical dependencies of an organization become baked in more or less constitutionally as part of the organization, leading to the robustness of installed base of a computing platform over time.
This ebb and flow of contract negotiation with software vendors was a bit unsettling to me when I first encountered it on the job, but I think it’s safe to say that most people working in the industry accept this as How Things Work. Perhaps it’s the continued influence of orthodox economics that makes this all seem inefficient somehow, and TCE is the right way to conceptualize things that makes better sense of reality.
But back to the Penguins…
Hoofnagle and Whittington make the case that sharing PII with a service that then personalizes its offerings to you creates a kind of bilateral dependence between service and user. They also argue that loss of privacy, due to the many possible uses of this personal information (some nefarious), is a hidden cost that can be thought of as an ex post transaction cost that is a hazard because it has not been factored into the price ex ante. The fact that this data is valuable to the platform/service for paying their production costs, which is not part of the “free” transaction, is an indication that this data is a lot more valuable than consumers think it is.
I am still on the fence about this.
I can’t get over the feeling that successfully selling a user a personalized, upgraded digital igloo is such an absurd example of a “hidden cost” that it belies the whole argument that these services have hidden costs.
Splitting hairs perhaps, it seems reasonable to say that Penguin Club has a free version, which is negotiated as one transaction. Then, conditional on the first transaction, it offers personalized igloos for real dollars. This purchase, if engaged in, would be another, different transaction, not an ex post renegotiation of the original contract with the Disney. This small difference changes the cost of the igloo from a hidden transaction cost into a normal, transparent cost. So it’s no big deal!
Does the use of PII create a bilateral dependence between Disney and the users of Penguin Club? Yes, in a sense. Any application of attention to an information service, learning how to use it and getting it to be part of your life, is in a sense a bilateral dependence with a switching cost. But there are so many other free games to play on the internet that these costs seem hardly hidden. They could just be understood as part of the game. Meanwhile, we are basically unconcerned with Disney’s “dependence” on the consumer data, because Disney can get new users easily (unless the user is a “whale”, who actual pays the company). And “dependence” Disney has on particular users is a hidden cost for Disney, not for the user, and who cares about Disney.
The cases of identity theft or job loss are strange cases that seem to have more to do with freaky data reuse than what’s going on with a particular transaction. Purpose binding notices and restrictions, which are being normed on through generalized GDPR compliance, seem adequate to deal with these cases.
So, I have two conclusions:
(1) Maybe TCE is the right lens for making an economic argument for why purpose binding restrictions are a good idea. They make transactions with platforms less incomplete, avoiding the moral hazard of ex post use of data in ways that incurs asymmetrically unknown effects on users.
(2) This TCE analysis of platforms doesn’t address the explanatorily powerful point that attention is part of the trade. In addition to being concretely what the user is “giving up” to the platform and directly explaining monetization in some circumstances, the fact that attention is “sticky” and creates some amount of asset-specific learning is a feature of the information economy more generally. Maybe it needs a closer look.
Hoofnagle, Chris Jay, and Jan Whittington. “Free: accounting for the costs of the internet’s most popular price.” UCLA L. Rev. 61 (2013): 606.