Replacing subsidies with something worse?

For decades, the US cellphone operators have been addicted to handset subsidies. Like crack addicts, they know they should stop but they can’t. It’s a form of prisoner’s dilemma — it would be great if they all agreed to end them, but none want to make this move alone.

The good aspect of subsidies is they reduce the sticker price of handsets (typically by $200), spurring adoption of more capable phones. The bad aspects of subsidies are that they raise the cost of wireless service (to reclaim the subsidy) and mean that most users are on some form of contract, making it unlikely they’ll do anything about a new phone (or new carrier) for two years. The only exception to the two year lock-in is if consumers pay an “early termination fee” to recoup the subsidy.

More seriously, in Europe (where subsidies never caught on), consumers buy often phones independent of service. (Such third party sales in the US are estimated at less than 5%). This means a wide range of models and choices, which many in the industry believe encourages innovation. It certainly reduces the gatekeeper role that operators play in deciding what handsets consumers can and cannot have.

The transition could be wrenching. In Japan, where the government has been pushing to phase them out, they are blamed (rightly or wrongly) for declining sales this year. However, DoCoMo profits are up on the change, and more consumers have less expensive monthly plans.

Now, change may be coming from an unexpected source. As reported last week by the so-called “consumer” columnist in our local rag, cellphone subscribers who don’t like early termination fee are (as is common in California) taking it to court. Also as is common in the US, the case is being driven by lawyer greed, in hopes of winning class action status and pocketing millions (if not billions) in legal fees.

One such attorney has won the first round of such a case against Sprint, awarded (at least temporarily) $18 million class action damages for all California consumers. The decision is patently absurd, but given the next step is the wacky 9th Circuit Court of Appeals, who knows what will happen?

The most likely outcome is that early termination fees will be pro-rated, to match the payoff of the subsidy over time. This probably wouldn’t affect things much, other than to perhaps pull forward carrier switching by a few months. (It’s hard to see how any reading of the law could go further).

However, the new Obama administration is expected to create a more populist (i.e. interventionist) FCC. The FCC — as both rule-maker and rule-enforcer — gets to make up its own policies, and thus could conceivably ban early termination policies entirely. If so, handset subsidies would evaporate with the mechanism to pay them back.

For handset makers, this could provide an entree: those with innovative products that are underrespeented in the US (notably Nokia and Sony Ericsson) have the most to gain. Companies with weak recent offerings but strong US distirbution (Motorola, Palm) have the most to lose.

However, paying the full price of handsets, consumers would tend to favor cheap over expensive handsets. This could easily increase pressures towards commoditizing handsets, away from the $400-500 models like the iPhone and towards the mature, entry-level models like those from LG, Samsung and Sanyo. Companies at the high end of the market without entyr plevel phones (RIM, Apple) would be at risk, and presumably would be forced to offer a wide range of products (as Apple does today with the iPod) to keep consumer mindshare and market share.

The impact of banning subsidies would be even more traumatic for U.S. network operators, disrupting their standard business model of the past two decades.

Churn will certainly go up, and without contracts, carriers will face a dilemma of how to pay for their billions in advertising costs. (In its last full year of independent reporting, Verizon Wireless reported advertising expenditures of $1.2 billion in 2005). To cover handset costs, operators could look more like dealers, using handset exclusives — with healthy markups — to recover marketing costs. Will this eliminate most TV advertising — thus nullifying the economies of scale enjoyed by AT&T Wireless and Verizon Wireless? Or it will widen the gap between the Big Two and the also-rans?

Without subsidies, the overall tendency will be to blur the lines between prepaid and postpaid market. Both would favor cheaper handset models, but postpaid would offer cheaper buckets of minutes via bulk pricing.

It’s also possible (if however unlikely) that the new Congress or FCC would ban locking handsets to a carrier, as is (mostly) true in Europe. The issue was briefly a hot one when the iPhone first came up. Who knows, since the SCOTUS prefers European law to the US constitution, it could even happen via the courts.

The operators are hoping that the FCC will pre-empt state regulation to stop cases in state courts and the associated legal fees and potential damages. But the carriers should be careful what they wish for: it’s clear that the Obama FCC would block a pro-consumer ruling only if it simultaneously substituted another (perhaps more far-reaching) measure to regulate operators in the name of consumers.