Why Eliminating Handset Exclusivity Drops the Price of Cell Phones; or “How Is A BlackBerry Like A Pill?”

Back in February, I bought a Samsung Omnia and regretted it almost immediately thereafter. So when my touch screen finally died, I resolved to get a BlackBerry Curve 8330, as my wife has one and recommended it. Yes, she is on Sprint and I am on Verizon, but you can get the same model on both networks.

I was totally unprepared for the sticker shock. $450. Why? Because I was not eligible to buy new equipment. Did I want a replacement Omnia? No, I decided I really did hate my Omnia $450 worth. Out of curiosity, I asked how much it would cost if I were getting a new contract. Answer: $150, plus a $100 rebate.

Verizon claims here in policy land that this represents a subsidy, which they can only do if they have handset exclusivity. Mind you, this model is not actually exclusive, but let that go. Could it really be that Verizon subsidizes my phone $400? That seems an awful lot. So I decided I would look on Best Buy, assuming that it would represent the actual unsubsidized retail price. So I went to bestbuy.com and plugged in Blackberry Curve 8330. Sure enough, the price for the Verizon phone was $499, close enough to $450 to make Verizon’s subsidy claim feasible.

Then I noticed something odd. The same model phone, but for Alltel, cost $680, for Sprint, $750, and for MetroPCS, $400. Why should the same model phone, purchased at the same place, have such a wild swing in price? Remember, these are the prices without the subsidies for buying a new contract, so it can’t be the difference in what the companies chose to provide. The Best Buy price should reflect the unsubsidized retail price. The only difference, in theory, is the plan, (unless we are pretending to make the same model available to every provider and really aren’t). How could the wireless plan make such a difference?

Then it occurred to me where else I’ve seen this dynamic. Go to the drug store and you can see three people getting exactly the same prescription. But one pays $10, another pays $120, and the third pays $500. How is that possible?

Before elaborating below, I will first make it clear that I am rather short on critical data because most of the critical data is proprietary. So what I’ve got is a tentative hypothesis based on observed facts rather than something I can say with certainty. But it is enough for me to say: “Hey! FCC! Go and use your regulatory powers to get the providers to fork over the necessary data to see if I’m right.”

More below . . .

So how is my Blackberry like my prescription drugs? Answer: in both cases, the third party payer system warps the price structure. The result is that pricing is extremely irrational and the average consumer ends up paying more than he or she would pay in a standard system.

In health insurance, third party payers are the insurance companies. Each insurance company cuts its own deals with various suppliers, getting the discounts it can, then cuts a separate deal for a monthly plan payment with you (through your employer, usually). In addition to the monthly payments, you also potentially pay some subsidized rate for services which includes the volume discount (the thing on your statement that tells you what the provider charged your medical insurer) and your co-pay and deductible.

We have a similar dynamic in the wireless industry with handsets. Wireless providers negotiate with equipment manufacturers. They get a volume discount, offset by whatever they pay for exclusivity (if the wireless provider pays anything, some providers may agree to exclusivity just to get approved). The wireless provider then passes on the volume discount plus whatever additional subsidy to the plan subscriber.

Note some additional tweaks for wireless. Verizon doesn’t actually subsidize my phone $400. If I’m buying my $450 Curve with a subsidy, I get charged $150 and then get a rebate of $100 if I fill in the paperwork. I will then get back a little pre-paid credit card. Since many people do not send in the paperwork for the rebate, and many that do do not spend down their cards all the way, I actually credit this as a only a $50 average per phone rather than $100. And, of course, I have no idea what volume discount Verizon gets from Blackberry. So while I expect Verizon actually does subsidize my phone to some degree, it is not anything like the $400 subsidy claimed.

Impact On the Market As A Whole

OK, so Verizon isn’t spending as much out of pocket as it looks, but so what? They do some subsidy, which they claim they can only do because they get exclusives. How does this impact the market as a whole?

Lets start with the assumption that smart phones are like laptops in the sense of being a consumer electronic device, so this would appear to be the most relevant comparable market. In a standard market, big buyers like Wal*Mart or other box stores get volume discounts on consumer electronic goods based on the consumer market as a whole. This is a huge market, so economies of scale kick in. It is also a highly competitive market with relatively few bottlenecks. Result: Econ 101 works. Manufacturers make razor thin margins, several different sets of box stores compete and drive prices down overall (killing Mom ‘n Pop retailers with higher costs and lower volume, but that’s life), and prices get set according to a combination of cost and consumer demand with a dash of “what the market will bear” for trendy items with high mark ups. That’s why laptops range from reasonably cheap to pricey and functionality generally corresponds to price in a fairly transparent way.

Add a third party payer to the mix and things get much more complicated. Here, as in health insurance, you have several different complicated dynamics going on. For one thing, the largest wireless providers, like the largest insurers, get the volume discounts. But the discounts are not necessarily as great as if the box stores captured them because they do not deal with the same level of volume as the consumer market as a whole. Layer on top of that the individual decisions of providers to vary subsidy as a marketing strategy, and the fact that each contract with an equipment provider may include exclusives or other clauses that impact the price paid by the third party payer/wireless provider before they set a price for you.

Note that this means that smaller providers get crappier deals, and must either pay bigger subsidies (for the models they can get) or essentially charge a higher price for the same plan. If we care about smaller providers either from a competition standpoint, or because rural customers have far more limited choices of provider, this matters.

As if this weren’t complicated enough, the availability of the subsidy clouds the rest of the consumer market. The fact that I could get a phone for a different price depending on the plan makes me less likely to buy my phones from outlets like Best Buy, further minimizing the overall ability for consumers to capture the volume discount directly via consumer electronics outlets. As a result, to the extent there is a market in unsubsidized phones, the price is artificially inflated as compared to what people pay when getting subsidized. Again, this is similar to the dynamic in prescription drugs. Drug companies set the “base price” of drugs high in part to compensate for the fact that they will give deep discounts to the largest insurers. As a result, an uninsured patient pays much more than what they would pay if no one had insurance, because the “list price” before discount includes a mark up for the discount to the rest of the market (like the way stores used to raise prices before Xmass so they could give a Xmass discount).

So What’s The Harm?

At this point, all I’ve established is that pricing is irrational. By that I mean that pricing of handsets in the wireless market has much less to do with factors that make sense in Econ 101 — cost of production and demand — and much more to do with factors that have nothing to do with the actual cost of producing handsets. That makes it very difficult to identify harms with specificity, although the model does suggest some generalities.

The first harm is that anybody purchasing an unsubsidized phone, such as myself when I needed to replace the Samsung that I TOTALLY HATED, pays a much higher price than they would in the real world. It also creates some harms for smaller providers who can’t get volume discounts. If this were a standard consumer electronics market, the volume discount would come from the box stores like Best Buy so every consumer would have access to the same level of discount from their local box store or from online merchants regardless of what plan they used. With exclusives and the warping effect of third party payers, smaller providers get screwed twice — the selection of phones they can offer is drastically smaller than the selection offered by larger rivals and they pay significantly more for the phones they can get.

Possible Benefits?

So are there benefits to this scheme? Arguably, yes. If equipment price is a point of competition/differentiation, it is possible that consumers benefit by competition among providers for subsidy. Verizon’s decision to give my Curve a bigger subsidy (but only when I sign/renew a servic contract) because it perceives that this is a way to gain/retain customers puts pressure on other providers to increase the subsidy on their Curves (or equivalents).

The problem with this is that providers could compete on subsidy without exclusives. The whole notion of handset subsidies that get recouped by wireless providers locking me in to multi-year contracts goes back to the old days when the market was young. In the mid-1990s, phones were expensive and the value of mobile to consumers remained unproven. For most, cell phones remained a luxury, or an expensive emergency back up for when you got stranded somewhere without a phone. There was a valid argument that unless providers directly subsidized phones, they would be too expensive for people unsure whether this “mobile phone” stuff was worth it.

Those days, of course, are long gone. Cell phones have gone from being exotic and expensive items to being a consumer electronic device. Except that the legacy of older times and the ability of wireless providers to demand exclusives creates this bizarre 3rd payer dynamic.

So What Happens If We Eliminate Handset Exclusivity?

The largest wireless providers, particularly AT&T and Verizon, have claimed that without exclusives they could not afford to offer subsidies for cell phones and the price would rise enormously. If I’m right, ending handset exclusivity should result in an overall drop in price for handsets as box stores once again capture the volume discounts and share them with the market as a whole. The exception potentially being Verizon and AT&T customers, because those providers should be getting the steepest volume discounts under the current system. But the price rise for these customers should be relatively modest, not the full $400 extra I paid when I bought an “unsubsidized” phone. Furthermore, nothing prevents providers from subsidizing phones without demanding exclusives. If AT&T and Verizon see the phone subsidy as an important element of competition, they can still offer a subsidy on any new phone of any particular model you bring them. The phone manufacturers will still have incentive to negotiate for such rebates, because there is a clear advantage to Nokia or RIM if the major carriers offer rebates for new models of their phones. Meanwhile, the volume discount will be more evenly distributed in the usual way for consumer electronics.

What I’m lacking is good numbers on how the wireless providers get their discounts and what cut stores like Best Buy get. But I can’t access this information because it’s proprietary. On the other hand, the FCC can demand that network providers and manufacturers provide this information to them. When the FCC gets around to starting the long-promised inquiry into mobile handset exclusives, I will suggest this to them.

Stay tuned . . .

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10 Comments

  1. Jon Baker says:

    And really, what do you get from a Blackberry that you couldn’t get in a Palm Tungsten C, for $350, 7 years ago? The cost of electronics usually goes down with time, not up. Color screen, keyboard, radio (Palm had WiFi, this has cell radio), small computer – that’s a smartphone. There’s no reason it should cost $680 on the open market. $4-500, maybe. I’d really think more like $300. But since you have to buy it through this or that middleman, who wants their cut, it gets more expensive.

  2. EconoMuse says:

    Among subsidies, price discrimination, volume discounts, exclusivity and third party purchase problems, subsidy is the most important.

    A comparison is ink or toner cartridge refills which can easily cost more than the printer, but under effective competition, the latter cannot “subsidize” the former as part of a competitively priced package, the price that counts and would be driven to cost with normal profit (no economic profit).

    Once the subsidy is gone due to competition, so is price discrimination, where volume discounts are reflected in price as a cost variance. Exclusivity wouldn’t matter due to substitutes, nor would third party payers, such as health insurers who would sell insurance and not overpriced health care (the “discounts” are overpriced already, and the non-discounts are obscene).

    However, effective competition is absent in most of these cases, so the package price remains above economic cost due to various forms of market power, and that’s where the true source of a subsidy comes into play, the ability to raise price in one market in order to charge below market price in another, particularly when the objective is to lock in the customer from future choices.

  3. TheLongshot says:

    One aspect you didn’t address at all in this article is that handset exclusivity is one of the driving forces in customers changing carriers. Hanging out in wireless forums, I find it is a big motivation for some to switch. When you have phones like the iPhone, the Pre and now Droid, you are going to get people to move, especially if they aren’t satisfied with their selection.

    Also, I’m not sure if I agree with your theory about the effect of subsidies on smaller carriers. For example, Verizon heavily subsidizes their phones, but their rate plans tend to be pricey. T-Mobile’s subsidies tend to be lower, but so are their rate plans. One problem that I haven’t been able to figure out is the logic of why one phone goes to one carrier and another goes to another carrier.

    Ending exclusivity doesn’t solve the problem by itself. There is the problem of incompatibilities between networks. While Sprint and Verizon phones probably could be made compatible, they aren’t because of differences in software. I also don’t see the will for anyone to make compatible phones. (Tho, Sprint has made phones that run on both their Sprint and Nextel networks, so it is possible to do such things.)

    Things are a bit easier on the GSM side of things, but there is still the issue that AT&T and T-Mobile’s 3G networks use different frequencies. It is still an oddity that Nokia’s N900 will be compatible with T-Mobile’s 3G network, but not AT&T’s. Maybe they are aiming at an exclusive with T-Mobile, tho there hasn’t been any solid information that they will do it. Meanwhile, the unlocked version is on their way to retailers.

  4. Harold says:

    Longshot:

    You may be right that equipment differentiation is useful to the carrier, which is why they want to preserve it. The question to me, from a policy stand point, is whether that is a good consumer benefit. Does making this an adjunct to the carrier improve innovation? Does it lower price? I think in both cases, the answer is no. Equipment manufacturers have incentive to innovate in handsets if we eliminate exclusivities. Indeed, they arguably have more incentive, because they can capture more of the profit of innovation. My response to cost is, of course, the subject of the post.

    There is a third argument, which is that these are matters of private contract and it is inappropriate to meddle with them except under extraordinary circumstances. Even if we accept this as the general case (and I will agree it is a reasonable approach in a typical market), the problem with the wireless market, as I’ve discussed in previous posts, is that it is not very contestable. As structured, the wireless market has a limited number of competitors set by the need to acquire a government-issued license for spectrum use. IMO we therefore either eliminate spectrum licensing as a pre-requisite of using spectrum (not merely convert licenses into property, perpetuating the government monopoly) or we accept that wireless markets are not standard markets and require additional intervention.

  5. Subnumine says:

    You can pay two different prices for the same good, depending on whether you are being subsidized or not; Blackberry is receiving different prices for the same good, depending whether or not the Blackberry in question is part of Verizon’s bulk purchase or not (one of the things the FCC could usefully investigate is the actual cash flows there; is there a further subsidy, rebate, or drawback between Verizon and Blackberry?)

    This economic structure is not a market; there is no market price. It is not a market in order to inhibit A’s captive customers from losing their brand loyalty. Therefore (by Hayek’s definition) it is not free – some buyers are inhibited from dealing with some sellers.
    And the contracts being offered are constraints on trade; indeed, they change your position from a contracting party to the status of Omnia client. You can buy your way out (this time), but the direction of this road is clear.

    This is the classical prediction of the effect of subsidies; whether they are public or private subsidies is less important.

    Incompatibility between networks is not a new problem; it has always been dealt with by compatibility standards. Again, whether those standards come from Underwriter’s Laboratory or the FCC is a question of detail.

  6. Michael W says:

    Try this on for size. What if a few years ago some one said to you that you will be offered phone service, at majorly increased pricing than your current service. In addition you will lose the capability of multiple phones on a single line, the service will have intermitent lapses, drop the calls in mid sentence, have less flexibility than your current service and be restricted regionally. What you gain would be portability, gadgets on the phone itself and a loss of privacy. And the phones themselves would be priced in the hundreds of dollars range. Would you have bought into it?

  7. It’s not clear what problem you’re trying to solve here, Harold. In the net neutrality debate, I understand that advocates of increased regulation of Internet access concede that the system is working well today, and they want to ensure that it works well in the future as well. In the wireless handset business,the argument is apparently that the system is not working well today but that it would with a ban on contracts between operators and manufacturers. But these contracts have been a feature of wireless from the beginning, and are essentially a world-wide phenomenon. They’re especially important in the US because we have diversity in both technology (CDMA and UMTS) and in frequencies (T-Mobile’s 2100 Mhz AWS-2). Historically, operators had handsets made to order to fit their networks, and expanded on this system to compete with each other. People used to care a lot about which carrier they had, but now seem to be more interested in the handset; if you want an iPhone, you can get one, and anybody who complains about lock-in to a carrier other than AT&T made their choice well after the iPhone was introduced over two years ago, so what’s the problem?

    In our technically diverse environment, things are as they are. After the transition to LTE networks will be more uniform and portability will be more practical, but I don’t see why it’s a real concern today.

  8. Paul says:

    This is a nice analysis and it advances the debate quite about on subsidies and handset exclusivity. But toward the end of the post I had to laugh at this statement —

    “Handset exclusivity should result in an overall drop in price for handsets as box stores once again capture the volume discounts and share them with the market as a whole. The exception potentially being Verizon and AT&T customers…”

    Verizon and ATT customers are 60% of the market! So ending handset exclusivity will actually result in higher handset prices for 60% of the market, and lower the price for 40% of buyers? Why would government want to do that?

    That sounds like the FCC’s attempt at cable rate regulation in 1994 which resulted in 1/3 of all cable subs actually paying higher rates after the regs took effect (seriously – look it up).

  9. Harold says:

    Paul:

    This is a good point. My sense is it should be mitigated by the fact that neither AT&T nor Verizon can achieve the same volume discounts as Wal*Mart and Best Buy, because the percentage of the market they can hope to capture is smaller. Verizon can only give a manufacturer a subset of its own customers, whereas a large retailer offers a segment of customers of all providers. What is needed here are actual numbers provided by manufacturers and network operators so the FCC can make a determination.

    I also point out that the subsidy issue is only one point in the balance. The competition and innovation arguments are usually the first argument, to which the response is the subsidy argument. My analysis suggests the subsidy argument is overstated. All of this is balancing multiple factors.

  10. Brett Glass says:

    Harold, who gave YOU the right to mandate a balance of these factors that you like, rather than allowing the market to decide? There is no need for regulation here; the market is working.

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