Cellphones and customer lock-in (literally)

In ECON100 we spend a whole topic looking at pricing strategy, which is a substantial departure from most microeconomics principles courses. Pricing strategy is important because it helps to explain why firms don't typically price at the point where marginal revenue is exactly equal to marginal cost (the point that would maximise profits for a firm selling a single product at a single price). We also look at non-price business strategies that are related to creating and capturing value (in other words, ways of increasing profits).

One of the areas we look at is switching costs and customer lock-in. Switching costs are the costs of switching from one good or service to another. Switching costs might include contract termination fees, but also include other costs such as the cost of searching for an alternative good, and learning how it works, etc. Customer lock-in occurs when customers find it difficult (costly) to change once they have started purchasing a particular good or service. Switching costs typically generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products.

Which brings me to this opinion piece by Juha Saarinen last month, which makes the case against telcos locking their customers in:

With that in mind, it seems a shame that SIM locking has reared its ugly head again.

This is a feature in GSM networks that allows providers to restrict or lock phones bought from them so that only their SIM cards can be used in them. The idea here is that telcos will "subsidise" phones - or on some plans, include it for no money upfront - but you have to stay on their networks.

Having to pay less upfront for phones is an attractive proposition for many, especially when it comes to expensive smartphones.

However, telcos are not charities and they make up for the cost of the device in usage charges over the time it is locked to their networks. You're not going to save money in other words, and likely lose out over time as better deals and plans come online.

Juha is describing the act of multi-period pricing, a common counterpart to switching costs and customer lock-in (and the reason why we discuss these things in a topic on pricing strategy). Multi-period pricing occurs where the initial price is low (to attract customers) and then the price is raised when the customers are locked in. Multi-period pricing only increases profits if the customer is locked in - if the customer is free to move to other providers, then when the price is increased they are likely to do so. There are lots of examples of multi-period pricing - one of my favourites is that it is a good explanation for why drug dealers give away free samples of their highest-quality (and most addictive) product.

In the case of locked mobile phones, the customer is literally locked in because the phone they are given for free (or heavily discounted) is unable to be used with any other network. The telcos are not dummies - they're doing this because it increases their long-run profits. They take a hit by giving away the handset at below cost, and make up for it through monthly plan charges from a long-term locked-in customer.

If that sounds a bit unfair or anti-competitive to you, then according to Juha you may be right:

You'd think that the Commerce Commission would frown upon telcos again trying to lock in customers with SIM locking to prevent "churn", or moving to other providers with more competitive deals, but no. The regulator has done a one-eighty on SIM locking lately.

"We don't believe SIM locking is anti-competitive. It's analogous to early termination provisions in post-pay contracts," a commission spokesperson told me.

"Customers have choices of buying handsets directly or honour some sort of undertaking if they accept a handset subsidy," the spokesperson added.

Those arguments are both flimsy though. First, a contract between a telco and a person or company doesn't stop customers from moving to other providers.

Sure, you'll have to honour the contract or pay termination fees (which can be exorbitant), but you can use your phone on another network if it's compatible with it.

Let's say Telco A's service in your area is bad but Telco B is good; you need phone service and will bite the bullet and switch providers. With an unlocked phone, you can.

I have to agree with the Commerce Commission here. While on the surface locking customers into a long term relationship sounds anti-competitive or unfair to the customer, the customer is still free to choose not to purchase from the provider offering a locked phone and to go with another provider (even if it means being locked into purchasing from the other provider instead). The only difference is that this mobile phone lock-in is technological rather than contractual. But the customer need not be locked in - they could purchase the phone at full price and not have a locked phone (or be locked into a contract with termination fees) at all. They would then be free to change provider at will.

Another key point is that owning a locked phone doesn't stop customers from moving to other providers - it only stops them taking their phone to another provider. If the customer wants out of their contract and they are willing to pay termination fees, then probably they are willing to purchase a new phone to get out of a locked phone. The $30 cost to unlock the phone (quoted in the article) hardly seems excessively prohibitive alongside the contract termination fees which might be hundreds of dollars, depending on the phone. I don't see the issue here. As for customers who want to change because of poor service in their area, perhaps they should have looked at the quality of service in their area before purchasing the phone, locked or otherwise.

In this last bit I think Juha misses the point:

Large multinational telcos can use their market power to hammer out exclusive deals with phone makers and offer handsets to customers at low initial cost, provided they agree to be locked in over a period of time.

They can also offer network features and services exclusively to locked-in customers - and refuse to connect customers who have bought handsets directly. Telcos may also be tempted to offer plans with more expensive local and roaming rates to customers who bring their own handsets so as to steer them towards locked ones with better deals for calling, texting and data.

So, customers can get phones cheaper as a result of exclusive deals between the telcos and phone makers? The horror! As for telcos offering their locked-in customers features and services not available to those who aren't locked in, this sounds like a good deal for both the customer and the telco. The customer will be made better off (than going with some other provider without a locked phone) provided that the extra features and services are more valuable to the customer than the freedom to change provider. The telco will be made better off because this incentivises more customers to lock themselves into using their service.

Customer lock-in and multi-period pricing are a legitimate tool for increasing profits, and can actually make both the customer (who can get a better phone earlier than if they had saved up for it) as well as the telco better off. Having said all that though, as a customer it pays to think carefully about the total cost of the phone plus the monthly plan charges over the locked in period - is it worth it?

Could technology eliminate moral hazard in car insurance?

A couple of weeks ago, Bloomberg reported that car insurers are offering discounts to insured drivers who agree to have the equivalent of aircraft black boxes installed in their cars:

Smartphone applications and devices that record trip and vehicle data are set to infiltrate auto insurance at a rapid pace, bolstered by discounts of as much as 30 percent. Consultancy Oliver Wyman forecasts that car insurance using driver data to set prices will grow 40 percent a year to become a $3.6 billion market by 2020.

Why would car insurers do this? You can be sure it isn't out of the goodness of their hearts, so there must be something in it for them.

One thing that the insurers are trying to do is to overcome moral hazard - the tendency for someone who is imperfectly monitored to take advantage of the terms of a contract (a problem of post-contractual opportunism). Drivers who are uninsured have a large financial incentive to drive carefully and avoid accidents, because if they have an accident they must cover the full repair cost themselves (not to mention the risk to life and limb). Once a car in insured, the driver has less financial incentive to drive carefully because they have transferred part or all of the financial cost of any accident onto the insurer (though the risk of injury remains, of course). The insurance contract creates a problem of moral hazard - the driver's behaviour could change after the contract is signed.

Now, car insurers aren't stupid and insurance markets have developed in order to reduce moral hazard problems. This is why we have excesses (deductibles) and no-claims bonuses - paying an excess or losing a no-claims bonus puts some of the financial burden of any accident back on the driver and increases the financial incentive for driving safely. This is also why driving illegally usually voids an insurance policy.

However, despite these contract 'enhancements' moral hazard remains a problem for car insurers. The problem remains because the insured drivers' driving behaviour isn't able to be perfectly monitored by the insurance company - they don't know if you're driving safely or not (that is, the asymmetric information about your driving behaviour remains).

This is where new technology comes in. If a black box is installed and the insurance company has ready access to the collected data, then there is little information asymmetry remaining as drivers won't be able to hide their misbehaviour from the insurance company. Now, the black box doesn't let the insurance company know who is driving the car, but since the insurance company is really insuring the car and not the driver it matters little since they should price the insurance policy on the way the car is driven. If your cars turns out to be consistently driven in a risky manner, then you can expect a higher insurance premium to compensate the insurance company for the higher risk. So, the moral hazard problem will be reduced (but not eliminated - there is still an incentive for insurance fraud, and now a new incentive for tampering with the black box).

What's to stop the risky drivers from simply opting out of having a black box? That way, the insurance company wouldn't be able to tell they are driving unsafely, right? Wrong. Since the black box comes along with a premium discount for those who install it, low-risk drivers have an incentive to have the black box installed - they needn't be worried that the insurance company will find out that they are low risk (but they might be worried about the security of their driving data being held by insurance companies!). High-risk drivers want to avoid the insurance company knowing they are high risk, so are less likely to agree to having the black box installed. So, the low-risk and high-risk drivers sort themselves in a way that is advantageous to the insurance company - it helps the insurance company overcome the adverse selection problem.

The adverse selection problem arises in car insurance because the uninformed party (the insurer) cannot tell those with 'good' attributes (low-risk drivers) from those with 'bad' attributes (high-risk drivers). To minimise the risk to themselves, it makes sense for the insurer to assume that everyone is a high-risk driver, and price their premiums accordingly. This leads to a pooling equilibrium - low-risk and high-risk drivers are grouped together because they can't easily differentiate themselves. However, the black boxes solve this problem by causing the low-risk and high-risk drivers to separate themselves in terms of who agrees to have a black box installed (a separating equilibrium) - the low-risk drivers will choose to install the black box, while the high-risk drivers will not.

The insurance companies have also chosen an interesting way of framing this option for consumers. They could have described it as higher premiums for high-risk drivers, but instead they frame it as a discount for those who install the black box. On the surface, this makes it sound a lot more attractive to consumers, since a 30% discount for installing the black box probably seems a whole lot better than a 43% penalty for not installing the black box (even though they are mathematically equivalent). However, it would be interesting to see how drivers would respond to framing this the other way (a penalty for not installing the black box). We know that people are loss averse, and more willing to avoid losses than they are willing to receive equivalent gains - so framing it as avoiding a penalty might actually encourage more consumers to install the black box, as consumers try to avoid the penalty. On the other hand, insurance companies prefer to insure low-risk drivers, so attracting new insurance contracts with low-risk drivers by enticing them with a discount is probably a better move overall. Either way though, moral hazard is likely to be reduced.

Dealing with squealing children at least cost

Paul Little wrote an interesting Herald on Sunday column the week before last, about squealing children:

Spare a thought in your charity for the residents of Stonefields, an "urban village" at Mt Wellington where, among other things, the "planting of pohutukawa trees along the boulevards, mimics the original lava flows", a market includes "substantive family restaurant and other dining/takeaway options" and parks provide "for a range of passive and active recreational spaces".

The planning and design of the joint appears exemplary. Unfortunately, it didn't allow for the people.

Such as those who have been complaining because those parks' recreational spaces are just a little too active.

As resident Alan Gilder says: "The park is awesome but they haven't put a lot of thought into it - the flying fox generates a lot of squealing.

Squealing. How awful, but how true. Where there are children there will likely be squealing.

And where there are flying foxes there will almost certainly be a lot of squealing.

If there is a sound more aggravating than that of children enjoying themselves then I don't know what it is.

Now, squealing children is a classic negative externality - an uncompensated impact of the actions of one party on a bystander. The poor residents of Stonefields face a cost that is imposed on them by the unscrupulous actions of the children. Since the children have no incentives to take into account the costs that they are imposing on the residents of Stonefields, they generate too much noise compared to the socially efficient optimum.

How can the externality problem be solved? One option is government intervention, as Paul explains:

What to do? Perhaps the residents could crowdfund a shush monitor - someone in attendance with a decibel reader who could hiss "shush" at the children when the squealing reached a certain level.

A "shush monitor" is an example of a command-and-control policy. The local government puts in place a limit on the allowable amount of noise, and when that noise is exceeded the nasty noisemakers can be sanctioned - perhaps by fines, or sending them to bed without dessert. If the noise level consistently exceeds the limit, the playground could be closed. No more negative externality.

Now, this solution follows from what is called the "polluter pays principle". Under this principle, the party that is responsible for the pollution is solely responsible for making restitution for the damage they cause. Since the children are causing the noise pollution, they have to pay the cost of making things right. Even if that means closing the playground. So, the cost of reducing the externality in terms of foregone fun could be pretty high.

There is an alternative to the polluter pays principle. Instead of making the polluter pay, we could try to solve the problem of the externality at the least cost (maybe we call this the 'least cost principle'). Instead of closing the playground at the cost of lots of fun times (which would be an ongoing cost, since fun would be lost every year that the playground is not there), perhaps the government could soundproof the houses that are next to the park? That would be a one-off cost, and likely a lower cost in total than the lost fun.

Of course, maybe no government-based solution is required at all. The Coase Theorem tells us that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention). In the case of a bargaining solution under the Coase Theorem, it depends crucially on the distribution of entitlements (property rights and liability rules). Do children have the right to play and make noise? If so, then the residents would have liability to pay the children to be quiet - maybe buy them a bunch of Playstations and send them indoors to be quiet. Either that, or the children can just keep having fun in the playground and making as much noise as they like. On the other hand, do the residents have the right to peace and quiet? If so, then the children would have liability to compensate the residents for the noise of their playing. Either that, or they have to give up the playground.

Probably the right to peace and quiet prevails - in New Zealand homeowners have the right to quiet enjoyment of their property. So, the children will have to compensate the Stonefields residents for their excessive squealing. Or will they? The residents of Stonefields chose to live close to a park, and the cost of the negative externality will be factored into the price of the houses (if squealing children makes houses in Stonefields less desirable, then houses there will consequently be cheaper). So, you could argue that the residents of Stonefields have already been compensated for the negative externality, which has been incorporated into the price of housing (at no additional cost to the children). In which case, the residents should just suck it up or move somewhere quieter.

Are sex services in Russia a Veblen good?

The Moscow Times reports (emphasis added):

In the Urals, sex workers have raised prices by between 50 and 100 percent, Uralpolit.ru said Wednesday, citing unnamed clients of prostitutes.

In addition to the falling ruble, the sex tariff inflation may have been boosted by an influx of sex workers fleeing war-torn Ukraine, the website said. The new competition is forcing local sex workers to hike their rates in order to pay their bills, the report said.

So, there is an increase in the number of people supplying sex services (because of the influx of Ukrainian sex workers), and that leads to an increase in the price of sex services? Only if the demand curve is upward sloping. Otherwise, an increase in competition should lead to a decrease in the price (after all, this is one of the reasons that competition is argued to be good for consumers).

Could the demand curve for sex services be upward sloping? It seems unlikely, but there are some types of goods where the demand curve is upward sloping. One of these types of goods is Veblen goods - luxury goods where the price is a signal of the high status of the purchaser. In this case, when the price goes up people the good is an even more powerful signal of high status, and so consumers who are seeking status demand more of the good. To show their high status, the purchasers then want to broadcast their purchase to many people (especially those who are close to them in actual social status) - this is conspicuous consumption, otherwise the signal is worthless. That doesn't seem a particularly likely scenario for sex services. Neither are sex services consistent with other types of goods that have upward-sloping demand (Giffen goods, goods with network effects, goods with bandwagon effects).

More likely, Uralpolit.ru and the Moscow Times have demonstrated temporary economic illiteracy. Increased supply doesn't increase prices. On the other hand, inflation does increase prices and that is what is being observed.

[HT: Marginal Revolution]