Sunday, March 04, 2007

Cell Phone Pricing

I was recently surprised when our cell phone bill -- usually around $55 -- hit over $400. What had happened? Turns out that, like most cell phone plans, we had a certain number of "free" minutes (actually, closer to 7 cents per minute when divided into the fee for the plan), but if you go over the limit, it jumps up to 45 cents per minute. We had gone over the limit that month. A lot.

Why are cell phones priced this way?

I think the answer stretches back to the polymath Frank Ramsey and to a lesser-known article by Ronald Coase ("The Marginal Cost Controversy").

The problem with cell phone service (as with other network industries and intellectual property) is that it has high fixed costs and low marginal costs. Thus, if prices are set at marginal costs, the firm will never recover the fixed costs, and will be unable to survive.

One solution to this problem is a two-part system of pricing -- one set of prices for access to the system, and another set of prices for usage (or usage above a certain level).1 This is described by Kenneth Train, in his 1991 book from MIT Press, Optimal Regulation: The Economic Theory of Natural Monopoly2:
When access demand is fixed, the optimal access/usage tariff consists of a usage charge equal to the marginal cost of usage and an access fee that is sufficiently high to allow the firm to break even. First-best optimality is achieved. This is called the 'Coase result.'
This isn't quite it, of course. The access fee for cell phone usage is comparatively low, while the usage charge for going over the limit is 45 cents per minute -- far above marginal cost.

But wait:
When access demand is price sensitive, the optimal access/usage fees are determined by the Ramsey rule. Usage is priced above its marginal cost . . . and the access fee is lower than it would be if access demand were fixed. Second-best optimality is attained.
That's it. That's what is going on with cell phone pricing.

Ramsey's theory was that industries with high fixed costs can recover those costs by charging relatively more to those users with relatively higher inelasticities of demand. Put that together with the Coase theory, and you get cell phone pricing: Low access fees to draw in users with lower demand, and higher usage fees to recover more from the users who are less concerned with price.3

1See also pages 83-84 of Mitchell and Vogelsang's Telecommunications Pricing: Theory and Practice (recommending "discriminatory two-part tariffs").

2Quotes are from Chapter 7. The entire book is actually online here.

3Not that this is me or my family: The pricing system in use now has our full attention, and over-usage won't happen again.


Blogger Mobile Phones said...

Is there a relationship to insurance here? For instance, I buy insurance to cover possibilities. If I opt out of certain possibilities, then I wind up bearing the brunt of the costs based on my inability to foresee or plan for certain eventualities. It’s a gamble, in other words. The same essentially holds true for cell phone usage. If I believe that I will only be talking for 100 minutes each month, I am forecasting certain limits on my usage. If it turns out that my wife is suddenly hospitalized (to mix the two metaphors a bit), and I need to make lots of calls to relatives to let them know, then I am liable based on my inability to forecast correctly. The end result for the phone company, as for the insurance company, is that people by and large feel that they must buy more than they need in order to feel secure. And this means that phone companies, like insurance companies, do make a profit on fixed minute cell phone plans, since those plans will generally involve more minutes than a person will use.

6:28 PM  
Anonymous Anonymous said...

Why do you suppose that land lines did not stumble upon this sort of pricing earlier? Traditionally long distance, for instance, was done with a bottom-line pricing system of a certain price per minute. In fact, in general I’m interested in what has happened in terms of business structure between land lines and cell phones. It seems like almost from the very beginning cells were subject to very different pricing plans. Why? Is this shift somehow connected to the way we use cells, and if so what exactly is the difference – less infrastructure to finance, the integration of functions other than phoning? Is it a matter of more competition in the market? Or, as you suggest, is this at root the result of cell phone companies simply recognizing that a new model would be more cost-efficient?

11:48 PM  

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