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?