Crazy Cell Phone Contracts for Crazy Americans

Would you rather pay $399 now and $20 a month for two years, or $199 now and $30 a month for two years? If you are a rational consumer, you probably prefer the $399 deal. The other one is like a $200 loan at 20% interest.

And yet, according to a long and meandering article from yesterday’s New York Times on the madness of cell phone pricing schemes, we wacky Americans preferred the iPhone at $199 with a $30 data plan over the previous deal of $399 with a $20 plan. I’m not sure I buy that. iPhone sales could have increased for a number of reasons, including the fact that the $199 phone was an upgraded version. Still, the Times piece does bring up a number of peculiarities about the economics of cell phones.

In case you live in a cave, I’ll explain that here in the Land of the Free we "buy" heavily subsidized cell phones from the companies who run the cell phone networks and in exchange agree to a service contract with that network, generally for two years. The cell phone company takes a loss on the phone and makes it up on the service end.

Even within our complex consumer culture, that’s a fairly unique way to pay for something. It would be like Exxon selling cars at a big discount if you promised to buy their gas at $5 a gallon. The closest analogue I can think of is the classic razors/razorblades or printers/printer cartridges strategy.

But that’s not quite the same thing. When you buy a printer you are not contractually obligated to buy a certain number of ink cartridges. You can stop using the printer any time you want. And the manufacturer is banking on the assumption that you will underestimate how many cartridges you will buy in the future.

With cell phones, you know how much you will be forced to pay over two years. That means it should be very easy to work out what a phone will cost in total. So why bother with the subsidy and contract thing?

(The Times says what I thought to be true, that this is a uniquely American method and that those sensible Europeans buy phones like any other electronic gadget and pay for service separately. I mentioned this to the German teenager who lives in my house and she looked at me like I had two heads. Turns out, Germans buy subsidized cell phones on contracts too.)

I think that we pay for cell phones the way we do because of a combination of convention and mental accounting. Cell phones are phones, after all, and as we all know, you pay for phones monthly. Comparing an ongoing monthly expense to a lump sum requires the use of math and some knowledge of finance. Yuck.

And it’s not just the math. We don’t like moving things from one mental bucket to another and changing from monthly to lump sum just upsets the way we think about our money. For example, ask yourself this: which has more appeal, investing $1000 in a CD that paid 4% or $1000 in new appliances for your home that would save you $3.50 a month in utility bills? The appliance deal is a little better, but not as attractive to most people because swapping savings for lower ongoing payments isn’t something we like to do.

This only scratches the surface of the oddities of the cell phone business. The Times also mentions, but does not really discuss, consumer preferences for buying a maximum number of minutes rather than paying for actual use and the fact that providing cell phone service on the margin costs essentially nothing. It does not even bring up how or why ATT will give you a phone for free by charging you $50 and rebating that back in the form of a gift card.

The article did have one disturbing tidbit. The average American cell phone user sent 518 text messages a month in the first half of this year. That’s more than 17 a day. Average. I’ve never felt so old.

Economics, Media | Frank Curmudgeon | November 16, 2009 12:59 pm

No Comments

By Neil, November 16, 2009 @ 4:05 pm

Hardly a uniquely American problem. Everywhere I’ve spent time, there’ve been these sorts of cell phone deals. Their popularity varies a lot by country, and the US is unusually prone to buying them.

Still, I can understand it. When I trade money today for reduced future payments, I need a pretty quick payback period. Switching to a prepaid cell phone took only 3 months to recover my costs, so was completely worth it. I had, however declined the same deal a year earlier (when it first became available) because of the penalty for breaking my existing contract made it take 10 months to recover my costs.

And finally, your appliance example is a poor one. The extra $2 per year that your theoretical person is saving comes at the cost of liquidity, so the CD’s “premium” is completely rational.
By Rob Bennett, November 16, 2009 @ 4:14 pm

The people trying to sell us stuff understand well that emotion dominates in money decisions.

The people who give us money advice assume rationality in most of the guidelines they offer.

Many bemoan the fact that we save and invest so ineffectively.

Rob
By TFB, November 17, 2009 @ 1:56 am

I still prefer $1,000 in a CD than $1,000 in new appliance because the appliance depreciates much faster than cash. After 5 years, I still have $1,000 whereas the $1,000 appliance will probably be worth $300.
By Phil, November 17, 2009 @ 6:03 am

The appliance buying analogy applies to readers of your site – not most Americans who would opt charge to a credit card some shiny new gadget vs save any day.
By kosmo @ The Casual Observer, November 17, 2009 @ 9:55 am

I won’t argue with your logic, but your interest rate is wrong. $200 now vs. $10 a month for 24 months is not 20% APR
By Frank Curmudgeon, November 17, 2009 @ 10:11 am

Sorry. I meant 18.5%. Which is a little like 20%.
By kosmo @ The Casual Observer, November 17, 2009 @ 10:49 am

The 20% extra you’re paying (240 vs. 200) is split over TWO years. So the APR is half that.
By Frank Curmudgeon, November 17, 2009 @ 6:38 pm

Well, no. The “loan” is paid off over two years but it’s half gone after a year or so, meaning that the average balance over the period is about $100. A $200 loan at 18.5% will amortize at $10 a month over two years. Try it in Excel.
By Kosmo @ The Casual Observer, November 17, 2009 @ 9:38 pm

Lol. I stand corrected. I was using simply TVM rather than amortization/annuity. Guess it’s a bad Monday for me. Er, Tuesday
By TJR, November 18, 2009 @ 6:02 am

Turns out those Germans *can* buy phone and service separately, and it is becoming increasingly popular to do so. The plans are often called “Pre-paid”, “Mobilfunk-Discounter” etc.

Turns out those Belgians even cannot get phones subsidised by law.
By MJM, November 18, 2009 @ 6:11 pm

While your math in general may be accurate, once you factor in the present value of your payments, you’re only saving $30 (@1%), so the decision is not as “crazy” as you point out.
By zach, November 19, 2009 @ 2:11 am

After spending a year living in Sweden, I can tell you that there is an option for a contract and when Telia landed the iphone exclusively, people had to get it at a 2-year contract. My girlfriend at the time worked for Telia.

That aside, I found like myself, that a large part of the population uses the prepaid phone. Oh and their service makes the US look third-word. All incoming calls and messages are free. like 2cents for everything out and 5cents to land..What’s att doing 25cents? 10 if you prepay enough minutes?

But that is also why residents there get 100mb internet connections for 1/4 the cost of verizons BRAND NEW 50mb FIOS network!!!
By Amanda Bidyes, November 23, 2009 @ 11:48 am

The phone company makes the profit as soon as you pay $200 for an Iphone. I have a phone with maximum minutes, I pay monthly and got the phone for free. A touch phone.
Anyway, about buying the phone with the loan. I guess some people just want to have the phone and can’t pay the full amount up front. Goot for them.
By Attorney, December 15, 2011 @ 1:02 am

The reason many European countries don’t offer the service contract for discounted cellphones have to do with the anti-trust laws there. In America, two companies can cooperate to have their products “packaged” together if they are related to each other. Ie: cellphones and mobile phone services. In Europe, the antitrust laws are stricter in many nation states so this would be deemed illegal tying.
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