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Are Handset Subsidies Good for Carriers and Consumers?

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Are Handset Subsidies Good for Carriers and Consumers?
May 25, 2010
By Gary Kim, Contributing Editor


Some observers think U.S. consumers would be better off if all handsets were sold unbundled, at full retail, instead of being discounted and bundled with a service contract. Ironically, handset subsidies actually harm carriers, in financial terms, despite the strategic value.

First quarter results at MetroPCS Communications illustrate just how high a cost the subsidies represent. In its most recent quarter, net income plunged 48 percent year-over-year to $22.7 million on account of a 30 percent year-over-year increase in operating expenses directly attributable to high handset subsidies and costs related to introduction of new rate plans.

NTT (News - Alert) DoCoMo announced earnings for its fourth quarter of 2009 that show the Japanese operator more than doubled year-over-year profits, which the company attributed to its decision to slash the amount it pays to subsidize handset sales.

NTT cut operating costs by 7.6 percent and as a result, DoCoMo's net profit rose from $365.6 million to $802.1 million for the fourth quarter.

The company attributes a rise in network services sales and more revenues from handset sales for dramatically increased operating profits. Operating profits jumped from $895.7 million to $1.3 billion.

Financial analysts likewise have been questioning AT&T (News - Alert) executives over the past couple of years about the impact of Apple iPhone subsidies on AT&T's operating profits.

The point is that, at a very real level, both carriers and consumer advocates can agree that multi-year service contracts, necessitated by handset subsidies, are an irritant or harmful to welfare.

At the same time, there is clear evidence that handset subsidies are responsible, especially early in the product lifecycle, for boosting consumer demand for, and access to, the latest handset models and new services.

In fact, there isn't much evidence that consumers actually prefer the 'no contract, no handset discount' approach, at least in the U.S. market, and historically in the Japanese and Korean markets as well.

There is, on the contrary, some clear evidence that carrier handset subsidies harm mobile service provider profits, even though they might continue to be a 'necessary evil.' That's the irony of the demand for an end to handset bundling with contracts: carriers actually would arguably be better off ending the practice, in some respects.

But the matter is complicated for one salient reason: under current market conditions, subsidies likely are required to spur adoption of smartphones, which in turn drive key data revenues.

On this one point both opponents and proponents of an end to handset subsidies (which is what unbundled handsets represent) can agree on: handset subsidies 'harm' users and carriers, at some real level.

Of course, the situation is more complicated than that. It is not so much the handset subsidies but the contracts that some consumer advocates oppose.

And it is not so clear which 'evil' carriers actually would prefer. Handset subsidies have to be recouped, and carriers get their money back from the service contracts, which create a customer relationship for enough months to pay for the device discounts carriers have provided. So one line of thinking is that contracts would not be necessary if subsidies were not a cost to be recovered.

On the other hand, smartphone penetration would plummet if users had to pay the full cost of the latest models, upfront. And carriers benefit from higher smartphone penetration, as users presumably do. The carrier benefits range from higher average revenue per user to an increase in crucial data revenues to offset declining voice revenue. Users presumably benefit from ability to use more advanced services and features, in some cases also avoiding the need to pay for comparable fixed line services.

Also, despite the financial drag handset subsidies impose, carriers likely would see an increase in churn and marketing expense if contracts and handset subsidies were ended.

Most European markets are handset-centric in a sense that the handset and the mobile service are only loosely bundled. Japan and Korea are more service-centric as consumers buy the service and handset together, and the operator has a stronger role as a handset channel.

In economics, the law of demand indicates that there is a relationship between the price and the quantity demanded of a handset, or subscription. As the price is lowered, more people are willing to purchase, and the quantity increases. That's why handset subsidies represent an 'upside' for both providers and users: they get access to new devices, features and services faster than would be the case if there were no discounts.

One might also suppose that elasticity (think of it as the sensitivity of demand to a promotion) is higher for subsidized 'premium' services than for 'basic' service. People in the past realized they 'needed' a mobile phone, and texting. They have not, until recently, 'needed' mobile email or Web access. So far, one might argue that there has been high elasticity of demand for subsidized smartphones.

Most would agree that bundling of service with handsets, typically with a subsidy, has enhanced adoption of advanced services.

As a general rule, subsidies are likely most effective earlier in the product life cycle than later in the cycle, as there are fewer customers to attract, no matter how high the subsidies might be. That suggests subsidies can be lowered for older devices and application use cases.

In other words, older model basic phones require fewer subsidies, in part because they are less costly.

At some level, smartphone subsidies, in particular, are a 'necessary evil.' Ironically, though there is some logic to consumer opposition to contracts, contracts are the 'necessary evil' to subsidize smartphones, and both carriers and end users gain from rapid smartphone adoption enabled by cheaper handsets.

Contracts perhaps are the lesser of two evils. Consumers don't like contracts. Carriers don't like subsidy costs. But contracts bundled with subsidized handsets arguably are better for both carriers and users.

Gary Kim (News - Alert) is a contributing editor for TMCnet. To read more of Gary's articles, please visit his columnist page.

Edited by Kelly McGuire

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