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The future of smartphone subsidies has been a frequent topic of conversation on Wall Street over the past year or two. Analysts have speculated that wireless carriers are unhappy about the subsidy model, where they must incur large up-front costs in order to attract (and retain) subscribers. Analysts have been particularly concerned that carriers will eventually refuse to subsidize Apple's (AAPL) iPhone by $400 or more, as they currently do. Obviously, there would be a great benefit to Verizon (VZ), AT&T (T), and Sprint (S) if they could maintain the same subscriber fees while cutting subsidy costs. However, it is one thing to say that the phone companies would like to reduce subsidies, and another thing to say that they will actually do so.

The problem for telecom companies is that they face a "prisoner's dilemma" scenario in the smartphone market. In game theory, the prisoner's dilemma refers to a "game" where the players are better off cooperating, but each individual can do better by "defecting" (i.e. not cooperating). The prisoner's dilemma is often illustrated by the following scenario: two suspects are placed in separate interrogation rooms. If the two prisoners "cooperate" by staying silent, the DA will only be able to convict them on a lesser charge, and they would go to prison for three years. If they each confess to the higher charge, the prisoners will get plea bargains of seven years. However, if only one confesses, he will be given immunity in exchange for testifying against the other (who will get a very heavy sentence of twenty years in prison). For each individual, it pays to confess regardless of what the other prisoner does (immunity vs. 3 years if the other prisoner remains silent; 7 years vs. 20 years if the other prisoner confesses)! The suspects thus both end up worse off (7 years in prison) than if they cooperated and remained silent (3 years in prison). Yet they cannot achieve the best collective outcome because of each individual's incentive to confess and offer to testify.

This stylized scenario has strong parallels to the situation confronting the major telecom firms today. The three largest U.S. telecom firms would obviously prefer to offer lower subsidies. However, customers have shown very clearly that they like the subsidy model. For example, Virgin Mobile has been offering a $30/month prepaid iPhone plan for unlimited data and text plus 300 minutes of voice (or 1200 minutes of voice for another $10/month) since June. The plan does not offer a phone subsidy, but can save customers $500 or more over the typical two-year contract of a postpaid plan. Nevertheless, this plan does not seem to have stunted iPhone subscriber growth at the Big Three whatsoever.

Therefore if one or two wireless carriers reduce subsidies, the others have a strong incentive to maintain subsidies and promote them as a differentiating factor in order to gain market share. If all three reduced subsidies simultaneously, most subscribers would probably resign themselves to paying more for their smartphone upgrades. However, the carriers are not permitted to collude (e.g. by signing an agreement to change pricing simultaneously). As a result, each individual carrier knows it could benefit from maintaining subsidies while other carriers raise prices; alternatively, raising prices while other carriers maintain their subsidies would result in customer loss and eventual profit declines.

The move by Sprint (and more recently, by T-Mobile (OTC:DTEGY)) to offer unlimited data as a differentiating point highlights the fact that competition between wireless carriers remains strong. Yet only a small percentage of smartphone users need more than 2 GB of data per month (a standard offering for capped plans at AT&T and Verizon). By contrast, almost every smartphone user takes advantage of subsidies to upgrade every two years or so. Therefore, like the prisoners in the "prisoner's dilemma" each individual U.S. telecom firm is better off maintaining subsidies regardless of what the others do, even though the Big Three could theoretically benefit by all cutting subsidies simultaneously. As users come off contract, many would switch to another carrier if it were cheaper to upgrade by doing so. This fact (combined with antitrust laws against collusion) makes it very unlikely that subsidies will be cut anytime soon.

Apple and other high-end smartphone makers thus do not have to worry about a sudden increase in pricing pressure. Telecom firms may wish they could cut subsidies, but the subsidy model is so deeply ingrained in the U.S. that it would be far too risky for carriers to drop subsidies. The "prisoner's dilemma" structure of the smartphone market discourages cooperation amongst telecom firms, and benefits device makers and (to a lesser extent) consumers.

Source: Why Phone Subsidies Are Here To Stay In The U.S.