Microsoft Word - BarGill-post

Harvard Journal of Law & Technology

Volume 23, Number 1 Fall 2009

MOBILE MISPERCEPTIONS

Oren Bar-Gill and Rebecca Stone



TABLE OF CONTENTS

I. INTRODUCTION................................................................................51

A. Three Design Features...............................................................51

B. Rational Choice Explanations?..................................................53

C. Welfare Costs.............................................................................54

D. Market Solutions and their Limits .............................................55

E. Policy Implications.....................................................................57

II. THE CELL PHONE AND THE CELLULAR SERVICE MARKET ............59

A. The Rise of the Cell Phone.........................................................59

1. Technology..............................................................................59

2. History.....................................................................................60

3. Economic Significance............................................................62

B. The Cellular Service Market......................................................64

1. Structure ..................................................................................64

2. Competition.............................................................................65

3. Related Markets.......................................................................69

a. The Handset Market ............................................................69

b. The Applications Market......................................................72

III. THE CELLULAR SERVICE CONTRACT............................................73

A. Three-Part Tariffs ......................................................................73

B. Lock-In Clauses..........................................................................75

C. Complexity.................................................................................76

1. Postpaid Plans — The Basics..................................................76

2. Family Plans............................................................................77

3. Add-Ons ..................................................................................78

4. Phones and Lock-In Clauses ...................................................78

5. Prepaid Plans...........................................................................79

IV. EXPLAINING THE CELLULAR SERVICE CONTRACT .......................80

A. Three-Part Tariffs ......................................................................80

1. A Behavioral Economics Theory ............................................80

 NYU School of Law. We thank Jennifer Arlen, Adi Ayal, Lucian Bebchuk, Kevin Da-

vis, Clay Gillette, Michael Grubb, Raghuram Iyengar, Lewis Kornhauser, Florenica Marotta

Wurgler, Rick Pildes, Howard Shelanski, Phil Weiser, and workshop participants at NYU

and Tel-Aviv University for their helpful comments and suggestions. We gratefully ac-

knowledge the financial support of the D’Agostino/Greenberg Fund at NYU School of Law.

Michael Biondi, Osnat Dafna, and Paul McLaughlin provided outstanding research assis-

tance. We thank the Center for Customer Relationship Management at Duke University for

letting us use its Telecom Dataset.

50 Harvard Journal of Law & Technology [Vol. 23

a. Theory..................................................................................80

b. Data... ..................................................................................82

2. Rational Choice Theories and Their Limits ............................87

B. Lock-In Clauses..........................................................................90

1. A Behavioral Economics Theory ............................................90

2. Rational Choice Theories and Their Limits ............................93

C. Complexity.................................................................................94

1. A Behavioral Economics Theory ............................................94

2. Rational Choice Theories and Their Limits ............................96

V. WELFARE COSTS............................................................................96

A. Three-Part Tariffs ......................................................................96

B. Lock-In Clauses..........................................................................97

C. Complexity.................................................................................98

D. Countervailing Benefits?...........................................................98

VI. MARKET SOLUTIONS ....................................................................99

A. Catering to Sophisticated Consumers........................................99

1. Unlimited Calling Plans ........................................................100

2. AT&T’s Rollover Minutes ....................................................101

3. Prepaid Plans.........................................................................102

4. Graduated ETFs.....................................................................103

5. Open Access..........................................................................104

B. Market Solutions and Consumer Welfare ................................104

VII. POLICY IMPLICATIONS ..............................................................105

A. Existing Regulations Affecting the Cellular Service

Contract.................................................................................105

1. Who Can Regulate?...............................................................105

2. Indirect Effects ......................................................................106

3. Direct Regulations of the Consumer-Carrier

Relationship ....................................................................108

a. Disclosure..........................................................................108

b. False Advertising...............................................................110

c. Challenging ETFs..............................................................111

B. New Proposals: Rethinking Disclosure....................................112

1. From Product Attributes to Use Patterns...............................112

2. Disclosing Use Pattern Information ......................................113

a. Average-Use Disclosures...................................................113

b. Individual-Use Disclosures................................................114

c. Individual-Use Disclosures in Real Time ..........................116

3. Combining Use-Pattern Information with Product

Attribute Information......................................................116

4. Mobile Disclosure .................................................................117

5. From Description to Prescription ..........................................118

No. 1] Mobile Misperceptions 51

VIII.

CONCLUSION............................................................................118

I. INTRODUCTION

The cellular service market is an economically significant market

that has substantially increased consumer welfare. From 1990 to 2008,

the U.S. market grew from 5 million subscribers to 263 million sub-

scribers. Eighty-six percent of Americans have a cell phone, and an

increasing number of households rely entirely on wireless communi-

cations, giving up landlines altogether. Annual revenues of the four

national carriers — AT&T, Verizon, Sprint, and T-Mobile — total

over $150 billion. Our focus, however, is on the failures of this mar-

ket. We argue that the carriers design their contracts in response to

systemic mistakes and misperceptions of their customers. In doing so

they impose welfare costs on consumers, reducing the net benefit that

consumers derive from wireless service. We focus on three design

features common to most cellular service contracts: three-part tariffs,

lock-in clauses, and sheer complexity.

A. Three Design Features

The basic pricing scheme of the common cellular service contract

is a three-part tariff comprising: (1) a monthly charge; (2) an alloca-

tion of voice minutes that the monthly charge pays for; and (3) a per-

minute price for minutes beyond the plan limit. We argue that the

three-part tariff is a rational response by sophisticated carriers to con-

sumers’ misperceptions about their cell phone usage. Consumers

choose calling plans based on a forecast of future use patterns. The

problem is that many consumers do not have a very good sense of

these use patterns. The three-part tariff is advantageous to carriers

because it exacerbates the effects of consumer misperceptions, leading

consumers to underestimate the cost of cellular service.

Specifically, some consumers underestimate whereas others over-

estimate their future usage. Crucially, consumers are not aware that

their estimates are incorrect, which enables firms to exploit their mis-

perceptions. The overage fee component of the three-part tariff targets

the underestimators. These consumers underestimate the probability

of exceeding the plan limit and incurring an overage fee, and as a re-

sult will underestimate the cost of cellular service. The other compo-

nents of the three-part tariff — the monthly charge and the fixed

number of minutes that come with it — target the overestimators.

These consumers think that they will use all, or most, of their allotted

minutes and so expect to pay a per-minute price equal to the monthly

charge divided by the number of allotted minutes. In fact, the overes-

timators end up using far fewer minutes and paying a much higher

52 Harvard Journal of Law & Technology [Vol. 23

per-minute price than they anticipate. Thus, overestimators also un-

derestimate the cost of cellular service.

Carriers seem to be aware of consumer misperceptions. As a top

U.S. cellular phone carrier pricing manager has explained, “people

absolutely think they know how much they will use and it’s pretty

surprising how wrong they are.”

We empirically confirm the preva-

lence of consumer misperceptions using a unique dataset of sub-

scriber-level monthly billing and usage information for 3,730

subscribers at a single wireless provider. These data allow us to calcu-

late not only the total cost of wireless service under each consumer’s

chosen plan, but also the total amount that the consumer would have

paid had he chosen other available plans. Thus, we can determine the

plan that best fits his actual cell phone usage. We show that over 65%

of consumers chose the wrong plan. Some chose plans with an insuf-

ficient number of allotted minutes, whereas others chose plans with an

excessive number of allotted minutes. Subscribers exceeded their

minute allowance 17% of the time, by an average of 33%, suggesting

underestimation of use. And, during the 81% of the time when the

allowance was not exceeded, subscribers used only 47% of their min-

ute allowance on average, suggesting overestimation.

In addition to the three-part tariff pricing structure, most calling

plans come with a free or substantially discounted phone and lock the

consumer in for a substantial time period — typically two years —

with long-term contracts and early termination fees (“ETFs”). Lock-in

clauses and the accompanying ETFs can also be explained as a market

response to the imperfect rationality of consumers. Consumers under-

estimate the cost of lock-in if they underestimate the likelihood that

switching providers will be beneficial down the road. Switching pro-

viders may be beneficial if service is not as good as promised,

monthly charges are higher than expected (due to the misperception of

use levels discussed above), or another carrier is offering a better deal.

The lock-in that is enforced by the ETF also facilitates the common

bundling of phones and service. The long-term revenue stream that

lock-in guarantees enables carriers to offer free or subsidized phones.

Rational consumers would not be enticed by a free phone, realizing

that they will pay for this “free” phone in the long-term. Imperfectly

rational consumers, by contrast, discount the long-term cost and seek

out “free” phone offers.

Finally, cellular service contracts are complex and multidimen-

sional, and choosing among numerous contracts can be a daunting

task. The three-part tariff itself is complex. Lock-in clauses and ETFs

add further complexity. And the true cost of a calling plan depends on

1. Michael Grubb, Selling to Overconfident Consumers 1 & n.2 (Mar. 26, 2008) (unpub-

lished manuscript, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=721701).

2. The remaining 2% use up their allowances exactly.

No. 1] Mobile Misperceptions 53

numerous other features. For example, most plans offer unlimited

night and weekend calling, but carriers offer different definitions of

“night” and “weekend.” Also, consumers must choose between unlim-

ited in-network calling, unlimited calling to five numbers, unlimited

Walkie-Talkie, roll-over minutes, and more. Finally, different carriers

offer different ranges of handsets, handset subsidies vary, and so on.

Complexity is further increased when family plans are added to the

mix, when data services are added to voice services, when pre-paid

plans are considered in addition to post-paid plans, etc. According to

one industry estimate, the cellular service market boasts millions of

plan and add-on combinations.

This level of complexity can itself be viewed as a contractual de-

sign feature that responds to the imperfect rationality of consumers.

Complexity allows providers to hide the true cost of their contracts.

Imperfectly rational consumers do not effectively aggregate the costs

and prices of the many components of available plans. Inevitably,

consumers will focus on a subset of salient features and prices, and

ignore (or underestimate the importance of) the remaining non-salient

dimensions. In response, providers will increase non-salient prices or

reduce the quality of the non-salient features, which, in turn, will gen-

erate or free-up resources for intensified competition on the salient

dimensions. Competition forces providers to make the salient features

attractive and the salient prices low. This can be achieved by adding

revenue-generating non-salient features and prices. The result is an

endogenously derived high level of complexity and multidimensional-

ity. Interestingly, consumer learning can exacerbate the problem.

When consumers learn the importance of a previously non-salient

feature, carriers have a strong incentive to come up with a new one,

further increasing the level of complexity.

B. Rational Choice Explanations?

Before we can draw normative and prescriptive implications from

these behavioral theories, we must consider whether the more tradi-

tional rational choice model can explain the same design features. If

the rational choice model comes up short, then we have good reason

to appeal to behavioral economics to assess the appropriate policy

response. The leading rational choice explanation for three-part tariffs

views them as mechanisms for price discrimination or market screen-

ing between rational consumers with different ex ante demand charac-

teristics. We show that the price discrimination argument rests on

specific assumptions about the distribution of consumer types — as-

sumptions that are not satisfied in the cell phone market. With the

distribution of types that we actually observe, providers facing ra-

tional consumers will not offer three-part tariffs.

54 Harvard Journal of Law & Technology [Vol. 23

Lock-in clauses can arise when consumers are rational. This oc-

curs when sellers incur substantial per-consumer fixed costs and li-

quidity-constrained consumers cannot afford to pay upfront fees equal

to these fixed costs. In the cell phone market, fixed costs are indeed

high with carriers investing up to $400 in acquiring each new cus-

tomer. However, these costs are also in large part an endogenous con-

sequence of carriers’ decisions to offer free or subsidized phones. This

raises a series of questions. Why do carriers offer free phones and

lock-in contracts? Why not charge customers the full price of the

phone and avoid lock-in? How many consumers cannot afford to pay

for a phone up front? For how many of these liquidity-constrained

consumers is the carrier the most efficient source of credit? The ra-

tional choice model can explain the presence of lock-in clauses, but

only in a subset of contracts.

The rational choice explanation for complexity is straightforward.

Consumers have heterogeneous preferences, and the complexity and

multidimensionality of the cellular service offerings cater to these

heterogeneous preferences. It is likely that this heterogeneity explains

some of the observed complexity in the cell phone market. But, it is

unlikely that it can fully account for the staggering level of complex-

ity exhibited by the long menus of multi-dimensional contracts that

are available to consumers. Even for the rational consumer, acquiring

information on the range of complex products and comparing differ-

ent plans with many different features are time-consuming and costly

activities. Beyond some level of complexity, the costs exceed the

benefit of finding the perfect plan. Comparison shopping is deterred,

and the benefits of the variety and multidimensionality are left unreal-

ized. It seems that in the cell phone market the optimal level of com-

plexity has been exceeded.

C. Welfare Costs

The design of cellular service contracts is best explained as a ra-

tional response to the imperfect rationality of consumers. Mistakes

that consumers make and providers’ responses to these mistakes hurt

consumers and generate consumer welfare costs. First, overconfident

consumers choose the wrong three-part tariff, that is, they do not

choose the plan that would minimize their total costs. We estimate the

total annual reduction in consumer surplus from the three-part tariff

structure to be $11.92 billion. Moreover, while the average harm per

consumer, $47.68, is small, this average masks potentially important

distributional implications. The $11.92 billion harm is not evenly di-

vided among the 250 million U.S. cell phone owners. Many of these

subscribers choose the right plan. Even among those who choose the

wrong plan, there is substantial heterogeneity in the magnitude of

No. 1] Mobile Misperceptions 55

their mistakes. We estimate that each year 42.5 million consumers

make mistakes that cost them at least 20% of their total yearly wire-

less bill, or $146 per consumer annually. Moreover, the distribution of

mistakes implies a potentially troubling form of regressive redistribu-

tion, since revenues from consumers who make mistakes keep prices

low for consumers who do not make mistakes.

Lock-in prevents efficient switching and thus hurts consumers.

One survey found that 47% of subscribers would like to switch plans,

but only 3% do so — the rest are deterred by the ETF. Switching is

efficient when a different carrier or plan provides a better fit for the

consumer. Lock-in can also slow down the beneficial effects of con-

sumer learning and prolong the costs of consumer mistakes, since

even consumers who learn from experience cannot benefit from their

new-found knowledge and switch to another carrier’s plan or to a pre-

paid plan. (Insofar as carriers allow consumers to switch among their

own monthly plans, consumers can benefit from learning.) In addition

to these direct costs, lock-in may inhibit competition, adding a poten-

tially large indirect welfare cost. Since lock-in may prevent a more

efficient carrier from attracting consumers who are locked into a con-

tract with a less efficient carrier, it can deter new carriers from enter-

ing the market.

The high level of complexity of cell phone contracts can reduce

welfare in two ways. First, consumers will tend to make more mis-

takes in plan choice when the menus are complex, and these mistakes

will reduce consumer welfare. Second, complexity inhibits competi-

tion by discouraging comparison shopping. By raising the cost of

comparison shopping, complex contracts reduce the likelihood that a

consumer will find it beneficial to carefully consider all his options.

Without the discipline that comparison shopping provides, cellular

service providers can behave like quasi-monopolists — raising prices

and reducing consumer surplus.

D. Market Solutions and their Limits

Do these behavioral market failures result from imperfect compe-

tition in the cell phone market? The simple answer is ‘no.’ In fact,

enhanced competition would likely make the identified design fea-

tures more pervasive and the resulting welfare costs greater. If con-

sumers are overconfident about their future use levels, then

competition will force carriers to offer three-part tariffs. If consumers

are myopic, then competition will force carriers to offer free phones

3. A carrier’s relative efficiency depends on its costs of providing service and the quality

of service that it offers. Thus, a carrier that provides the same quality of service at lower

cost than another or a higher quality service at the same cost as another is a more efficient

carrier.

56 Harvard Journal of Law & Technology [Vol. 23

and cover the cost of the subsidy with lock-in contracts. Finally, if

consumers, faced with complex, multidimensional contracts, ignore

less salient price dimensions, then competition will force carriers to

shift costs to the less salient price dimensions. When demand for cel-

lular service is driven by imperfect rationality, competitors must re-

spond to this biased demand; otherwise they will lose business and be

forced out of the market. Accordingly, ensuring robust competition in

the cellular service market would not solve the problem.

But it is a mistake to take the level of imperfect rationality as giv-

en. Competition coupled with consumer learning can reduce levels of

bias and misperception and thus trigger a shift to more efficient forms

of contractual design. In fact, the cellular service market has exhibited

numerous examples of such market correction in recent years and now

boasts a large set of products and contracts that can be seen as cater-

ing to more sophisticated consumers. At the same time, the evolution

of the market demonstrates limits on the power of consumer learning

to correct behavioral market failures.

We consider two key examples. First, the market has responded

to greater awareness of the costs of underestimated use among con-

sumers who have experienced the sting of large overage charges.

Since 2008, the major carriers have been offering unlimited calling

plans that arguably respond to demand generated by this heightened

consumer awareness of misperceptions. Similarly, AT&T’s roll-over

feature, which predates the unlimited calling plans, can also be seen as

a response to consumer learning about the costs of underestimated use

in the presence of overage charges. Yet, while overage fees make it

easy to learn the cost of underestimated use, the costs of overesti-

mated use are more difficult to learn since it is not so obviously penal-

ized. The result of this uneven learning is unlimited plans rather than

the optimal two-part tariff pricing scheme comprised of a fixed

monthly fee and a constant per-minute charge.

Second, the shift from a time-invariant ETF to a time-variant,

graduated ETF structure responds to consumers’ increased awareness

and sensitivity to ETFs. This shift is not a pure market solution. Ra-

4. Cf. Oren Bar-Gill, The Behavioral Economics of Consumer Contracts, 92 MINN. L.

REV. 749 (2008) (arguing that welfare losses result from sellers responding strategically to

consumer misperceptions, even in competitive markets); Oren Bar-Gill, Bundling and Con-

sumer Misperception, 73 U.

CHI. L. REV. 33 (2006) (arguing that the bundling of products

can be a response to consumer misperception even in competitive markets); Oren Bar-Gill,

The Law, Economics and Psychology of Subprime Mortgage Contracts, 94 C

ORNELL L.

REV. 1073 (2009) (arguing that certain elements of subprime mortgage contracts are a re-

sponse to consumers’ imperfect rationality and not the result of a lack of market competi-

tion); Oren Bar-Gill & Elizabeth Warren, Making Credit Safer, 157 U.

PA. L. REV. 1 (2008)

(arguing that intense competition in the credit market does not protect consumers because of

a lack of perfect information and rationality); Oren Bar-Gill, Seduction by Plastic, 98 N

U.L. REV. 1373 (2004) (examining exploitation of consumers’ behavioral biases in the

credit card market and arguing that biased contracting is not the product of imperfect com-

petition).

No. 1] Mobile Misperceptions 57

ther, it is an example of how consumer learning and legal intervention

can work in tandem to change business practices. The change in ETF

structure likely began with a small number of consumers who learned

to appreciate the cost of ETFs and initiated litigation against the carri-

ers. The threat of liability and greater consumer awareness of ETFs

then pushed carriers to adjust their ETF structures. Innovations like

these suggest that the market has an impressive capacity to correct for

consumer misperceptions. Yet, market solutions are imperfect. Not all

biases are easily purged by learning. Not all consumers learn equally

fast, as evidenced by the limited take-up of many design innovations.

The speed of consumer learning and the market’s response matter,

since welfare costs will be incurred in the interim period. Moreover,

when consumers learn to overcome one mistake, or when a previously

hidden term becomes salient, carriers have an incentive to add a new

non-salient term and to trigger a new kind of mistake. Even if con-

sumers always catch-up eventually, this cat-and-mouse game imposes

welfare costs on consumers.

E. Policy Implications

While market solutions are imperfect and welfare costs remain,

the potential for self-correction in the cellular service market leads us

to support a regulatory stance that does not impede market forces, but

rather facilitates their operation. We focus on disclosure regulation.

Our proposal deviates from existing disclosure rules and from other

proposals for heightened disclosure regulation. While existing rules

and proposals focus on the disclosure of product attribute information,

i.e., information on the different features and price dimensions of cel-

lular service, we also emphasize the disclosure of use-pattern informa-

tion, i.e., information on how the consumer will use the product. To

fully appreciate the benefits and costs of a cellular service contract,

consumers must combine product attribute information with use-

pattern information. For example, to assess the costs of overage fees,

it is not enough to know the per minute charges for minutes not in-

cluded in the plan, as proposed in the Cell Phone User Bill of Rights.

Consumers must also know the probability that they will exceed the

plan limit and by how much. The essence of our proposal lies in the

recognition that use-pattern information can be as important as prod-

uct-attribute information. The disclosure regime should be redesigned

to ensure that consumers have access to both.

Use-pattern disclosures can be divided into average-use disclo-

sures and individual-use disclosures. One potentially beneficial aver-

age-use disclosure would target the misperception of use levels that

underlies the three-part tariff pricing structure. Carriers could be re-

quired to disclose the average overage charges that consumers pay.

58 Harvard Journal of Law & Technology [Vol. 23

Carriers could also be required to disclose the percentage of consum-

ers who use, say, 50% or less of the allotted minutes, or the percent-

age of consumers who would save money if they switched to a lower

fixed-fee, lower limit plan. But the efficacy of average-use disclosures

is likely limited by consumer heterogeneity and by consumer opti-

mism. Fortunately, use-pattern disclosure in the cellular service mar-

ket need not be limited to average-use information. The long-term

relationship between carriers and consumers allows for the provision

of individualized use-pattern information.

Individual-use disclosures can also reduce consumers’ mispercep-

tions of their future use. Carriers already provide consumers with in-

formation on overage charges. This disclosure targets consumers’

underestimation of use. We propose a parallel disclosure that would

target consumers’ overestimation of use. Carriers should be required

to disclose the number of minutes used. While some carriers already

provide this information voluntarily, others do not. More importantly,

carriers should be required to disclose the actual monthly per-minute

price, calculated as the monthly fixed fee (plus any overage charges

incurred in a given month) divided by the number of minutes used

that month. This disclosure could be further supplemented by infor-

mation on alternative service plans that would reduce the total price

paid by the consumer given his current use patterns. The proposed

individual-use disclosures, including the comparison with other plans,

should be provided not only on the monthly bill but also in aggregate

form as part of a year-end summary to account for month-to-month

variations in use.

Individual-use disclosures can also effectively be provided in real

time. There are consumers who inadvertently exceed the plan limit

because they cannot easily keep track of the number of minutes that

they are using. To reduce the incidence of inadvertently exceeding the

plan limit, carriers could be required to notify consumers when they

are about to exceed the plan limit. A consumer receiving such notifi-

cation may well decide to cut the conversation short, switch to a land

line, or postpone the conversation until off-peak hours.

This Article contributes to a budding literature that views con-

sumer contracts as the combined product of consumer psychology and

market forces.

By providing evidence of consumer biases and pro-

5. See sources cited supra note 4; see also Stefano DellaVigna & Ulrike Malmendier,

Contract Design and Self-Control: Theory and Evidence, 119 Q.J.

ECON. 353 (2004) (con-

sidering the interaction “between profit-maximizing firms and consumers with time-

inconsistent preferences and naïve beliefs”); Stefano DellaVigna & Ulrike Malmendier,

Paying Not to Go to the Gym, 96 A

M. ECON. REV. 694 (2006) (examining contract data

from health clubs and suggesting that consumer overconfidence may contribute to consumer

behavior); Xavier Gabaix & David Laibson, Shrouded Attributes, Consumer Myopia, and

Information Suppression in Competitive Markets, 121 Q.J.

ECON. 505 (2006) (showing that

“shrouding” of hidden fees occurs in competitive markets when some consumers are naïve

and don’t anticipate shrouding).

No. 1] Mobile Misperceptions 59

viders’ contractual design responses to these biases in an important

market — the cellular service market — we challenge the still domi-

nant rational choice approach to consumer markets.

In addition to

extending the reach of behavioral analysis and confirming the broad

role that psychology plays in consumer markets, this Article under-

scores the importance of in-depth market-specific analysis. The policy

implications of consumer mistakes are context-dependent. The effi-

cacy of learning and market correction varies from market to market.

In some markets learning is slower and the welfare costs of consumer

mistakes higher. In these markets, heavy-handed legal intervention

may be warranted. In other markets, like the cellular service market,

market solutions are relatively effective, and legal intervention would

facilitate rather than inhibit market forces. Finally, the range of policy

tools in the regulator’s arsenal varies from market to market. While

disclosure mandates may have limited effect in markets where sellers

have only average-use information, disclosure can have a more sub-

stantial effect in markets, like the cellular service market, where pro-

viders possess large amounts of individual-use information.

The remainder of this Article is organized as follows: Part II pro-

vides background information on the cell phone and the cellular ser-

vice market; Part III describes the key features of common cellular

service contracts; Part IV develops the behavioral economics theory

that explains these contractual design features; Part V discusses wel-

fare implications; Part VI considers the efficacy of market solutions;

and Part VII describes our policy proposals.

II. THE CELL PHONE AND THE CELLULAR SERVICE MARKET

A. The Rise of the Cell Phone

1. Technology

The key technological innovation that underpins cellular commu-

nications is the cellular concept itself. A cellular system divides each

geographic market into numerous small cells, each of which is served

by a single low-powered transmitter. This allows the system to reuse

the same channel or frequency many times, albeit in non-adjacent

cells in order to avoid interference.

Thus, multiple users can simulta-

6. See Richard A. Epstein, The Neoclassical Economics of Consumer Contracts, 92

INN. L. REV. 803 (2008) (defending the traditional rational choice approach).

7. See SRI

INTERNATIONAL, THE ROLE OF NSF’S SUPPORT OF ENGINEERING IN

ENABLING TECHNOLOGICAL INNOVATION, FINAL REPORT PHASE II 94–97 (1998),

http://www.sri.com/policy/csted/reports/sandt/techin2/contents.html [hereinafter SRI-NSF

REPORT]. For a more technical treatment, see THEODORE RAPPAPORT, WIRELESS

COMMUNICATIONS 26–30 (Camille Trentacoste ed., 1996), and MISCHA SCHWARTZ,

MOBILE WIRELESS COMMUNICATIONS 62–64 (2005).

60 Harvard Journal of Law & Technology [Vol. 23

neously make use of the same frequency. Sophisticated technology

locates subscribers and sends incoming calls to the appropriate cell

sites, while complex handoff technologies allow mobile consumers to

move seamlessly between cells.

High demand for cellular service has prompted the development

of digital technology, which generates enhanced capacity without de-

grading service quality. Two kinds of capacity-increasing technologi-

cal solutions have emerged. The first employs time-slicing

technology: signals associated with several different calls are aggre-

gated within the same frequency by assigning to each user a cyclically

repeating time slot in which only that user is allowed to transmit or

receive. Time-slicing techniques include Bell Labs’ time division

multiple access (“TDMA”) and Global System for Mobile (“GSM”),

which are used by AT&T and T-Mobile, and Integrated Digital En-

hanced Network (“iDEN”), which is used by Nextel.

Spread spec-

trum techniques, by contrast, spread many calls over many different

frequencies while using highly sophisticated devices to identify which

signals belong to which calls and decode them for end users.

The

family of digital standards employing spread spectrum technology is

known as Code Division Multiple Access (“CDMA”).

CDMA stan-

dards are used by Verizon and Sprint.

The introduction of these digi-

tal cellular technologies, starting in the early 1990s, marked the

advance from first generation (“1G”) systems to second generation

(“2G”) systems. Third generation (“3G”) systems, which began to

operate in the U.S. in 2002, incorporate more advanced technologies

that provide the increased speed and capacity necessary for multime-

dia, data, and video transmission, in addition to voice communica-

tions.

2. History

Although the key concepts essential to modern cellular systems

were conceived in 1947,

the Federal Communications Commis-

8. JONATHAN E. NUECHTERLEIN & PHILIP J. WEISER, DIGITAL CROSSROADS 265–66

(2005); SRI-NSF REPORT, supra note 7, at 97. For a more detailed discussion of handoff

operations, see R

APPAPORT, supra note 7, at 31–36, and SCHWARTZ, supra note 7, at 235–

38.

9. N

UECHTERLEIN & WEISER, supra note 8, at 277–78; RAPPAPORT, supra note 7, at

400–02;

SRI-NSF REPORT, supra note 7, at 106; see also SCHWARTZ, supra note 7, at 138–

42.

10. N

UECHTERLEIN & WEISER, supra note 8, at 277–78; RAPPAPORT, supra note 7, at

405–07; see also S

CHWARTZ, supra note 7, at 142–58.

11. R

APPAPORT, supra note 7, at 405–07.

12. N

UECHTERLEIN & WEISER, supra note 8, at 278.

13. W

ILLIAM STALLINGS, WIRELESS COMMUNICATIONS AND NETWORKING 329 (Vince

O’Brien ed., 2002).

14. SRI-NSF

REPORT, supra note 7, at 88. Non-cellular mobile radio systems were al-

ready in existence at that time.

No. 1] Mobile Misperceptions 61

sion’s (“FCC”) refusal to allocate substantial frequencies to mobile

radio service meant that significant development of cellular telephone

services was delayed for several decades.

It was not until the early

1980s that the FCC allocated 50MHz of spectrum in the 800MHz

band to cellular telephone service.

The FCC rules created a duopoly

of two competing cellular systems in each of 734 “cellular market

areas” — one owned by a non-wireline company and one owned by

the local wireline monopolist in the area.

Each carrier received

25MHz of spectrum.

The first set of cellular licenses, which per-

tained to the thirty largest urban markets (the “Metropolitan Service

Areas,” or “MSAs”) were allocated by comparative hearings.

How-

ever, the FCC was so overwhelmed by the number of applicants that

in 1984 Congress authorized the use of a lottery system to allocate

spectrum in the remaining markets.

By 1986, all the MSA licenses

had been allocated, and by 1991 licenses had been allocated in all

markets.

As demand for cellular service rapidly increased over sub-

sequent years, the FCC allocated more spectrum to wireless commu-

nications. New spectrum has been allocated by auction rather than

lottery ever since Congress gave the FCC authority to issue licenses

through auctions in the 1993 Budget Act, a move designed to raise

revenues and cut down on delays associated with the lottery system.

The more recent history of the cellular service market in the U.S.

is one of consolidation.

As noted above, the cellular service industry

began with the local structural duopolies that were created by the

FCC’s lottery mechanism.

With different firms operating in different

geographical markets, the national market initially included a large

number of players.

The number of firms increased further as the

FCC auctioned off more and more radio spectrum for cell phone use.

But this high level of market dispersion did not last long. The FCC

placed few restrictions on the ability of firms to merge across markets,

and a long history of voluntary merger and acquisition activity fol-

15. See id. at 88–90.

16. N

UECHTERLEIN & WEISER, supra note 8, at 268.

17. FCC, FCC

06-142, ANNUAL REPORT AND ANALYSIS OF COMPETITIVE MARKET

CONDITIONS WITH RESPECT TO COMMERCIAL MOBILE SERVICES, ELEVENTH REPORT, 21

F.C.C.R. 10947, 10974 ¶ 62 (2006) [hereinafter FCC

ELEVENTH REPORT].

18. Id.

19. Id.

20. N

UECHTERLEIN & WEISER, supra note 8, at 236–37.

21. FCC

ELEVENTH REPORT, supra note 17.

22. N

UECHTERLEIN & WEISER, supra note 8, at 237; see Omnibus Budget Reconciliation

Act of 1993, Pub. L. No. 103-66, Title VI, § 6002(a), 6002(b)(2), 197 Stat. 312, 387–93

(codified as 47 U.S.C. § 309(j) (2006)); see also Kevin Werbach, Supercommons: Toward a

Unified Theory of Wireless Communication, 82

TEX. L. REV. 863, 877–78 (2004).

23. See infra Part II.B.

24. See FCC

ELEVENTH REPORT, supra note 17, at 10974 ¶ 62.

25. Jeremy T. Fox, Consolidation in the Wireless Phone Industry 7 (Net Inst. Working

Paper No. 05-13, 2005), available at http://www.netinst.org/Fox2005.pdf.

62 Harvard Journal of Law & Technology [Vol. 23

lowed.

Soon a handful of firms — AT&T Wireless, Cingular,

Nextel, Sprint, T-Mobile, and Verizon Wireless — gained a dominant

position as nationwide carriers.

Consolidation activity intensified in

1999, as carriers sought to expand their coverage areas and increase

the capacity of their networks,

and was further facilitated by the

FCC’s 2003 decision to abolish the regulatory spectrum cap that had

limited the amount of spectrum that a company could own in any one

geographical market, since this increased opportunities for mergers by

companies with overlapping coverage areas.

Most significantly, in

October 2004, Cingular and AT&T Wireless merged to become

AT&T Wireless,

while in December 2004 Sprint and Nextel merged

to become Sprint-Nextel.

3. Economic Significance

The FCC estimates that at the end of 2007, there were 263 million

cellular service subscribers in the U.S., which corresponds to a na-

tionwide penetration rate of 86%.

The market has been growing rap-

idly. Cellular service providers added 21.2 million new subscribers in

2007, 28.8 million in 2006, 28.3 million in 2005, 24.1 million in 2004,

and 18.8 million in 2003.

Taking a longer-term view, 258 million

subscribers were added between June 1990 and the end of 2007.

26. Id. at 3, 7.

27. Id. at 6.

28. FCC

ELEVENTH REPORT, supra note 17, at 10970 ¶¶ 53, 55.

29. Fox, supra note 25, at 9.

30. FCC,

FCC 05-173, ANNUAL REPORT AND ANALYSIS OF COMPETITIVE MARKET

CONDITIONS WITH RESPECT TO COMMERCIAL MOBILE SERVICES, TENTH REPORT, 20

F.C.C.R. 15908, 15930 ¶ 58 (2005).

31. FCC

ELEVENTH REPORT, supra note 17, at 10971 ¶ 56.

32. FCC, DA 09-54, A

NNUAL REPORT AND ANALYSIS OF COMPETITIVE MARKET

CONDITIONS WITH RESPECT TO COMMERCIAL MOBILE SERVICES, THIRTEENTH REPORT, 24

F.C.C.R. 6185, at 6279–80 ¶ 197 (2009) [hereinafter FCC

THIRTEENTH REPORT].

33. Id.; FCC

ELEVENTH REPORT, supra note 17, at 11017 ¶ 158.

34. See FCC

THIRTEENTH REPORT, supra note 32, at 6279–80 ¶ 197; SRI-NSF REPORT,

supra note 7, at 94. From a comparative perspective, penetration rates in Western European

and developed Asian-Pacific countries have been, and still are, higher than in the U.S.,

although the U.S. is quickly catching up. For a historic comparison, see FCC,

FCC 00-289,

ANNUAL REPORT AND ANALYSIS OF COMPETITIVE MARKET CONDITIONS WITH RESPECT TO

COMMERCIAL MOBILE SERVICES, FIFTH REPORT, 15 F.C.C.R. 17660, at 17685 (2000);

FCC,

FCC 02-179, ANNUAL REPORT AND ANALYSIS OF COMPETITIVE MARKET

CONDITIONS WITH RESPECT TO COMMERCIAL MOBILE SERVICES, SEVENTH REPORT, 17

F.C.C.R. 12985, 13033–34 (2002); FCC

ELEVENTH REPORT, supra note 17, at 11029

¶¶ 158, 191. For an account of the recent convergence, see FCC,

FCC 08-28, ANNUAL

REPORT AND ANALYSIS OF COMPETITIVE MARKET CONDITIONS WITH RESPECT TO

COMMERCIAL MOBILE SERVICES, TWELFTH REPORT, 23 F.C.C.R. 2241, 2341–43 ¶¶ 229–

31 (2008) [hereinafter FCC

TWELFTH REPORT]. Moreover, average minutes of use per sub-

scriber have tended to be higher in the U.S. See FCC

TWELFTH REPORT, supra, at 2343

¶ 233 (noting that in the fourth quarter of 2006, average minutes of use (“MOUs”) in the

U.S. was approximately 838 per month; Hong Kong came in second with 460 MOUs per

month; while Europe was far behind with an average of 150 MOUs per month).

No. 1] Mobile Misperceptions 63

While cell phones complement landline phones for most users, a sig-

nificant and increasing number of users view the cell phone as a par-

tial or even complete substitute for the traditional, landline phone. At

the end of 2005, nearly a third of American households made at least

half of their long-distance calls at home from their cell phones rather

than from their landlines.

In the last half of 2007, an estimated

15.8% of households used only wireless phones, up from 12.8% at the

end of 2006, 8.4% at the end of 2005, and 4.2% at the end of 2003.

The high revenues enjoyed by carriers provide an indication of

the magnitude of the cellular service market. In the third quarter of

2008, Verizon posted wireless revenues of $12.7 billion,

AT&T

$12.6 billion,

Sprint an estimated $7.5 billion,

and T-Mobile $5.5

billion.

Quarterly wireless revenues for the four national carriers

summed to $38.3 billion, which potentially translates into total annual

wireless revenues of $153.2 billion, ignoring seasonal variations.

Wireless telecommunications have become the largest source of profit

for nearly all major telecommunication providers. For example, Veri-

zon’s wireless services are about two times more profitable than its

wireline offerings.

Looking at revenues from spectrum auctions is

also instructive. In 2006, the FCC’s Auction No. 66 raised a total of

$13.7 billion in net bids from wireless providers for 1,087 spectrum

licenses in the 1710–1755MHz and 2110–2155MHz bands.

In 2008,

the FCC’s Auction No. 73 raised a total of $19.0 billion in net bids

from wireless providers for 1,099 licenses in the 698–806MHz band

(known as the “700MHz Band”).

Investment in telecommunications infrastructure in general —

and one could argue cellular technology in particular — promotes

35. FCC ELEVENTH REPORT, supra note 17, at 11036 ¶ 206.

36. FCC

THIRTEENTH REPORT, supra note 32, at 6301 ¶ 230.

37. Press Release, Verizon, 3rd Quarter 2008 Earnings Conference Call (Oct. 27, 2008),

http://news.vzw.com/investor/20081027_bw.pdf.

38. AT&T,

INVESTOR BRIEFING 3RD QUARTER 2008 (Oct. 22, 2008),

http://www.att.com/Investor/Financial/Earning_Info/docs/3Q_08_IB_FINAL.pdf.

39. See Roger Cheng & Amol Sharma, Sprint Squeezed as Customers Flee, W

ALL ST. J.,

Nov. 8, 2008, at B5 (noting that total revenues, for 2008:3Q, were $8.82 billion); Sprint

Nextel Corp., H

OOVER’S CO. IN-DEPTH RECS., Dec. 11, 2008, 2008 WLNR 23757630 (not-

ing that in 2007, 85% of Sprint’s revenue came from wireless services; the $7.5 billion

figure assumes that the 85% figure carries over to 2008:3Q).

40. Press Release, T-Mobile USA, T-Mobile USA Reports Third Quarter 2008 Results

(Nov. 6, 2008), http://www.t-mobile.com/company/InvestorRelations.aspx?tp=

Abt_Tab_InvestorRelations&ViewArchive=Yes (follow “T-MOBILE USA REPORTS

THIRD QUARTER 2008 RESULTS” hyperlink).

41. George Gilder, The Wireless Wars, W

ALL ST. J., Apr. 13, 2007, at A13 (stating that

Verizon’s mobile phones generated $804 million in profits, whereas its wired phones gener-

ated $393 million in profits).

42. Auction of Advanced Wireless Services Licenses Closes: Winning Bidders An-

nounced for Auction No. 66, 21 F.C.C.R. 10521 (2006).

43. Auction of 700 MHz Band Licenses Closes: Winning Bidders Announced for Auc-

tion

73, 23 F.C.C.R. 4572 (2008).

64 Harvard Journal of Law & Technology [Vol. 23

economic growth by reducing the costs of interaction, expanding

market boundaries, and enhancing information flows.

Specifically,

cellular technology can create value by facilitating communication

between individuals who are on the move, thus helping individuals to

better coordinate their activities and respond to unforeseen contingen-

cies.

Wireless services also boost growth by expanding telephone

networks to include previously disenfranchised consumers through

prepaid service that is unavailable for fixed lines.

Analysts estimate

that the decades-long delay in the development of cellular networks

after the discovery of the cellular concept

cost the US economy

around $86 billion (measured in 1990 dollars).

B. The Cellular Service Market

1. Structure

The U.S. cellular service industry is dominated by four “nation-

wide”

facilities-based carriers: AT&T Wireless, Verizon Wireless,

Sprint Nextel, and T-Mobile.

At the end of 2007, each had networks

covering at least 235 million people.

AT&T had 70.1 million sub-

scribers, Verizon 65.7 million, Sprint Nextel 45.3 million, and T-

Mobile 28.7 million.

In addition to the national carriers, there are a number of regional

carriers, including Leap, U.S. Cellular, and MetroPCS.

There is also

a growing resale sector, consisting of providers who purchase airtime

44. Leonard Waverman, Meloria Meschi & Melvyn Fuss, The Impact of Telecoms on

Economic Growth in Developing Countries, in T

HE VODAFONE POLICY PAPER SERIES

. 3, AFRICA: THE IMPACT OF MOBILE PHONES 10, 10 (March 2005),

http://www.vodafone.com/etc/medialib/attachments/cr_downloads.Par.78351.File.tmp/

GPP_SIM_paper_3.pdf.

45. See, e.g., Robert Jensen, The Digital Provide: Information (Technology), Market Per-

formance, and Welfare in the South Indian Fisheries Sector, 122 Q.J.

ECON. 879, 881–83

(2007) (describing how the introduction of cell phones revolutionized the fishing industry in

Kerala, leading to dramatic reductions in price dispersion, the complete elimination of waste

(previously 5–8% of the daily catch), an 8% average increase in fishermen’s profits, a 4%

decline in consumer prices, and a 6% increase in consumer surplus).

46. See, e.g., Waverman et al., supra note 44, at 12.

47. See supra text accompanying notes 14–16.

48. N

UECHTERLEIN & WEISER, supra note 8, at 268. Developing countries that lack a

well-developed wireline network stand to gain even more from the development of wireless

networks. See, e.g., Waverman et al., supra note 44, at 11 (“We find that mobile telephony

has a positive and significant impact on economic growth, and this impact may be twice as

large in developing countries as compared to developed countries.”).

49. This means that all operate networks in at least some portion of the Western, Mid-

western, and Eastern United States. FCC

THIRTEENTH REPORT, supra note 32, at 6199 ¶ 14.

50. Id.

51. Id.

52. Id.

53. Id.

No. 1] Mobile Misperceptions 65

from facilities-based carriers and resell service to the public, typically

in the form of prepaid plans rather than standard monthly tariffs.

2. Competition

The overlapping geographic coverage of the national and regional

providers gives rise to competition between cellular service providers.

The FCC estimates that 95.5% of people have three or more different

operators offering cell phone services in the census blocks where they

live, 90.5% live in census blocks with four or more operators, 64.9%

live in census blocks with five or more operators, and 24.6% live in

census blocks with six or more operators.

The FCC measures market

concentration by computing the average Herfindahl-Hirschman Index

(“HHI”) across 172 “Economic Areas” (“EA”s) — aggregations of

counties that have been designed to capture the “area in which the

average person shops for and purchases a mobile phone, most of the

time.”

The HHI is a measure of market concentration that ranges

from a value of 10,000 in a monopolistic market to zero in a perfectly

competitive market.

In December 2006, the average HHI, weighted

by EA population, was equal to 2674, while the median was given by

2730.

The FCC found virtually no change in average concentration

in 2007.

These figures, however, might well underestimate market

concentration, since the FCC’s methodology gives equal weight to a

mobile carrier assigning cell phone numbers in one county as it does

to a carrier that assigns numbers in multiple counties in a given EA.

Indeed, one analyst calculated an average HHI value exceeding 6000

with 2005 data, using the amount of spectrum controlled by a carrier

in a market as a proxy for market share.

The relatively high level of concentration in the cell phone market

is the product of an ongoing consolidation process.

This consolida-

54. The resale sector accounted for 7% of the market at end of year 2007. Id. at 6200–01

¶ 17.

55. Id. at 6210 ¶ 41 tbl.1.

56. Id. at 6212 ¶ 45.

57. Formally, the HHI is given by

HHI  100s



i1



, where s

is the fractional mar-

ket share of firm i, and I is the number of firms in the market. Thus a monopolistic market

has an HHI of 10,000, a market that is equally divided between two firms has an HHI of

5000, a market that is equally divided between three firms has an HHI of 3333.33, a market

that is equally divided between four firms has an HHI of 2500, etc.

58. FCC

TWELFTH REPORT, supra note 34, at 2268 ¶ 52.

59. FCC

THIRTEENTH REPORT, supra note 32, at 6212 ¶ 46.

60. Id. at 6212 ¶ 45 n.87.

61. Fox, supra note 25, at 15–17. Moreover, this figure excludes data on Nextel, and so

the Sprint Nextel merger does not contribute to the high HHI, suggesting that this figure

may underestimate the true concentration. Id. at 16 n.11.

62. See supra Part II.A.2.

66 Harvard Journal of Law & Technology [Vol. 23

tion activity is at least partly motivated by a desire to realize econo-

mies of scale and enlarge geographic scope. Broad coverage can be

provided at lower cost by a single nationwide carrier than by regional

carriers through roaming agreements with carriers operating in differ-

ent geographic areas.

In addition, extending the national network

spreads fixed costs, such as marketing expenditures and investments

in developing new technology over a wider base of customers.

Fi-

nally, economies of geographic scope arising from complementarities

between markets may provide an efficiency reason for consolida-

tion.

However, even if consolidation reduces certain costs, it may

increase other costs. Consolidation tends to reduce competition and

facilitate collusion as the number of multi-market contacts between

the dominant national carriers increases.

The magnitude of entry barriers provides another important

measure of competitiveness. If barriers to entry are low, even a market

with a small number of firms will behave competitively. Government

control of spectrum — limiting the amount of spectrum allocated to

wireless communications and requiring that carriers obtain govern-

ment-issued licenses — has the potential to create significant barriers

to entry.

However, recently the FCC has alleviated many of these

concerns by increasing the amount of spectrum available for cellular

communication services and allowing market forces to determine

market structure through elimination of the old structural duopolies

and abolition of the spectrum cap.

Moreover, the Telecommunica-

tions Act and FCC regulations reduce entry barriers by imposing in-

terconnection and roaming obligations.

The ability to purchase

63. See Patrick Bajari, Jeremy T. Fox & Stephen Ryan, Evaluating Wireless Carrier

Consolidation Using Semiparametric Demand Estimation 5 (Nat’l Bureau of Econ. Re-

search, Working Paper No. 12425, 2006), available at http://www.nber.org/papers/w12425;

see also Elstrom, supra note 114.

117. Peter Elstrom, Mike Armstrong’s Strong Showing, B

US. WK., Jan. 25, 1999, at 94.

A year ago, [Armstrong] promised to improve profitability by attract-

ing high-revenue customers — even if the effort cost him revenue

growth. With its innovative Digital One Rate, which carries no long-

distance or roaming charges for cellular customers, the average sub-

scriber bill rose to $58 a month in the third quarter from $50 six

months earlier.

Id.; see also Elstrom, Wireless With All the Trimmings, supra note 114 (“While simplicity is

flat-rate calling’s biggest appeal, there is fine print you need to consider . . . . The only catch

is that the cheapest plan you can get is a steep $90 per month — so you have to be a heavy

user to make it pay.”).

118. Elstrom, Wireless With All the Trimmings, supra note 114.

119. Elstrom, Mike Armstrong’s Strong Showing, supra note 117.

No. 1] Mobile Misperceptions 75

B. Lock-In Clauses

In addition to the three-part tariff pricing structure, most postpaid

calling plans share the two features. First, they come with a free or

substantially discounted phone. Second, they lock the consumer in for

substantial periods of time with long-term contracts and ETFs. At the

time of writing, T-Mobile gave away a Samsung t649 phone with a

suggested retail price of $199.99 for free. Consumers who want a fan-

cier phone could get a Samsung Behold with a suggested retail price

of $399.99 for $64.99. Similarly, AT&T and Apple heavily subsidized

the iPhone, sacrificing short-term revenues,

120

and Sprint sold Sam-

sung’s music phones for only $149, which is far below cost.

121

The

free or heavily subsidized phone strategy pervades the U.S. cell phone

market. A recent survey by J.D. Power found that 36% of customers

receive a free cell phone when subscribing to a wireless service.

122

Of course, the free phones are not really free. Carriers recoup the

costs of the phones through subscription fees.

123

To make sure that

they collect enough subscription fees to cover the cost of the phone,

they lock consumers into long-term contracts.

124

Such lock-in is se-

cured by substantial ETFs. For example, in June 2007, T-Mobile

charged a fixed $200 termination fee,

AT&T charged a fixed termina-

tion fee of $175,

and Sprint charged a termination fee of up to $200

depending on the service selected.

125

Historically, the same termina-

tion fees were charged regardless of when the agreement was broken

120. See Amol Sharma & Roger Cheng, iPhone Costs Prove a Drag for AT&T, WALL

ST. J., Oct. 23, 2008, at B4 (“The company said $900 million in customer-acquisition costs

related to the iPhone shaved 10 cents off its earnings,” but “AT&T executives said the in-

vestment will pay off because iPhone users are lucrative in the long-term, spending about

$95 a month on average, or about 1.6 times the amount other customers do.”). The German

company Deutsche Telekom, the largest telecommunications company in the European

Union, has gone further, selling the iPhone for only one euro with a two year contract. T-

Mobile Will Sell New iPhone in Germany, W

ALL ST. J., June 17, 2008, at B5.

121. Cliff Edwards & Roger O. Crockett, New Music Phones — Without the i, B

US. WK.,

Apr. 16, 2007, at 39.

122. Press Release, J.D. Power and Associates, Wireless Customers are Keeping Their

Mobile Phones Longer as Term Contracts Impact the Replacement Cycle 1 (May 30, 2007),

http://www.jdpower.com/corporate/news/releases/pdf/2007079.pdf. In 2007, customers paid

$93 on average for their cell phones (after discounts), which was a decrease from $103 in

2002. Id. The J.D. Power survey also provides information about average ownership tenure.

Specifically, in May 2007 customers were keeping their mobile handsets for an average of

17.5 months, which represents an increase from 16.6 months in November 2006, and the

first increase in average ownership tenure since 2002, when the average was 18.4 months.

Id.

123. Wu, supra note 74, at 7–8.

124. When no-contract plans are offered, phone subsidies disappear. For example, a cus-

tomer with no contract would be required to pay an additional $400 beyond the contract

price for the same iPhone. AT&T Plans to Offer No-Contract iPhone, W

ALL ST. J., July 2,

2008, at B5.

125. Carriers allow locked-in consumers to switch from one plan to another within the

carrier’s menu of plans without incurring an ETF.

76 Harvard Journal of Law & Technology [Vol. 23

meaning that a consumer would have paid the entire termination fee

for ending a two year contract one month early.

126

In the wake of a

number of class action lawsuits challenging the legality of these

fees,

127

providers have begun to offer contracts with termination fees

that decline over the life of the contract. Verizon led this transition

when, in June 2007, it started charging customers a termination fee of

$175 minus $5 for each full month that the customer remains on the

initial contract.

128

By the end of 2008, all the major carriers were of-

fering similar graduated ETFs.

129

C. Complexity

Cellular service contracts are complex and multidimensional.

This complexity can be viewed as a contractual design feature. In this

subsection, we attempt to provide a sense of the high level of com-

plexity that characterizes cellular service contracts. Most cellular ser-

vice contracts are highly complex even when considered in isolation.

This high level of complexity increases substantially when we shift

from the single-contract perspective to the perspective of a consumer

facing many different multidimensional contracts. According to one

industry estimate, the cellular service market boasts “millions of vari-

ous plan/add-on combinations.”

130

1. Postpaid Plans — The Basics

Even the basic components of the common postpaid calling plan

are complex. As described above, the basic pricing scheme is three-

dimensional. Moreover, each provider offers a long menu of different

three-part tariffs. To make things even more complicated, the menus

126. See generally Andrew Lavallee, Ex-Customers Sue Qwest Over Cancellation Fees,

ALL ST. J., Oct. 17, 2008, B5 (explaining that two former Qwest customers filed a lawsuit

against the provider challenging Qwest’s $200 ETF for broadband service); cases cited infra

note 233 (listing cases where class action lawsuits were brought against the major cellular

service providers for the ETF policy described)

127. See infra notes 233–37 and accompanying text.

128. See Verizon Wireless, Customer Agreement, http://www.verizonwireless.com/

b2c/index.html (last visited Dec. 20, 2009) (follow “Customer Agreement” hyperlink at the

bottom of the page); see also Jeffry Bartash, AT&T to Cut Plan-Exit Fees, W

ALL ST. J., Oct.

17, 2007, at D8.

129. See AT&T, Plan Terms, http://www.wireless.att.com/cell-phone-service/legal/

plan-terms.jsp#gsm (last visited Dec. 20, 2009); Press Release, Sprint Nextel Corp., Sprint

Launches One of the Industry’s Most Customer-Friendly Policies on Pro-Rated Early Ter-

mination Fees (Oct. 31, 2008), http://newsreleases.sprint.com/phoenix.zhtml?c=

127149&p=irol-newsArticle_newsroom&ID=1220442; T-Mobile, T-Mobile Terms & Con-

ditions, http://www.tmobile.com/templates/popup.aspx?passet=ftr_ftr_termsandconditions&

print=true (last visited Dec. 20, 2009).

130. See BillShrink.com, Frequently Asked Questions, http://www.billshrink.com/how-

it-works/ (last visited Dec. 20, 2009).

No. 1] Mobile Misperceptions 77

of three-part tariffs vary among providers.

131

Further complexity is

introduced by the diversity of additional service features covered by

the fixed monthly fee. Some of these features are offered by all carri-

ers in the exact same way. Others are offered by some carriers but not

others or are offered in varying formats by the different carriers.

For example, all four major carriers offer unlimited calls during

off-peak times, i.e., nights and weekends. There is, however, some

potentially significant variation. Nights are defined differently across

carriers. For AT&T and Verizon the night begins at 9 pm and ends at

6 am. For T-Mobile the night begins at 9 pm and ends at 7 am. For

Sprint the night begins at 7 pm and ends at 7 am (except for the

$29.99 plans, where the night begins at 9 pm and ends at 7 am). By

varying the definition of “night,” providers can offer up to three extra

hours of unlimited calling. These extra three hours represent an addi-

tional 33.3% of unlimited calling time. But since most consumers

probably talk more during the three hours between 7 pm and 9 pm and

between 6 am and 7 am than they do during the three hours between 1

am and 4 am, say, these extra three hours of unlimited calling proba-

bly represent much more than a 33.3% increase in value.

To take another example, consumers might also consider whether

to select Verizon’s Friends and Family program, offering unlimited

calls to five phone numbers selected by the user, or Sprint Nextel’s

Direct Connect plans, offering customers the ability to instantly and

simultaneously connect with up to 20 other Direct Connect capable

users on the network.

2. Family Plans

We have thus far focused on individual calling plans. The four

major carriers also offer family plans, adding another layer of com-

plexity. The identifying feature of a family plan is the ability to share

the allotted minutes between up to five users, each operating on a dif-

ferent line. For example, Verizon offers family plans with monthly

charges ranging from $69.99 to $269.98, allotted minutes ranging

from 700 to unlimited, and overages ranging from $0.45 to $0.20.

These monthly prices include two phone lines, and families can add

up to three more lines for an additional $9.99 per month per line.

131. We briefly mention two additional dimensions: (1) The directionality of the calls

that consume allotted minutes, and (2) the one-time activation charge. Along dimension (1),

allotted minutes are typically used up on both outgoing calls and incoming calls, although at

one time Sprint offered a plan with free incoming minutes. As for (2), AT&T and Sprint

charge a $36 activation fee while Verizon and T-Mobile charge $35.

78 Harvard Journal of Law & Technology [Vol. 23

3. Add-Ons

Cell phones can be used for much more than voice communica-

tion. Carriers offer advanced communication services, including text

messaging, multimedia messaging, and internet and email data ser-

vices.

132

They also offer applications such as ring-tones and games, as

well as monthly mobile Internet access packages.

133

These services

and applications are marketed to consumers primarily as add-ons to

their voice services.

Pricing of these services adds additional complexity. Providers

offer advanced communication services to consumers in one of three

modes: (1) pay-as-you-go, applied mainly to text and multimedia

messaging, where the consumer pays per message sent or received;

134

(2) fixed-quantity monthly packages, where the consumer pays a

monthly fee for a fixed number of allotted messages or megabytes of

data;

135

and (3) unlimited-quantity monthly packages, where the con-

sumer pays a monthly fee for unlimited messaging or data transmis-

sion.

136

Entertainment applications, specifically ring-tones and games,

can be purchased for a one-time download rate. Advanced applica-

tions, such as GPS location services and music and TV applications,

are now also available from some providers, typically for an addi-

tional monthly or daily fee.

4. Phones and Lock-In Clauses

Free or discounted phones that come with most postpaid plans

add additional dimensions of complexity to the cellular product. Dif-

ferent carriers offer different phones with varying discounts. The car-

rier’s choice between an outright discount and a rebate adds another

twist. The flipside of the free or discounted phones is the lock-in

clause that ties the consumer to the specific carrier. The lock-in

132. Id.

133. Id.

134. For example, as of December 20, 2009, Verizon charged $0.20 per text message and

$0.25 per multimedia message. See Verizon Wireless, Cell Phones, Prepaid Cell Phones,

Cell Phone Plans, supra note 110.

135. For example, as of December 20, 2009, AT&T charged $5.00 per month for 200

text or multimedia messages and $15.00 for 1500 messages. See AT&T, Cell Phones and

Cell Phone Plans, supra note 110. Customers of Verizon’s basic plan, which includes no

messaging services, could add bundles containing unlimited incoming text or multimedia

messages with 250, 500, 1500, or 5000 outgoing messages to non-Verizon customers and

unlimited messages to Verizon customers for, respectively, an additional monthly charge of

$5.00, $10.00, $15.00, or $20.00. See Verizon Wireless, Cell Phones, Prepaid Cell Phones,

Cell Phone Plans, supra note 110.

136. For example, AT&T charged $20.00 per month for unlimited messaging and $15.00

per month for unlimited data transmission as of December 20, 2009. See AT&T, Cell

Phones and Cell Phone Plans, supra note 110. Unlimited messaging and even data are cov-

ered by the monthly fee component of the basic three-part tariff in some premium plans. Id.

No. 1] Mobile Misperceptions 79

clauses vary in duration and in the magnitude of the ETF. The com-

mon lock-in period is two years, but one and three year periods are

also offered. The termination fees vary between $175 and $200. The

recent move to graduated ETFs introduced additional variation, as

different carriers adopted different formulas to govern the gradual

reduction in ETFs over the life of the contract.

137

5. Prepaid Plans

We have thus far focused on postpaid plans, but the cellular ser-

vice market offers another, substantially different contractual de-

sign — the prepaid plan. Not only is it difficult to choose among the

many different postpaid plans, the consumer must make a preliminary

choice between postpaid and prepaid. Moreover, prepaid plans them-

selves come in many shapes and sizes. Prepaid offerings fall into two

categories: the monthly prepaid category, in which customers pay a

monthly fee for a fixed number of minutes, and the pay-as-you-go

category, in which customers buy credit to pay for minutes on a min-

ute-by-minute basis.

The monthly prepaid category more closely resembles the post-

paid calling plans. The main differences are that under the prepaid

plans: (1) the fixed monthly fee is paid in advance, (2) there is no

commitment (the subscriber can leave the carrier at any time without

incurring an ETF), and (3) the allotted number of minutes cannot be

exceeded in the prepaid version, not even for a high overage charge.

Moreover, per-minute prices, that is, the monthly charge divided by

the allotted number of minutes, are higher in prepaid plans, perhaps

reflecting the loss of revenue from overage charges. For example, for

a $39.99 monthly charge, AT&T’s prepaid GoPhone plan offers 300

minutes, as compared to the 450 minutes offered under AT&T’s post-

paid plan. Prepaid plans also offer fewer additional features. For ex-

ample, night and weekend minutes are not always unlimited, and

roaming charges are levied.

138

The second category of prepaid plans offers pay-as-you-go ser-

vice. Consumers purchase calling cards that hold varying numbers of

minutes. For example, AT&T’s pay-as-you-go service offers a $15

card, a $25 card, a $50 card, a $75 card, and a $100 card. These card

values translate into calling minutes at a $0.25 per minute rate. Pay-

as-you-go calling cards come with expiration dates: AT&T’s $15 card

expires in 30 days, the $25 and $75 cards expire in 90 days, and the

$100 card expires in 365 days. AT&T’s pay-as-you-go consumers can

also pay a fixed fee of $3 to use the phone for an unlimited number of

minutes in a particular day, or $1 to use the phone for a day at a rate

137. See supra notes 128–29 and surrounding text.

138. None of the four major operators charges for roaming in its postpaid pricing plans.

80 Harvard Journal of Law & Technology [Vol. 23

of $0.10 per minute. Like the monthly prepaid plans, pay-as-you-go

services typically offer higher per-minute prices and fewer additional

features, as compared to the postpaid plans.

IV. EXPLAINING THE CELLULAR SERVICE CONTRACT

The contractual design features described in Part III can be ex-

plained as a market response to consumer mistakes.

A. Three-Part Tariffs

1. A Behavioral Economics Theory

a. Theory

Basic voice services are commonly priced using three-part tariffs.

To choose the right three-part tariff from the menu of available tariffs,

the consumer must accurately anticipate her future cell phone usage.

But many consumers, when asked to choose a calling plan, are not

armed with accurate estimates of how they will use their cell phones.

The three-part tariff responds to consumers’ misperceptions about

their future use.

139

Consumers both overestimate and underestimate their use levels.

A carrier who is aware that consumers suffer from such mispercep-

tions can make its service plan appear more attractive to consumers

than it really is by using a three-part tariff, charging a low per-minute

price for minutes up to the plan limit and a high per-minute price the-

reafter. Consumers who overestimate their usage overestimate the

value of the low prices because they overestimate the probability that

they will consume most of these free minutes. Conversely, consumers

who underestimate their usage pay insufficient attention to the high

overage fees because they underestimate the probability of exceeding

the plan limit. For a monopolist carrier, the three-part tariff creates

opportunities for increased profits, while carriers operating in a com-

petitive market will adopt the three-part tariff because it maximizes

perceived consumer surplus.

140

139. Other behavioral explanations are less convincing. For example, the “flat-rate bias”

can explain the prevalence of two-part tariffs involving a high monthly fee and a low per-

unit charge, but it cannot explain observed three-part tariffs, where high overage charges

cause the marginal price to sharply increase after the consumer has used his allotted min-

utes. On the flat-rate bias as an explanation for tariff choice, see generally Anja Lambrecht

& Bernd Skiera, Paying Too Much and Being Happy About It: Existence, Causes, and Con-

sequences of Tariff-Choice Biases, 43 J.

MKTG. RES. 212 (2006). On the difficulties in using

the flat-rate bias to explain tariff choice in the cell phone market, see generally Grubb, supra

note 1.

140. Grubb shows that three-part tariffs can arise when consumers are overconfident

about their ability to predict their future use. This means that the same consumers exhibit a

No. 1] Mobile Misperceptions 81

We demonstrate these ideas using a simple numeric example. As-

sume that several carriers are operating in a highly competitive mar-

ket. All carriers face the same cost structure: a $10 per-consumer

fixed cost and a $0.10 per-minute variable cost. Consumers have the

following preferences: they value each minute of airtime at $0.40 per

minute up to a certain saturation point, s, while minutes beyond the

saturation point are worth zero to the consumer. There are two types

of consumers: heavy users and light users. Fifty percent are heavy

users with a saturation point of 300 minutes, and fifty percent are light

users with a saturation point of 100 minutes. If consumers are rational

and accurately perceive their saturation points, then the carriers will

set a two-part tariff with a fixed monthly fee of $10 and a constant,

per-minute marginal price of $0.10. Heavy users will pay

10 + 300 · 0.1 = 40, light users will pay 10 + 100 · 0.1 = 20, the carri-

ers will just cover their costs, as expected in a perfectly competitive

market. Under this two-part tariff, heavy users enjoys a surplus of

300 · (0.4 − 0.1) − 10 = 80, and light users enjoy a surplus of

100 · (0.4 − 0.1) − 10 = 20.

141

We now introduce consumer misperceptions. We assume that

light users overestimate their saturation point, mistakenly perceiving a

saturation point of 200 minutes instead of the actual 100 minutes. And

heavy users underestimate their saturation point, mistakenly perceiv-

ing a saturation point of 200 minutes instead of the actual 300 min-

utes. With such misperceptions, a three-part tariff becomes more

appealing than the two-part tariff.

Consider the following three-part tariff: a fixed $10 monthly fee,

200 allotted minutes (at a marginal price of zero), and an overage

charge of $0.40 per minute beyond the 200 minute allocation. The 200

minute allocation tracks the common perceived saturation point, the

$0.40 overage is the maximal marginal price that would not deter us-

age beyond the plan limit, and the $10 fixed fee is calculated to ex-

actly cover the carrier’s expected costs: 10 + (½ · 100 + ½ · 300) ·

0.1 − ½ · (300 − 200) · 0.4 = 10.

142

Under this tariff, heavy users will

tendency to both over- and underestimate future use. But, as this Article argues, three-part

tariffs also should arise when some consumers overestimate and others underestimate their

use. Moreover, empirical evidence suggests that most consumers either underestimate or

overestimate their future use, but do not exhibit underestimation in certain months and over-

estimation in others. See Oren Bar-Gill & Rebecca Stone, Pricing Misperception: Explain-

ing Pricing Structure in the Cellular Service Market (June 24, 2009) (unpublished

manuscript) available at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1425046.

141. Price calculations add the fixed monthly fee to the number of minutes multiplied by

the per-minute price. Surplus calculations take the number of minutes multiplied by the

difference between the per-minute benefit and the per-minute price and subtract the fixed

monthly fee.

142. The carrier’s costs include a fixed cost of $10 and an expected variable cost of $0.1

per-minute multiplied by the expected number of minutes — 100 minutes for light users

(50% of users) and 300 minutes for heavy users (50% of users). The total cost is $30. The

82 Harvard Journal of Law & Technology [Vol. 23

pay 10 + (300 − 200) · 0.4 = 50. They will enjoy a surplus of

300 · 0.4 − (300 − 200) · 0.4 − 10 = 70, less than the surplus of 80

under the two-part tariff. But their misperceptions mean that they

misperceive the surplus. The perceived surplus under the three-part

tariff is 200 · 0.4 − 10 = 70, greater than the perceived surplus of

200 · (0.4 − 0.1) −10 = 50 under the two-part tariff. Light users will

pay $10 under the three-part tariff. They will enjoy a surplus of

100 · 0.4 − 10 = 30, more than the surplus of 20 under the two-part

tariff. More importantly, the perceived surplus under the three-part

tariff is 200 · 0.4 − 10 = 70, greater than the perceived surplus of

200 · (0.4 − 0.1) − 10 = 50 under the two-part tariff.

Intuitively, the three-part tariff extracts payments in the form of

overage fees that are invisible to consumers,

143

while reducing or eli-

minating payments that are visible to consumers, specifically fixed

fees and charges for minutes within the plan limit. Notice that the

heavy users, who underestimate their usage levels and end up paying

overage fees, are subsidizing the light users. But since the heavy users

do not anticipate paying the overage fees, a competitor cannot lure

them away ex ante by, for example, offering a different tariff with

lower overage fees. The three-part tariff maximizes the perceived

consumer surplus for both types of consumers, and thus will be se-

lected as the equilibrium tariff in a competitive market.

144

b. Data

We test the misperception theory using a unique dataset of sub-

scriber-level, monthly billing and usage information for 3730 sub-

scribers at a single wireless provider. These data provide information

on which of four calling plans a subscriber has chosen and his

monthly consumption of peak minutes for the period of September

2001 to May 2003. Each of the four calling plans offer a standard

three-part tariff with a fixed allocation of peak minutes and steep

overages for additional peak minutes consumed, as described in Ta-

ble 1 below.

145

carrier gets $20 from overage charges that the heavy users pay on their last 100 minutes.

The remaining $10 is collected as a fixed monthly fee.

143. In a more general model, overage charges would be underestimated, but not com-

pletely invisible.

144. We generalize this example in a companion piece. See Bar-Gill & Stone, supra note

140.

145. The database was provided by the Center for Customer Relationship Management at

Duke University. The description of the data in the text is based on the description provided

by the Center. See The Center for Customer Relationship Management, Telecom Dataset,

available at http://www.fuqua-europe.duke.edu/centers/ccrm/index.html#data; see also

Raghuram Iyengar, Asim Ansari & Sunil Gupta, A Model of Consumer Learning of Con-

sumer Service Quality and Usage, 44 J.

MKTG. RES. 529, 535–37 (2007). The four plans are

offered with many different optional features that consumers can choose from, including

messaging, long-distance, and roaming. Iyengar et al. determined that actual use of these

No. 1] Mobile Misperceptions 83

Table 1: Menu of Three-Part Tariffs

Plan 1 Plan 2 Plan 3 Plan 4

Market share (%) 47.36 9.92 32.1 10.62

Monthly fixed charge ($) 30 35 40 50

Number of included minutes 200 300 400 500

Overage rate ($) 0.40 0.40 0.40 0.40

The data reveal substantial variance in usage. Summary statistics

are provided in Tables 2a–2d. For plans 1, 3, and 4,

146

Tables 2a–2c

present the overall mean and standard deviation of minutes used. To

gain an initial sense of underestimation versus overestimation of us-

age, we also present, for each plan, average figures for underusage —

unused minutes per month — and overusage — minutes beyond the

plan allocation. We then aggregate this information across all plans in

Table 2d.

Table 2a: Summary Statistics — Plan 1

Plan 1

Usage/Allowance

Mean Std. Dev.

Under Allowance 0.815 0.45 0.294

Over Allowance 0.178 1.46 0.624

All Consumers 1 0.633 0.538

features was negligible in the data set and thus ignored the added variation in contractual

design. Iyengar et al., supra, at 536. We do the same. Furthermore, it is not entirely clear

from the data that all four plans were offered at all dates in all markets. We acknowledge

this limitation of the data and qualify our results accordingly. Our empirical strategy builds

on Grubb, supra note 1, who tested a related behavioral explanation, the overconfidence

theory, using a different dataset.

146. We omit information on Plan 2, since no Plan 2 subscriber remained with the plan

for more than ten months.

84 Harvard Journal of Law & Technology [Vol. 23

Table 2b: Summary Statistics — Plan 3

Plan 3

Usage/Allowance

Mean Std. Dev.

Under Allowance 0.836 0.466 0.297

Over Allowance 0.16 1.284 0.343

All Consumers 1 0.599 0.428

Table 2c: Summary Statistics — Plan 4

Plan 4

Usage/Allowance

Mean Std. Dev.

Under Allowance 0.717 0.573 0.296

Over Allowance 0.278 1.259 0.29

All Consumers 1 0.766 0.424

Table 2d: Summary Statistics — Aggregate

All Plans

Usage/Allowance

Mean Std. Dev.

Under Allowance 0.813 0.466 0.297

Over Allowance 0.165 1.326 0.433

All Consumers 1 0.612 0.456

In aggregate, subscribers exceed their minute allowance 16.5% of

the time, by an average of 32.6%. In the 81.3% of the time when the

allowance is not exceeded, subscribers use on average only 46.6% of

their minute allowance.

147

We next estimate both the percentage of consumers who arguably

chose the wrong plan, and the costs of their mistakes. We consider a

plan choice to be a mistake when, given the consumer’s usage, a dif-

ferent plan would have cost the consumer less. We limit our analysis

147. Cf. TELETRUTH, NEW NETWORKS INSTITUTE & LTC CONSULTING, PHONE BILL

SURVEY OF UCAN CUSTOMERS: SAN DIEGO, CALIFORNIA MARKET FOR LOCAL, LONG

DISTANCE, DSL/BROADBAND, CABLE SERVICES, WIRELESS SERVICES, WITH INTERVIEWS

45 (March 2009), http://www.teletruth.org/docs/UCANteletruth.pdf (finding, based on

evidence from 134 wireless customers in the San Diego area, that, on average, customers

used only 33% of their minute allowance each month).

No. 1] Mobile Misperceptions 85

to the 3456 consumers who stayed with a plan for at least ten months,

and take as our unit of analysis the consumer’s tenure with a plan.

Given the variance in usage from month to month, we believe that

identifying mistakes over shorter time horizons is less reliable. For

each of the 3456 consumers, we calculate the total cost of wireless

service under the consumer’s chosen plan and compare it to the total

amount that this consumer would have paid had she chosen each of

the other three plans. We measure the magnitude of the mistakes by

the difference, in both percentage and dollar terms, between the con-

sumer’s actual wireless costs and the lowest possible cost — the cost

that the consumer would have paid if she could have predicted her

usage with certainty.

148

The results are collected in Tables 3a and 3b. In these Tables,

each row represents the group of subscribers who chose a certain plan.

This group is then divided into four sub-groups according to the plan

that these subscribers should have chosen. For instance, the cell lo-

cated at the intersection of the Plan 3 row and the Plan 1 column

represents the sub-group of subscribers who chose Plan 3 but should

have chosen Plan 1. Table 3a presents the size, in percentage terms, of

these sub-groups. Table 3b presents the magnitude of the mistakes or

cost-savings, both in percentage terms and in annual dollar terms, for

each sub-group.

Table 3a: The likelihood of mistakes

Optimal Plan

Plan 1 Plan 2 Plan 3 Plan 4

Plan 1 74.09% 21.79% 1.49% 2.49%

Plan 3 27.20% 35.61% 21.19% 16%

Chosen

Plan

Plan 4 9.00% 10.66% 8.00% 73.33%

Table 3b: The magnitude of mistakes

Optimal Plan

Plan 1 Plan 2 Plan 3 Plan 4

Plan 1 0%

9.56%

$54.16

26.97%

$203.58

28.22%

$341.71

Plan 3 21.09%

$101.58

6.55%

$32.59

11.34%

$102.98

Chosen

Plan

Plan 4 36.71%

$220.27

12.38%

$75.31

7.00%

$39.90

148. This analysis assumes risk neutrality.

86 Harvard Journal of Law & Technology [Vol. 23

We present the results for one group of subscribers, those who

chose Plan 3, in Figure 1. We focus on this group of subscribers, since

it includes significant numbers of both underestimators, who should

have chosen Plan 4, and overestimators, who should have chosen ei-

ther Plan 2 or Plan 1. Figure 1 displays the share of Plan 3 consumers

who should have chosen each of the four plans (the dark gray bars).

For those who should not have chosen Plan 3, Figure 1 shows the

amount of money they would have saved, both in percentage terms

(the light gray bars) and in dollar figures.

Figure 1: Plan 3 Subscribers —Likelihood and Magnitude of Mistakes

$102.97

$32.59

$101.58

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

plan1 plan2plan3plan4

sbscr.% savings%

These figures underestimate the number and cost of mistakes, es-

pecially for plans with a lower allocation of minutes. For example, for

subscribers who chose Plan 1, our data only reveal mistakes arising

from underestimation of use, that is selection of Plan 1 when the sub-

scriber should have chosen Plan 2, Plan 3, or Plan 4. But, it is likely

that many Plan 1 subscribers who overestimated their use could have

done better by choosing a prepaid plan that is not included in the data-

set. We offer a conservative estimate of the number and magnitude of

the cost of such overestimation by adding a hypothetical prepaid plan

with a high per-minute charge of $0.40 (equal to the overage charges

in our data). An estimated 24.4% of Plan 1 subscribers would have

saved $149 annually on average had they chosen the prepaid plan.

149

149. These conclusions are tentative, since prepaid plans may differ from postpaid plans

on other dimensions. In particular, while the service quality offered by prepaid plans is

improving, in the period when the data were collected there was still a non-negligible differ-

ence in quality between prepaid and postpaid plans.

No. 1] Mobile Misperceptions 87

To sum up, many consumers fail to accurately anticipate their use

patterns, and the three-part tariff design can be explained as a market

response to such misperceptions. Consistent with this story, providers

do not seem to be troubled by consumers’ use-pattern mistakes. On

the contrary, they actively foster these mistakes by requiring, as a con-

dition for network access, that handset manufacturers disable the call-

timer feature that would make it easier for consumers to monitor their

usage.

150

However, consumers are becoming more aware of their use-

pattern mistakes and more frustrated with carriers who take advantage

of them. As elaborated in Part VII below, the market is responding to

the demand generated by these more sophisticated consumers.

2. Rational Choice Theories and Their Limits

The leading rational choice explanation for three-part tariffs

views these pricing schemes as a mechanism for price discrimination

or market screening between rational consumers with different ex ante

demand characteristics. For expositional purposes, we focus on two

dimensions of demand heterogeneity: average (or mean) monthly

minutes of use and variance of minutes used. To begin with, suppose

that consumers vary only on the first dimension. Under these condi-

tions, the rational model cannot explain three-part tariffs: to discrimi-

nate between heavy users with high average usage and light users with

low average usage, carriers would use a menu of two-part tariffs, not

three-part tariffs. A two-part tariff includes a fixed monthly fee and a

constant per-minute charge. Carriers can discriminate between heavy

users and light users by offering an “H” tariff with a higher monthly

fee and a lower per-minute charge and an “L” tariff with a lower

monthly fee and a higher per-minute charge. The heavy users care

more about the per-minute charge, and will thus prefer the H tariff.

The light users care more about the monthly fee, and will thus prefer

the L tariff.

While two-part tariffs provide a mechanism for discriminating be-

tween consumers based on their mean usage, three-part tariffs can

provide a mechanism for discriminating between consumers based on

variance of use. Assume that there are two types of consumers: one

type with highly variable, High-Variation (“HV”) demand, and an-

other type with more predictable Low-Variation (“LV”) demand.

151

150. Wu, supra note 74, at 9. For an example of the carrier-imposed difficulty customers

face in determining their unused plan-minute allowances, see Sherrie Nachman, Cranky

Consumer: How to Check Up on Your Cell Phone Minutes, W

ALL ST. J., June 18, 2002, at

D2.

151. Formally, the cumulative distribution function (“c.d.f.”) describing the priors over

the demand parameter of the predictable type must cross that of the variable type once from

below. Grubb, supra note 1, at 25–26 fig.6. For an analogous condition when there is a

continuum of types, see id.

88 Harvard Journal of Law & Technology [Vol. 23

other words, the HV type often uses a very high number of minutes

and often uses a very small number of minutes while the LV type usu-

ally consumes a more moderate number of minutes. A carrier can dis-

criminate between the HV types and the LV types using a menu of

three-part tariffs. Designing this menu, however, is quite tricky. The

problem lies in the tradeoff that the HV type faces. On the one hand,

the HV type is more concerned than the LV type about using a very

large number of minutes and will thus prefer a tariff with a larger al-

location of minutes to reduce the risk of paying substantial overage

fees. On the other hand, the HV type is more concerned than the LV

type about using only a very small number of minutes and will thus be

more reluctant to pay the higher monthly fee that comes with the lar-

ger allocation of minutes.

Therefore, in designing the HV tariff, the carrier will have to

strike a delicate balance. The HV tariff will offer a larger allocation of

minutes, M, than the LV tariff, M

> M

, to accommodate the like-

lihood that the HV type will use a large number of minutes. The HV

tariff will also include a larger monthly fee, F, than the LV tariff:

> F

. But the effective per-minute charge, F/M, within the plan

limit will be smaller under the HV tariff: F

/ M

< F

/ M

. This

is attractive to the HV type, who is likely to use only a very small

number of minutes. The LV type will not pay a higher monthly fee for

extra minutes that she will most likely never use. The LV type is less

concerned about paying a higher effective per-minute charge, because

she will generally use most of her allocated minutes. Therefore, the

LV type will choose the LV tariff.

While a three-part tariff pricing structure can facilitate price dis-

crimination, the assumptions required for this rational choice explana-

tion are often unrealistic. In the price discrimination model, the HV

type chooses a plan with a high number of allotted minutes and the

LV type chooses a plan with a low number of allotted minutes. More-

over, the highly variable use levels of the HV type imply that this type

is more likely than the LV type to end up using a very low number of

minutes. Our dataset suggests that this is unrealistic, as it shows that

consumers who choose plans with a higher number of allotted minutes

are less likely to end up using a very low number of minutes.

Using the subscriber-level billing and usage data described above,

we plot in Figure 2 the cumulative distribution functions of usage for

consumers choosing different three-part tariff plans.

152

152. Figure 2 omits Plan 2 subscribers, since no Plan 2 subscriber remained with the Plan

for more than ten months.

No. 1] Mobile Misperceptions 89

Figure 2: Cumulative Distribution Functions of Cell Phone Usage

0.2

0.4

0.6

0.8

1.2

120

160

200

240

280

320

360

400

440

480

520

560

600

640

680

720

760

800

840

880

920

960

1000

1040

1080

1120

1160

1200

1240

1280

1320

1360

1400

1440

1480

pla n 1

pla n 3

pla n 4

Figure 2 confirms that the cumulative distribution function corre-

sponding to a plan with a higher number of allocated minutes first-

order stochastically dominates the cumulative distribution function

corresponding to a plan with a lower number of allocated minutes. In

other words, consumers who choose plans with a higher number of

allotted minutes are less likely to end up using a very low number of

minutes. These findings are inconsistent with the price discrimination

theory that we sketched above.

153

An alternative rational choice explanation views the three-part

tariff, and specifically the steep overage fees, as offering consumers a

pre-commitment device that helps them avoid excessive usage.

154

Ra-

tional consumers who anticipate a temptation to talk too much may

want to bind their future selves by choosing a plan with a high over-

age fee. However, this theory does not fit the data very well. The data

reveal substantial overages, but if consumers are using the three-part

tariff as a commitment device we should expect to see a clustering of

minutes used just below the plan limits. Moreover, the pre-

commitment theory cannot explain the large number of subscribers

who consistently use a number of minutes that is well below the plan

limit.

Finally, in theory, the use patterns revealed in our data are consis-

tent with the behavior of perfectly rational but risk-averse subscribers.

153. Grubb’s analysis of a different dataset yields the same conclusion. Grubb, supra

note 1, at 34 fig.1.

154. It is not even clear that this is a rational choice theory. Arguably, preferences that

lead to temporal inconsistency and self-control problems, which generate a demand for pre-

commitment devices, are in some sense irrational.

90 Harvard Journal of Law & Technology [Vol. 23

Such subscribers would choose plans with more allotted minutes than

they expect to use to reduce the risk of paying substantial overage

fees. As a result, most of these subscribers will end up using much

less than their allotted minutes. This explanation fails for two reasons.

First, given the sums of money involved, the observed plan choic-

es are not consistent with risk aversion under the rational-choice Ex-

pected Utility Theory.

155

Second, while risk aversion may explain the

patterns of overusage and underusage given the three-part tariff struc-

ture, it cannot explain the emergence of the three-part tariff as the

equilibrium pricing structure. With rational, risk-averse subscribers,

we should expect to see two-part tariffs.

B. Lock-In Clauses

1. A Behavioral Economics Theory

The lock-in clauses that are common in postpaid plans and the

termination fees that enforce them can also be explained as a market

response to the imperfect rationality of consumers. Consumers often

underestimate the likelihood that switching providers will be benefi-

cial down the road; service may not be as good as promised, monthly

charges may be higher than expected, or another carrier may offer a

better deal.

156

As a result, consumers underestimate the long-term cost

of the lock-in clause. When consumers underestimate the likelihood

that they will want to switch providers before their contract expires,

they will be relatively insensitive to the ETF. Increasing the size of

the ETF thus becomes an appealing pricing strategy.

157

Moreover, the

ETF-enforced lock-in facilitates the common bundling of phones and

service. Termination fees guarantee providers a long-term revenue

stream, as subscribers must either refrain from switching carriers and

pay for service for the duration of their contracts or switch and pay the

termination fee.

158

This guaranteed revenue helps enable carriers to

offer free or subsidized phones to attract consumers.

155. See Matthew Rabin, Note, Risk Aversion and Expected-Utility Theory: A Calibra-

tion Theorem, 68 E

CONOMETRICA 1281, 1281 (2000). However, they may be consistent

with certain behavioral accounts of risk aversion. See id. at 1282 n.3.

156. See Lauren Tara Lacapra, Breaking Free of a Cellular Contract — New Web Sites

Help Customers Swap or Resell Phone Service; Avoiding $175 Termination Fee, W

ALL ST.

J., Nov. 30, 2006, at D1 (“[Consumers] often want out because service is poor or because

the monthly costs turn out to be more than they expected.”).

157. Oren Bar-Gill, Informing Consumers About Themselves 10 (NYU Law Sch. Law &

Econ. Res. Paper Series, Working Paper No. 07-44, 2007), available at http://

papers.ssrn.com/sol3/papers.cfm?abstract_id=1056381.

158. The ETF effectively deters switching. See Lacapra, supra note 156 (stating that ac-

cording to a July 2005 survey by the U.S. PIRG Education Fund, “[r]oughly 47% of cell

customers would switch or consider switching cellphone companies if early-termination

fees were abolished,” but “because of the fee, only 3% of customers go ahead with terminat-

ing the contract”).

No. 1] Mobile Misperceptions 91

But the story is more complicated. To subsidize the cost of

phones, carriers must charge an above-cost price for service. This

pricing strategy is attractive only if the price of service is underesti-

mated. As we have seen in Part V.A, such underestimation does exist.

Consumers underestimate the price that they will pay in the form of

overage fees when they underestimate usage. When they overestimate

usage, consumers underestimate the per-minute price that they will

pay under the plan. Of course, a single month’s worth of underesti-

mated service prices cannot cover the large phone subsidies. Carriers

cannot increase service charges to such a level that they would cover

the price of a phone (or a phone subsidy) after one month. Conse-

quently, lock-in is crucial. Lock-in ensures that the carrier will benefit

from (typically) two years’ worth of above-cost and underestimated

service charges or, if lock-in fails, from the underestimated termina-

tion fee. These compounded above-cost service charges can then pay

for the free or subsidized phones. Lock-in also facilitates the workings

of consumers’ myopia, further compounding the problem. The imme-

diate cost of the phone looms larger in the decision calculus than the

costs of the service contract, which are spread over time.

Carriers are quite explicit about their strategy of offering free or

subsidized phones and recouping their costs through long-term con-

tracts with ETFs. According to the vice president of marketing for

Cingular Wireless (now AT&T), the penalties are the price that con-

sumers must pay for the inexpensive or free phones customers get

when they sign up for service: “We subsidize the handset; in exchange

we want a commitment from the customer.”

159

Similarly, at the FCC

hearing on ETFs, an Executive Vice President of Verizon argued:

Term contracts allow the consumer to take advantage

of bundled services at competitive prices and the lat-

est devices they choose in exchange for a commit-

ment to keep the service for usually one or two

years. In return, service providers have some meas-

ure of assurance over a fixed period of time that they

may recover their investment, including equipment

subsidies, costs of acquiring and retaining customers,

159. Caroline E. Mayer, Griping About Cellular Bills; Differences From ‘Regular’

Phones Take New Users by Surprise, W

ASH. POST, Feb. 28, 2001, at G17; see also Fawn

Johnson, FCC Head Seeks Rules on Cell-Termination Fees, W

ALL ST. J., June 13, 2008, at

B7 (“Wireless carriers argue that the termination fees are used to subsidize the cost of cell-

phones to customers. People who sign up for one- or two-year contracts receive discounts

on phones and their monthly wireless rates.”); CTIA, Early Termination Fees Equal Lower

Consumer Rates 1, CITA,

Apr. 2006, http://files.ctia.org/pdf/PositionPaper_CTIA_

ETF_04_06.pdf (arguing that prohibiting carriers from charging ETFs will cause prices for

wireless services to increase).

92 Harvard Journal of Law & Technology [Vol. 23

and anticipated revenue for providing wireless ser-

vices.

160

Consider, for example, the pricing of the new iPhone. In June

2008, Apple made a big splash when it announced that the new

iPhone model would sell for $200 less than its predecessor ($199 in-

stead of $399).

161

However, at the same time Apple and its partner

AT&T raised the iPhone’s minimum monthly service subscription

from $60 to $70, adding $240 to the total cost of the two-year con-

tract.

162

AT&T and Apple executives were very clear about the short-

term versus long-term trade-off. They were willing to lose money on

the front end, but only because they were counting on making even

more money off the back-end, due to the two year lock-in contract.

163

Not surprisingly, when the same iPhone was later offered in unbun-

dled form, without a two year service plan, it was priced at $599,

which is $400 above the subsidized price (with a service plan).

164

The practice of offering free or subsidized phones with lock-in

contracts provides strong evidence of consumer bias. Moreover, carri-

ers seem to understand that consumers are attracted by the short-term

benefit (the free phone) even when this benefit is completely offset or

even outweighed by increased long-term costs.

165

While bundling of

phones and service is still the norm in the U.S. cellular service market,

this practice seems to be in decline. Consumers are more aware of

ETFs, an awareness that could partially be attributed to the ETF litiga-

tion, and carriers are reducing ETFs in response.

166

With lower ETFs

and thus weaker lock-in, phone subsidies become more difficult to

sustain. The drive towards open access also threatens the future of the

bundling strategy.

167

After initially resisting open access, carriers are

beginning to realize the benefits of shifting development and customer

service costs to handset manufacturers.

168

Finally, it is interesting to

160. Thomas J. Tauke, Executive Vice President, Verizon, Testimony at FCC Early Ter-

mination Hearing 1 (June, 12, 2008) [hereinafter Verizon Testimony], available at

http://www.fcc.gov/realaudio/presentations/2008/061208/tauke.pdf.

161. See Paul Wagenseil, That ‘Cheaper’ iPhone Will Cost You More, F

OXNEWS.COM,

June 11, 2008, http://www.foxnews.com/story/0,2933,365347,00.html.

162. Id.

163. See supra note 120.

164. AT&T Plans to Offer No-Contract iPhone, supra note 124.

165. The importance of handset subsidies is not limited to the U.S. market. Based on

econometric analysis of data from Chinese markets, researchers found handset subsides

were most effective in increasing the subject firm’s market share over a given period.

Chorng-Jian Liu et al., The Public Incumbent’s Defeat in Mobile Competition: Implications

for the Sequencing of Telecommunications Reform 12–17 (unpublished manuscript) avail-

able at http://ssrn.com/abstract=978707.

166. See Part III.B.

167. See Ante, supra note 74.

168. Id.

No. 1] Mobile Misperceptions 93

note that the practice of bundling phones and service has always been

less common outside the U.S. and especially uncommon in Europe.

169

2. Rational Choice Theories and Their Limits

Lock-in clauses can arise in a rational choice framework. When

the seller incurs substantial per-consumer fixed costs and the liquid-

ity-constrained consumer cannot afford to pay an upfront fee equal to

these fixed costs, the optimal solution may be a lock-in contract. In

the cell phone market, fixed costs are high but, more importantly, they

are endogenous. Carriers invest up to $400 in acquiring each new cus-

tomer.

170

Many of these customer acquisition costs, however, are at-

tributed to the free or subsidized phones that carriers offer.

171

This

raises a series of questions. Why do carriers offer free phones and

lock-in contracts? Why not charge customers the full price of the

phone and avoid lock-in? Many cell phone consumers can afford to

purchase the phone up-front. Moreover, it is unlikely that the carrier is

the most efficient source of credit available to all of those consumers

who are in fact liquidity-constrained. Thus, the rational choice model

can explain the presence of these design features in only a subset of

contracts.

172

An alternative argument views lock-in clauses as instrumental in

stabilizing demand and helping providers match capacity to demand

(especially in peak hours), thus reducing costs and benefiting con-

sumers. While lock-in clauses may reduce churn and thus reduce vari-

ation in demand, there are still substantial variations in the use-

patterns of the locked-in consumers, as shown above.

173

More impor-

tantly, it is not clear whether or not providers need lock-in clauses to

match capacity to demand. Providers have good information about

their customers’ use patterns, including how long they will stay with

the specific provider. A related argument is that ETF-enforced lock-in

generates a more predictable stream of revenues, which is necessary

169. Id.

170. Lacapra, supra note 156 (“It costs a cell phone company approximately $350 to

$400 to acquire a new customer, according to Phil Doriot, a partner in the consulting firm

CFI Group, who has studied company performance and customer satisfaction for major

cellular service providers.”); Jane Spencer, What Part of ‘Cancel’ Don’t You Under-

stand? — Regulators Crack Down on Internet Providers, Phone Companies That Make It

Hard to Quit, W

ALL ST. J., Nov. 12, 2003, at D1 (noting that customer acquisition costs are

approximately “$339 per new customer, according to Yankee Group, a technology research

firm”).

171. Jared Sandberg, A Piece of the Business, W

ALL ST. J., Sept. 11, 1997, at R22.

172. The practice of imposing time invariant termination fees raises doubts about the ar-

gument that ETFs were necessary to cover the cost of the free or subsidized phones, either

by inducing consumers to stay on and pay the monthly subscription fees or by replacing the

subscription fees of consumers who leave.

173. See supra Part IV.A.1.b.

94 Harvard Journal of Law & Technology [Vol. 23

for carriers to recoup their large capital investments.

174

Again, while

lock-in reduces uncertainty, carriers could generate reasonably accu-

rate revenue estimates without it. Though reduced risk is desirable,

the presence of manageable risk should not prevent investment.

C. Complexity

1. A Behavioral Economics Theory

The complexity and multidimensionality of the cell phone con-

tract can also be explained as a market response to the imperfect ra-

tionality of consumers.. Consider four basic plans offered by the four

major carriers:

(1)

AT&T’s $39.99 plan with 450 minutes, $0.45 per minute

overage, unlimited night (9:00pm–6:00am) and weekend

minutes, unlimited calling to AT&T customers, rollover min-

utes.

(2)

Verizon’s $39.99 plan with 450 minutes, $0.45 overage,

unlimited night (9:01pm–5:59am) and weekend minutes,

unlimited calling to Verizon customers.

(3)

Sprint’s $39.99 plan with 450 minutes, $0.45 overage, unlim-

ited nights (7:00pm–7:00am) and weekends, unlimited calls

to customers on the Sprint network.

(4)

T-Mobile’s $29.99 plan with 500 minutes, $0.45 overage,

unlimited calls to customers on the T-Mobile network, unlim-

ited nights (9:00pm–6:59am) and weekends.

175

To choose among these products, the consumer must answer a se-

ries of nontrivial questions. How important is unlimited calling within

the network? If unlimited calling within the network is important, on

which network are most of the consumer’s friends located? How

valuable is unlimited calling during weekends? How valuable is

unlimited calling at night? How large is the difference between unlim-

ited calling at night when “night” is between 7:00pm and 7:00am as

compared to a shorter “night” between 9:00pm and 6:00am? How

valuable is the rollover feature? There is considerable complexity

even when the comparison is between plans (1) to (3), which offer

consumers the same monthly charge, number of allotted minutes, and

overage charge. But, of course, the different dimensions of the three-

part tariff also change from one carrier to the next and from one plan

to the next in a single carrier’s menu of offerings. Consumers must

choose the combination of monthly charge, allotted minutes, and

174. See Verizon Testimony, supra note 160, at 2; see also CTIA, supra note 159, at 1.

175. Information as to basic plans acquired from sources cited supra note 110.

No. 1] Mobile Misperceptions 95

overages they prefer. As explained above, this choice requires accu-

rate estimates of the distribution of their future usage.

A perfectly informed and perfectly rational consumer would eas-

ily navigate this maze and find the best plan for him. But the amount

of information required is substantial, since it includes information

about both available plans and the consumer’s own use patterns. It is

unlikely that he will have all this information. Moreover, as shown

above, consumers are often mistaken about their future use. Even if

the consumer had the necessary information, translating this informa-

tion into a metric that would allow him to rank the different plans is a

daunting challenge that most consumers cannot be expected to over-

come.

Complexity allows providers to hide the true cost of the contract.

Imperfectly rational consumers cannot effectively aggregate the costs

associated with the different options and prices in a single cell phone

contract. Inevitably, consumers will focus on a subset of salient fea-

tures and prices, and ignore or underestimate the importance of the

remaining, non-salient features and prices. In response, providers will

increase prices or reduce the quality of the non-salient features, which

in turn will generate or free up resources for intensified competition

on the salient features. Competition forces providers to make the sali-

ent features attractive and the salient prices low. This can be achieved

by adding revenue-generating, non-salient features and prices. The

result is an endogenously derived high level of complexity and multi-

dimensionality.

This account of complexity as a response to imperfect rationality

is a dynamic one. It recognizes that consumers learn and that a feature

or a price that was not salient last month may become salient next

month. ETFs provide such an example.

176

When one price dimension

becomes salient, competition focuses on this dimension and carriers

shift to a new, less salient price dimension. According to some ac-

counts, carriers facing increased competition on fixed monthly fees

and allocations of included minutes are now relying more heavily on

revenues from charges for new data services.

177

The proposed account

of complexity not only allows for consumer learning, but also uses

consumer learning to explain the increasing level of complexity of the

cellular service contract: when consumers learn the importance of a

previously non-salient price dimension, carriers have a strong incen-

tive to create a new price dimension.

176. See infra Part V.B.

177. Andrea Petersen & Nicole Harris, Hard Cell: Chaos, Confusion and Perks Bedevil

Wireless Users, W

ALL ST. J., Apr. 17, 2002, at A1.

96 Harvard Journal of Law & Technology [Vol. 23

2. Rational Choice Theories and Their Limits

The rational choice explanation for complexity is straightforward.

Consumers have heterogeneous preferences. Different consumers

want different kinds of cellular services, so the complexity and multi-

dimensionality of the cellular service offerings cater to the heteroge-

neous preferences of cell phone users. This surely explains some of

the observed complexity in the cell phone market. But it is unlikely

that it fully explains the staggering level of complexity exhibited by

the long menus of cell phone contracts. Even for the rational con-

sumer, acquiring information on the range of complex products is

costly. Even for the rational consumer, comparing different plans with

different multidimensional features is costly. At some point, these

costs exceed the benefits of finding the perfect plan. When complexity

deters comparison shopping, the benefits of the variety and multidi-

mensionality are left unrealized. The rational choice account must

balance the costs and benefits of complexity. It seems that in the cell

phone market the level of complexity has reached a point beyond

what we should expect if it was simply a response to rational con-

sumer demand.

178

V. WELFARE COSTS

We have argued that the design of cell phone contracts can be ex-

plained as a response to the imperfect rationality of consumers. In this

Part, we assess the extent to which the mistakes that consumers make

and providers’ responses to these mistakes harm consumers and gen-

erate welfare costs.

A. Three-Part Tariffs

We have shown that misperceptions of use levels lead many con-

sumers to choose the wrong plan — the wrong three-part tariff.

179

The

average consumer in our data made a mistake that cost him 8% of his

total wireless bill, or $47.68 annually. Extrapolating from our data

178. A market for “comparison shopping services” is emerging, with vendors such as

BillShrink.com and Validas offering to find the best product/plan for any consumer who

would is willing to pay a fee. See infra notes 248–49 and accompanying text. The availabil-

ity of comparison shopping services reduces the cost of comparison shopping and increases

the optimal level of complexity in a rational choice model. However, it seems that most cell

phone users do not avail themselves of the services offered by BillShrink.com and Validas.

The emergence of a market for “comparison shopping services” suggests that complexity

makes it difficult for consumers to comparison shop by themselves. But since the majority

of consumers do not seek help from professional comparison shoppers and thus do not bene-

fit from the high level of complexity, the rational choice explanation for complexity is less

convincing.

179. See supra Part IV.A.1.b.

No. 1] Mobile Misperceptions 97

onto the entire U.S. population of cell phone users, numbering 250

million, we obtain a $11.92 billion annual reduction in consumer sur-

plus.

While the $11.92 billion figure is substantial, the average per-

consumer harm, $47.68, is small. But these averages hide potentially

important distributional implications. The $11.92 billion is not evenly

divided among the 250 million U.S. subscribers. In our data, 35% of

subscribers chose the right plan. Even among subscribers who chose

the wrong plan, the magnitude of the mistake, that is, the extra pay-

ment as compared to the right plan, varies substantially. In our data,

34% of consumers made mistakes that cost them at least 10% of their

total wireless bill, or $113 annually, and 17% of consumers made mis-

takes that cost them at least 20% of their total wireless bill, or $146

annually. Ten percent of consumers made mistakes that cost them at

least 25% of their total wireless bill, or $60 annually. This implies that

the really large mistakes, in percentage terms, had smaller stakes in

dollar terms.

While harm to consumers is important, it should be emphasized

that a reduction in the consumer surplus is not a welfare cost in and of

itself. Yet the identified consumer mistakes do generate welfare costs.

First, consumer mistakes imply allocative inefficiency, since consum-

ers are not buying the right products. Second, social welfare is re-

duced by regressive redistribution. Such redistribution occurs when

carriers profit from consumer mistakes. But regressive redistribution

occurs even if these excess profits are competed away if wealthier

consumers are less prone to make mistakes. The distribution of mis-

takes implies that revenues from consumers who make mistakes keep

prices low for consumers who do not make mistakes.

B. Lock-In Clauses

Lock-in prevents efficient switching and thus hurts consumers. A

2005 survey found that 47% of subscribers would like to switch plans,

but only 3% do so — the rest are deterred by the early termination

fee.

180

Switching is efficient when a different carrier or plan provides

a better fit for the consumer. Moreover, in light of the rapid techno-

logical advances in handset technology, a two year lock-in is rela-

tively long.

181

Beyond these efficiency costs, consumers lose from

lock-in when it prevents them from accepting a better deal offered by

a competing carrier. Lock-in can slow down the beneficial effects of

180. Lacapra, supra note 156.

181. See Abe Burhanuddin, Smartphone, a Modern Lifestyle Convergence, J

AKARTA

POST, Aug. 21, 2007, http://www.thejakartapost.com/news/2007/08/21/smartphone-modern-

lifestyle-convergence.html (discussing recent worldwide developments in handset technol-

ogy).

98 Harvard Journal of Law & Technology [Vol. 23

consumer learning. Consumers gradually learn to avoid misperception

and form more accurate estimates of their future use. If lock-in pre-

vents these consumers from switching to a plan that better fits their

actual use patterns, it prolongs the welfare costs identified in Part

V.A. Similarly, consumers will gradually learn the implications of

their complex cell phone contract. For example, they may learn that

they do not use their phone very often between 6am and 7am, and

thus conclude that they are not benefitting from the longer definition

of “night” in Sprint’s unlimited night calling. If lock-in prevents these

consumers from switching to a different carrier, it prolongs the wel-

fare costs of complexity.

182

In addition to these direct costs, lock-in may inhibit competition,

adding a potentially large indirect welfare cost. We have already men-

tioned that lock-in may prevent a more efficient carrier from attracting

consumers who are locked into a contract with a less efficient carrier.

Since lock-in makes large-scale entry into the market more difficult,

incumbents may have a greater incentive to seek monopolization

through predation or merger than in markets where easy entry limits

incumbents’ market power.

183

C. Complexity

The high level of complexity of cellular service contracts can re-

duce welfare in two ways. First, consumers will tend to make more

mistakes in plan choice when the choices are complex. Second, com-

plexity inhibits competition by discouraging comparison shopping. By

raising the cost of comparison shopping, complex contracts reduce the

likelihood that a consumer will find it beneficial to comparison shop.

Without the discipline that comparison shopping provides, cell phone

service providers can behave like quasi-monopolists — raising prices

and reducing consumer surplus.

D. Countervailing Benefits?

Three-part tariffs, lock-in clauses, and complexity harm consum-

ers and increase carriers’ profits. Competition among carriers, even if

imperfect, forces carriers to give back to consumers some of these

profits. Carriers will compete away excess profits by reducing prices

that are salient to consumers. Handset subsidies are the primary way

in which benefits flow back to consumers. However, these counter-

182. See infra Part V.C.

183. Joseph Farrell & Paul Klemperer, Coordination and Lock-In: Competition with

Switching Costs and Network Effects, in 3 H

ANDBOOK OF INDUS. ORG. 1967, 2005 (Mark

Armstrong & Robert Porter eds., 2007), available at http://www.nuff.ox.ac.uk/users/

klemperer/Farrell_KlempererWP.pdf.

No. 1] Mobile Misperceptions 99

vailing benefits do not eliminate the identified welfare costs. Even if

all excess profits are returned to consumers, there will still be an effi-

ciency cost. Consumer mistakes and the contractual design features

that respond to these mistakes lead consumers to misperceive the rela-

tive costs and benefits of different products. As a result, consumers

choose the wrong products and use these products sub-optimally.

Moreover, even if all excess profits are returned to consumers as a

group, there is no reason to believe that the benefit received by a con-

sumer will precisely offset the harm to that same consumer. In fact, it

is likely that consumers who are more prone to mistakes will be cross-

subsidizing consumers who are less prone to mistakes. The resulting

redistribution can reduce social welfare. Finally, one important effect

of lock-in and complexity is to reduce the level of competition in the

cellular services market. Reduced competition means that less of the

excess profits will find their way back into the hands of consumers.

VI. MARKET SOLUTIONS

Consumers make mistakes and carriers respond to these mistakes.

However, consumers also learn from their mistakes,

184

and carriers

respond to demand generated by the growing number of increasingly

sophisticated consumers. Moreover, in a competitive market, carriers

may have an incentive to correct consumer mistakes, at least when

these mistakes prevent consumers from fully appreciating the benefits

of the carrier’s product. We begin in Section A by describing a num-

ber of products and contracts that arguably respond to demand by

more sophisticated consumers. In Section B, we examine whether

these market solutions in fact solve the behavioral market failures

identified in this Article.

A. Catering to Sophisticated Consumers

The cellular service market boasts a large set of products and con-

tracts that arguably cater to more sophisticated consumers.

184. See Martin Gaynor et al., Cell Phone Demand and Consumer Learning — An Em-

pirical Analysis 25 (NET Inst., Working Paper No. 05-28, 2005),

available at

http://www.netinst.org/Shi.pdf (examining consumer behavior in Asia; finding “shrinking

posterior variances” of demand parameters to be evident of learning behavior). During the

first three months of their study, they also found a decline in the average number of minutes

used, a diversification of plan choices over time, a rapid decline in the deviation of actual

payment from the optimal payment, and a rapid increase in the proportion of consumers

choosing the optimal plan. Id. at 6–7. But this relatively quick learning and adjustment

behavior is a function of Thai calling plans, which have no lock-in feature. With lock-in,

learning is slower, since consumers cannot experiment with multiple plans over a short

period of time.

100 Harvard Journal of Law & Technology [Vol. 23

1. Unlimited Calling Plans

In February 2008, Verizon broke with industry pricing norms by

offering a $99 unlimited calling plan.

185

Soon after AT&T followed

suit, and T-Mobile went even further by including unlimited text mes-

saging along with unlimited voice in its unlimited plan.

186

Sprint then

unveiled a $99 plan that featured “unlimited voice, text messages,

email, web surfing, video, and other premium services.”

187

Unlimited

calling plans arguably respond to consumer complaints about overage

fees. Most likely, a sufficiently large subset of consumers, experienc-

ing the sting of large overage charges, generated demand for plans

without overage fees.

188

The rise of unlimited plans demonstrates both the power and pos-

sible unevenness of consumer learning. We have presented the three-

part tariff as a response to consumer misperceptions about future use.

Of the different components of the three-part tariff, the overage fee, is

likely to be the one which consumers learn to appreciate most quickly.

When consumers exceed the plan limit, they receive a very direct and

painful feedback which helps them learn. But, as argued above, the

underestimation of use that triggers overage charges is just one-half of

the problem. The other half — overestimation of use — is more diffi-

cult to learn. For a consumer using 50% of the allotted minutes, im-

plying a much higher per-minute rate than initially expected, there is

no direct feedback because the consumer still pays the same monthly

fixed fee. We doubt that many consumers divide this fee by the num-

ber of minutes actually used to derive the real per-minute price. The

185. Roger Cheng, Business Technology: Virgin Mobile to Join Flat Rate Phones Frenzy,

ALL ST. J., June 24, 2008, at B4.

186. Id.

187. Id. While these plans still entail a contract, smaller companies, like Virgin Mobile,

offer similar plans even without a lock-in contract. Id. The innovation was the introduction

of unlimited voice service. Data plans were always advertised as unlimited, but the fine

print included actual limits. Specifically, in the terms and conditions of their subscriber

contracts AT&T, Sprint, and Verizon reserve rights to impose additional charges or termi-

nate service if users use more than five gigabytes in a month, see, e.g., AT&T, Plan Terms,

supra note 129, while T-Mobile reserves such rights if users exceed ten gigabytes of usage

in a month, see T-Mobile, T-Mobile Terms & Conditions, supra note 129. Moreover, carri-

ers typically reserve rights to impose restrictions on consumers’ usage of other carriers’

wireless networks (“offnet usage”). Similarly, unlimited voice plans are not always truly

unlimited. For example, AT&T imposes limits on its unlimited voice services, specifying

that voice services are provided primarily for live dialog between two individuals. If a con-

sumer’s use of the service for conference calling or call forwarding exceeds 750 minutes in

a given month, the carrier may terminate the service or, after providing the user with notice

and an option to terminate, change the plan to one with no unlimited usage components. See

AT&T, Plan Terms, supra note 129.

188. See Amol Sharma & Dionne Searcey, For Big Talkers, Wireless Firms Offer Flat

Rates, W

ALL ST. J., Feb. 20, 2008, at D1 (explaining that carriers are eliminating overage

penalties because consumers “detest” these penalties).

No. 1] Mobile Misperceptions 101

result of this uneven learning is unlimited plans, rather than the opti-

mal two-part tariff pricing scheme.

189

Moreover, the currently available unlimited plans are attractive

only to a relatively small fraction of heavy users. With their high

monthly fees, the unlimited plans are less attractive than the standard

three-part tariff plans for most users.

190

Therefore, the unlimited plans

are, at best, a limited market solution, targeted at a small segment of

cell phone users. These heavy users may learn more quickly and more

readily demand products that cater to their needs. A more general

market solution to consumer learning about underestimation and

overage costs, such as a two-part tariff, is still absent and, as men-

tioned above, so is a market solution to the overestimation problem.

The move by Sprint and other carriers to bundle voice, messag-

ing, and data services in a single “unlimited” plan with a single

monthly fixed-fee

191

may be responding to learning of a different

kind. Consumers are “confused” by complex, multidimensional con-

tracts and are demanding greater “simplicity.”

192

While a single-price

“unlimited everything” plan is simpler, its simplicity can be over-

stated. In measuring simplicity, it is not enough to consider the price

and other product attributes of only a single plan. The level of com-

plexity is a result of the interaction between product attributes and

consumer usage patterns across a carrier’s entire menu of plans. So,

for example, in order to choose between a $99 unlimited plan and a

limited plan with a lower monthly fee (plus possibly separate charges

for text messaging and data services), consumers must still form accu-

rate estimates of their future use and calculate the expected total price

of both plans — a potentially difficult task.

2. AT&T’s Rollover Minutes

Consumer use varies from month to month. For example, a con-

sumer may talk 350 minutes one month and 550 minutes the next

month. With a standard 450 minute plan, this consumer will waste

100 minutes in the first month and pay overage charges for 100 min-

utes. With AT&T’s 450 minute plan, which includes the rollover

minutes feature, the 100 spare minutes in the first month are not

wasted. Rather they are “rolled over” to, that is, added to the available

189. Many consumers probably still overestimate their usage and could benefit from

moving from an unlimited plan to a limited plan with a lower monthly fee. See supra

Part IV.A.1.b.

190. See Jeff Blyskal, Mostly Talk: New Unlimited Cell Plans Won’t Pay for Most,

ONSUMERREPORTS.ORG, Feb. 26, 2008, http://blogs.consumerreports.org/electronics/

2008/02/mostly-talk-new.html.

191. See Cheng, supra note 185.

192. Blumenstein, supra note 116.

102 Harvard Journal of Law & Technology [Vol. 23

minutes for, the second month.

193

This means that in the second

month the consumer has 550 minutes instead of 450 minutes and thus

will not pay any overage.

194

The rollover feature, which predates the

unlimited calling plans described above, can also be seen as a re-

sponse to consumer learning about the costs of underestimated use

and overage charges. But, unlike unlimited plans that directly respond

to underestimation of use, the rollover feature seems to respond to a

different bias — overconfidence about use levels, which implies un-

derestimation of use in some months and overestimation of use in oth-

ers. By enabling the consumer to smooth his uneven use over time,

the rollover feature mitigates the costs of overconfidence.

3. Prepaid Plans

Prepaid, no-contract plans are the natural choice for a sophisti-

cated consumer who has learned the costs of lock-in and demands

flexibility. This flexibility, however, comes at a cost. Not only do pre-

paid, no-contract subscribers forgo the phone subsidies offered to

postpaid, locked-in subscribers, they also pay higher per-minute

charges (at least as compared to postpaid subscribers who use all the

allotted minutes under their plans). As a result, even a sophisticated

consumer would be reluctant to choose a prepaid plan. In fact, pre-

paid, no-contract plans were designed for distinct segments of con-

sumers, specifically younger and poorer consumers who have low

credit scores and do not qualify for a postpaid plan.

195

In other words,

prepaid plans are not a market response to consumer learning. None-

theless, these plans are attractive to sophisticated consumers with rela-

tively low use levels.

Despite their potential benefits, prepaid plans have a rather lim-

ited market share. In the U.S., only 16% of cell phone users have pre-

paid plans, and among households with incomes above $75,000, only

193. Unused minutes do not roll over forever. They expire after a year.

194. In this example, the rational non-AT&T customer will switch to a 900 minute plan

and pay an additional $20 per month because this charge is smaller than the average overage

paid in the seemingly cheaper plan: $45 / 2 months = $22.50 per month.

195. FCC

TWELFTH REPORT, supra note 34, at 2297–98 ¶¶ 116–18; see also Gerry Kher-

mouch & Catherine Yang, Richard Branson: Winning Virgin Territory, B

US. WK., Dec. 22,

2003, at 45 (noting that Virgin is attracting young customers by offering no-contract prepaid

cellular service). No-contract plans are less profitable for carriers, even though the rates per

minute of use are higher. For example, T-Mobile generates about $24 in revenue per prepaid

customer, as opposed to about $52 per postpaid contract user. Marin Perez, T-Mobile’s Data

Revenues Increase From Android-Powered G1, I

NFORMATIONWEEK, Nov. 6, 2008,

http://www.informationweek.com/news/telecom/business/

showArticle.jhtml?articleID=212001129; see also FCC

TWELFTH REPORT, supra note 34, at

2297 ¶ 116 (noting that prepaid plans were not heavily promoted by the industry in the past

because average revenues per unit tend to be lower and churn rates higher relative to post-

paid calling plans). It can thus be inferred that prepaid plans are targeted at consumer groups

that would not use cell phones absent the prepaid option, or that would pose too great a

credit risk to qualify for a postpaid plan.

No. 1] Mobile Misperceptions 103

6% of cell phone users have prepaid plans.

196

These figures lend sup-

port to the proposition that many prepaid users likely did not choose

prepaid plans but rather were denied the postpaid option. This rein-

forces the claim that prepaid plans target weaker segments of the mar-

ket and, for the most part, do not compete directly with postpaid

plans. Importantly, the low take-up of prepaid plans is not attributed

to a lack of familiarity with the prepaid option, as 86% of Americans

report that they are familiar with prepaid cell phones.

197

Arguably,

consumers are aware of the prepaid option but unaware of the cogni-

tive biases that render this option less attractive or, more accurately,

render the postpaid alternative more attractive. But this is starting to

change. Prepaid plans are now attracting consumers from segments of

the market previously controlled by postpaid plans. In 2008, sales of

prepaid plans grew 13% in North America, nearly three times faster

than traditional postpaid plans.

198

It should also be noted that prepaid plans, while solving the lock-

in problem, do not eliminate consumer mistakes. Misperceptions

about future use may still lead consumers to choose the wrong

monthly prepaid plan. Expiration dates on minutes purchased under

pay-as-you-go plans may be a response to consumers’ overestimation

of use.

4. Graduated ETFs

As described in Part III.B, carriers have been moving from a

time-invariant ETF to a time-variant, graduated ETF structure. This

shift responds to consumers’ increased awareness and sensitivity to

ETFs. The change in the design of ETF provisions is not a pure mar-

ket solution. Rather, it is an example of how consumer learning and

legal intervention can work in tandem to change business practices.

The ETF story likely began with a small number of consumers who

learned to appreciate the cost of ETFs and initiated litigation against

the carriers. The threat of liability probably pushed carriers to adjust

their ETF structure. But the litigation also facilitated greater aware-

ness and sensitivity to ETFs among consumers. This adjusted demand

was something that carriers could not ignore.

196. OPINION RESEARCH CORPORATION, PREPAID PHONES IN THE U.S.: MYTHS, LACK

CONSUMER KNOWLEDGE BLOCKING WIDER USE 4, 10 (Dec. 4, 2008), http://

www.newmillenniumresearch.org/archive/120408_prepaid_myths_survey_report.pdf.

197. Id. at 3.

198. Jenna Wortham, Cellphones Without Strings, N.Y.

TIMES, Feb. 20, 2009, at B1 (de-

scribing the growing attraction of prepaid plans and citing Pali Research, an investment

advisory firm, regarding the growth rate of prepaid plans); see also FCC

THIRTEENTH RE-

PORT

, supra note 32, at 6246 ¶ 117 (noting that according to one analyst’s figures, the per-

centage of major operators’ customers who subscribe to prepaid plans increased from 15%

at the end of 2006 to 17% at the end of 2007).

104 Harvard Journal of Law & Technology [Vol. 23

5. Open Access

Finally, the open-access movement in wireless telecommunica-

tions is a market-driven development that could reduce the costs of

lock-in and handset-service bundling. While carriers are still the lead-

ing handset retailers, recent developments are diminishing their power

such that it is likely that handset manufacturers will increasingly sell

their products directly to consumers, who can use the phone on any

network. Open access is not a response to consumer learning about

biases and the cost of lock-in. Nevertheless, it is an important devel-

opment that can reduce the costs of consumer biases.

B. Market Solutions and Consumer Welfare

Cell phone users learn from their mistakes, and the cellular ser-

vice market seems quite responsive to demand generated by these

increasingly sophisticated consumers. From a policy perspective, the

question is to what extent market solutions mitigate the welfare costs

identified in Part V. First, we have shown that the market promptly

responds when consumers quickly learn about the implications of

their mistakes, as they do when underestimated use leads to overage

charges. But we have also shown that the market responds more slug-

gishly when learning is slower because the feedback mechanisms are

weaker, as is the case with overestimated use. Second, while the mar-

ket solutions described above have the potential to minimize the wel-

fare costs of the identified behavioral market failure, in practice their

effects are more limited. The reason is that many consumers do not

take advantage of these market solutions. For example, unlimited

plans with their high monthly fees are attractive only to a small frac-

tion of heavy users. Prepaid plans are chosen by a small minority of

consumers. If consumers are not aware of their mistakes, then they

will not search for products that reduce the likelihood and conse-

quences of mistakes.

Finally, it is evident that consumers learn and that the market re-

sponds to the demand generated by these more sophisticated consum-

ers. But this does not mean that welfare costs are not incurred during

the interim period. We need to ascertain the speed of consumer learn-

ing and of the market response to changing demand in order to assess

the magnitude of welfare costs. Moreover, when consumers learn to

overcome one mistake, or when one hidden term becomes salient,

carriers have an incentive to add a new non-salient term and to trigger

a new kind of mistake.

199

Even if consumers always catch up eventu-

ally, this cat-and-mouse game imposes welfare costs. Wireless opera-

199. See Gabaix & Laibson, supra note 5, at 1–2.

No. 1] Mobile Misperceptions 105

tors are among the leading generators of consumer complaints.

200

Market solutions, while important, are clearly imperfect.

VII. POLICY IMPLICATIONS

The identified behavioral market failure imposes substantial wel-

fare costs. Consumer learning coupled with market forces works to

reduce these welfare costs, but do not eliminate them. Can legal inter-

vention help, perhaps only by reinforcing consumer learning and mar-

ket correction? In this Part, we initially survey existing rules and

regulations affecting the cellular service contract. We then tentatively

propose several reforms, focusing on the disclosure regime. Focusing

on disclosure targets the behavioral market failure by reducing con-

sumer misperceptions. More intrusive regulations, such as forcible

unbundling of equipment and service contracts, would eliminate costs

associated with consumer misperceptions, but at the cost of eliminat-

ing efficiency benefits that can arise through bundling in competitive

markets.

A. Existing Regulations Affecting the Cellular Service Contract

1. Who Can Regulate?

The FCC has plenary jurisdiction to license radio spectrum for

wireless communication under the Communications Act of 1934.

201

Accordingly, states lack the authority to license radio spectrum for

intrastate uses.

202

Moreover, the Omnibus Budget Reconciliation Act

of 1993 amended the Communications Act to preempt states from

regulating the entry of, or rates charged by, any wireless provider;

states, however, retain the right to regulate other terms and condi-

tions.

203

Consumers can sue wireless carriers under state tort, contract,

and consumer protection laws for false advertising, misleading billing

practices, and poor service.

204

States can petition the FCC for author-

200. See Spencer E. Ante, The Call for a Wireless Bill of Rights, BUS. WK., Mar. 20,

2008, at 80, available at http://www.businessweek.com/magazine/content/08_13/

b4077080431634.htm?campaign_id=rss_tech (noting that, according to the Better Business

Bureau, for each of the past three years, the wireless sector has received more complaints

than any other industry). In the second quarter of 2008, the FCC received 13,560 complaints

about wireless telecommunications. FCC,

QUARTERLY REPORT ON INFORMAL CONSUMER

INQUIRIES AND COMPLAINTS RELEASED 1 (Jan. 8, 2009), available at http://

hraunfoss.fcc.gov/edocs_public/attachmatch/DOC-287780A1.pdf.

201. William R. Drexel, Telecom Public Policy Schizophrenia: Schumpeterian Destruc-

tion Versus Managed Competition, 9 V

A. J.L. & TECH. 5, 7–8 (2004),

http://www.vjolt.net/vol9/issue2/v9i2_a05-Drexel.pdf; see also 47 U.S.C. § 301 (2006).

202. Drexel, supra note 201, at 8.

203. Id.; see also 47 U.S.C. § 332(c)(3)(A) (2006).

204. N

UECHTERLEIN & WEISER, supra note 8, at 273. Carriers, however, argue that such

regulation is preempted as it amounts to entry or rate regulation. See infra note 232.

106 Harvard Journal of Law & Technology [Vol. 23

ity to regulate rates for any commercial mobile service, which will be

granted upon a demonstration that market conditions fail to ade-

quately protect consumers against “unjust and unreasonable rates or

rates that are unjustly or unreasonably discriminatory.”

205

In addition,

states retain the authority to impose requirements on telecommunica-

tions services that are “necessary to ensure the universal availability

of telecommunications service at affordable rates.”

206

State and local

governments also retain zoning authority that gives them control over

the placement of wireless service facilities, so long as the regulations

do not have the effect of unreasonably discriminating among provid-

ers or prohibiting the provision of wireless services.

207

2. Indirect Effects

Under the 1996 Telecommunications Act, wireless carriers are

subject to certain provisions designed to promote competition.

208

For

instance, all telecommunications carriers have “the duty to intercon-

nect directly or indirectly with the facilities and equipment of other

telecommunications carriers.”

209

The FCC invoked its authority to

enact competition-enhancing regulations when it extended manual

roaming obligations — previously imposed only on cellular provid-

ers — to broadband PCS (personal communications service)

210

and

certain SMR (specialized mobile radio)

211

carriers.

212

205. 47 U.S.C. § 332(c)(3)(A)(i) (2006).

206. Id. § 332(c)(3)(A).

207. Id. § 332(c)(7).

208. A stated purpose of the Act is “[t]o promote competition and reduce regulation in

order to secure lower prices and higher quality services for American telecommunications

consumers and encourage the rapid deployment of new telecommunications technologies.”

Telecommunications Act of 1996, Pub. L. No. 104-104, purpose statement, 110 Stat. 56, 56

(1996) (codified as amended at 47 U.S.C. §§ 251–76 (2006)).

209. 47 U.S.C. § 251(a)(1) (2006).

210. The FCC has set aside the spectrum between 1850 MHz and 1990 MHz for broad-

band PCS. PCS licenses have been assigned through auction since 1995 with some blocks

assigned on the basis of 51 Major Trading Areas and others on the basis of 493 Basic Trad-

ing Areas. FCC

ELEVENTH REPORT, supra note 17, at 10974–75 ¶ 63. Broadband PCS

systems are similar to cellular systems, except that they operate in different spectrum bands

and have been designed from the beginning to use a digital format. Id.

211

. Specialized Mobile Radio (SMR) services were created by the FCC in 1974 to pro-

vide land mobile communications on a commercial basis to businesses, government agen-

cies, and individuals. U.S. C

ONG. OFFICE OF TECH. ASSESSMENT, THE 1992 WORLD

ADMINISTRATIVE RADIO CONFERENCE: ISSUES FOR THE U.S. INTERNATIONAL SPECTRUM

POLICY 39 (1991). In 1979, the FCC allocated 19 MHz of spectrum in the 800 and 900 MHz

bands exclusively for SMR services. FCC

ELEVENTH REPORT, supra note 17, at 10975–76

¶ 64. Nextel (and now Sprint-Nextel) is an SMR provider.

212. See In re Interconnection and Resale Obligations Pertaining to Commercial Mobile

Radio Services, Second Report and Order and Third Notice of Proposed Rulemaking, FCC

CC Docket No. 94–54, 11 F.C.C.R. 9462, 9463 (1996) (invoking its general authority under

the Telecommunications Act to extend number portability requirements, explicitly imposed

only on local exchange carriers, to wireless providers). In other areas, the FCC has taken a

deregulatory approach on the grounds that the market is sufficiently competitive. Thus, in

No. 1] Mobile Misperceptions 107

However, as we have seen, enhanced competition is not a general

solution to the identified behavioral market failure. If consumers suf-

fer from a systematic bias, competition may force carriers to design

their contracts in response to this bias. Nevertheless, regulations de-

signed to enhance competition have an indirect effect on the carrier-

consumer relationship and the cell phone contract — an effect that is

often beneficial to consumers, including imperfectly rational consum-

ers. First, competition can help reduce consumer bias as competing

carriers develop market solutions and advertise them to consumers.

Second, regulation designed to increase competition by reducing

switching costs

213

can help imperfectly rational consumers by pre-

venting, or at least increasing the costs to carriers of, bundling strate-

gies.

While regulation affecting consumer switching costs limits pro-

viders’ ability to employ bundling strategies, the FCC does not di-

rectly regulate the practice of bundling of equipment and service. The

FCC held that the Communications Act’s general prohibition on offer-

ing more favorable terms on services and equipment that are pur-

chased together rather than separately does not apply to wireless

carriers.

214

The FCC judged that the markets were sufficiently com-

petitive to ensure that the risks of carriers leveraging market power

from the services market to the equipment market were sufficiently

low and outweighed by the benefits of permitting bundling. In particu-

lar, the FCC determined that permitting bundling allows carriers to

provide service and equipment more economically.

215

If consumers are rational, it makes sense to permit bundling when

both markets are competitive. But the conclusion no longer necessar-

ily follows when, for example, consumers systematically underesti-

mate the cost of service so that carriers have an incentive to backload

the pricing by reducing the cost of the handset and increasing the

1996, the FCC determined that its rules prohibiting wireless carriers from imposing restric-

tions on resellers would “sunset” by 2001. N

UECHTERLEIN & WEISER, supra note 8, at 272.

213. E.g., In re Telephone Number Portability, FCC CC Docket No. 95-116, 19 F.C.C.R.

875, 875–76 (2004) (mandating number portability between networks); see also 37 C.F.R.

§ 201.40(b)(5) (2008) (exempting software that “unlocks” wireless handsets from the Digi-

tal Millennium Copyright Act). On this dimension, the U.S. is converging to the European

model. See Ante, supra note 74 (“European and Asian mobile carriers [have] backed tech-

nologies that allow subscribers to switch to rivals with ease.”). In Europe, regulations man-

dating uniform technological standards have facilitated switching and competition by

making it easier for consumers to take their phone from one carrier to another. FCC

THIR-

TEENTH

REPORT, supra note 32, at 6250–51 ¶ 126. And cell phone providers “use unlocked

GSM-type phones, which contain SIM cards” and allow users to switch their phones be-

tween networks. Reinhardt Krause, Sales of SIM Cards Might Shuffle Deck in Wireless

Services, I

NVESTOR’S BUSINESS DAILY, Sept. 18, 2008.

214. N

UECHTERLEIN & WEISER, supra note 8, at 270.

215. In re Bundling of Cellular Customer Premises Equipment and Cellular Service, Re-

port and Order, FCC CC Docket No. 91-34, 7 F.C.C.R. 4028, 4030 (1992).

108 Harvard Journal of Law & Technology [Vol. 23

price of service. Consumers end up purchasing too many cell phone

contracts because they underestimate the overall cost of the bundle.

3. Direct Regulations of the Consumer-Carrier Relationship

Regulation of the consumer-carrier relationship is largely limited

to regulation of the information that the provider must disclose to its

consumers. We begin by describing affirmative disclosure mandates.

We then proceed to discuss the flip-side of disclosure mandates,

namely, the prohibition on misleading disclosures, usually in advertis-

ing. We conclude with a description of the legal challenge to early

termination fees — the most prominent non-disclosure regulation.

216

a. Disclosure

Exercising its powers under the Communications Act, the FCC

promulgated rules intended to prevent fraudulent behavior by tele-

communications providers and to increase the transparency of provid-

ers’ billing practices. Providers must clearly identify the name of the

service provider associated with each billed charge and prominently

display a toll-free telephone number that customers can call to inquire

about or dispute any charges.

217

Most importantly, since 2005 charges

must “be accompanied by a brief, clear, non-misleading, plain lan-

guage description of the service or services rendered” that is “suffi-

ciently clear in presentation and specific enough in content so that

customers can accurately assess that the services for which they are

billed correspond to those that they have requested and received, and

that the costs assessed for those services conform to their understand-

ing of the price charged.”

218

The underlying rationale is “to allow

216. One form of regulation that is conspicuously missing is rate regulation. The states

are preempted from influencing rates except in very limited circumstances described above.

See supra note 203 and accompanying text. Under the Communications Act, wireless pro-

viders have an obligation to charge rates that are just, reasonable, and not discriminatory,

and the FCC is authorized to prescribe what is reasonable and just if a carrier is found to be

in violation of its duties under the Act. See 47 U.S.C. §§ 201(b), 202(a), 205(a) (2006).

However, the FCC has generally chosen to forbear from regulating rates for wireless com-

munications services. Using its authority under the Communications Act § 332, the FCC has

exempted wireless carriers from common carriers’ tariff obligations and market entry and

exit regulations on the grounds that competition renders such forms of regulation unneces-

sary. See N

UECHTERLEIN & WEISER, supra note 8, at 270.

217. 47 C.F.R. § 64.2401(a)(1), (d) (2008).

218. 47 C.F.R. § 64.2401(b) (2008). In 1999, the FCC set out general truth-in-billing

principles that required that bills (1) “be clearly organized, clearly identify the service pro-

vider, and highlight any new providers;” (2) “contain full and non-misleading descriptions

of charges;” and (3) “contain clear and conspicuous disclosure of any information that the

consumer may need to make inquiries about, or contest charges.” In re Truth-in-Billing and

Billing Format, First Report and Order and Further Notice of Proposed Rulemaking, FCC

CC Docket No. 98-170, 14 F.C.C.R. 7492, 7496 (1999) [hereinafter Truth-in-Billing 1999].

Although the FCC intended that these principles should apply to both wireline and wireless

No. 1] Mobile Misperceptions 109

consumers to better understand their telephone bills, compare service

offerings, and thereby promote a more efficient competitive market-

place.”

219

Further disclosure requirements are imposed at the state

level. In particular, state laws regulate wireless line item charges —

discrete charges that are separately identified on a consumer’s bill.

220

There have been calls for more stringent disclosure requirements.

For instance, in 2003, Senator Schumer introduced a bill — The Cell

Phone User Bill of Rights — designed to improve disclosure and

make it easier for consumers to choose among providers and plans.

The bill sought to ensure that marketing materials and contracts clear-

ly spell out the terms and conditions of service plans by requiring that

all wireless contracts and marketing materials display a box contain-

ing standardized information on a number of key issues. Providers

would have to disclose rate information, including the monthly fixed

charge, per minute charges for minutes not included in the plan, and

the method for calculating minutes charged. Information on included

weekday and daytime minutes and nights and weekend minutes, long-

distance charges, roaming charges, incoming call charges, and charges

for directory assistance would also have to be displayed. Termination

and start-up fees and trial periods would have to be outlined as would

any taxes and surcharges. In addition, the Bill would authorize the

FCC to monitor service quality industry-wide and make the resulting

data publicly available to enable consumers to make informed choices

among providers.

221

The Bill has not been enacted into law.

carriers, wireless carriers were initially exempted from the rule implementing (2) that re-

quired charges on bills to be accompanied by a brief, clear, non-misleading, plain language

description of the service or services rendered. See In re Truth-in-Billing and Billing For-

mat, Second Report and Order, Declaratory Ruling, and Second Further Notice of Proposed

Rulemaking, FCC CC Docket No. 98–170, 20 F.C.C.R. 6448, 6450–52 (2005) [hereinafter

Truth-in-Billing 2005]. However, the exemption was lifted in 2005. Id. at 6456.

219. Truth-in-Billing 2005, supra note 218, at 6450. The FCC rejected the argument that

competitive market conditions eliminate the need for the requirement concluding, on the

contrary, that “the provision of clear and truthful bills is paramount to efficient operation of

the marketplace” even under otherwise competitive conditions. Id. at 6456.

220. Id. at 6462. The FCC argued that these laws constitute rate regulation and are there-

fore preempted under § 332(c)(3)(A) of the Communications Act. Id. at 6462–63. However,

the 11th Circuit previously held that the Communications Act does not give the FCC the

authority to preempt states’ ability to regulate the use of line items in wireless customer

bills, arguing that such regulation affects the presentation of charges but not the amount

charged and that line item charges are not rates but rather are part of the “other terms and

conditions” that are subject to state regulations under § 332(c)(3)(A). See Nat’l Ass’n of

State Util. Consumer Advocates v. FCC, 457 F.3d 1238, 1254 (1996).

221. Cell Phone User Bill of Rights, S. 1216, 108th Cong. (2003). A similar bill, the

Wireless Consumer Protection and Community Broadband Empowerment Act, was pro-

posed more recently by Representative Edward Markey. See Press Release, Office of Rep.

Edward Markey, Markey Holds Hearings on Draft Bill to Address Wireless Customer Pro-

tections, Feb. 27, 2008, http://markey.house.gov/index.php?option=com_content&task=

view&id=3281&Itemid=241.

110 Harvard Journal of Law & Technology [Vol. 23

In 2004, the California Public Utility Commission (“CPUC”)

promulgated a similar set of rules.

222

These regulations required wire-

less providers and other telecommunications operators to (1) ensure

that subscribers receive clear and complete information about rates,

terms, and conditions when customers sign up for the service; (2) pro-

duce clearly organized bills that only contain charges that the sub-

scriber has authorized; and (3) list all federal, state, and local taxes,

surcharges, and fees separately.

223

The regulations were suspended by

the CPUC less than a year after their adoption, after the term expira-

tions of two commissioners who supported the rules.

224

The drive for

improved disclosure, however, is continuing. Twenty-two states have

introduced some form of a Cell Phone User Bill of Rights.

225

b. False Advertising

In addition to affirmative disclosure regulation, providers are sub-

ject to negative disclosure regulation, i.e., restrictions on what provid-

ers can tell consumers, mainly through advertising. Unfair or

deceptive advertising is generally policed by the FTC under the Fed-

eral Trade Commission Act.

226

However, the FTC Act explicitly ex-

cludes “common carriers subject to the Acts to regulate commerce,”

including the 1934 Communications Act,

227

to avoid interfering with

the FCC’s regulation of common carriers.

228

The FCC has interpreted section 201(b) of the Communications

Act, which prohibits “unjust and unreasonable” practices,

229

as giving

it the authority to police unfair or deceptive advertising by common

carriers.

230

However, it appears that the FCC rarely invokes its author-

ity under section 201(b).

231

Instead, advertising by cellular service

222. See Press Release, California Public Utilities Commission, PUC Sets Protection

Rules for Consumers Through Telecommunications Bill of Rights, May 27, 2004,

http://docs.cpuc.ca.gov/published/NEWS_RELEASE/36910.htm.

223. Id.; Robert W. Hahn et al., The Economics of “Wireless Net Neutrality,” 3 J.

COMPETITION L. & ECON. 399, 413 (2007).

224. California Suspends Wireless Bill of Rights, C

ONSUMERAFFAIRS.COM, Jan. 28,

2005, http://www.consumeraffairs.com/news04/2005/cpuc_wireless.html.

225. See Ante, supra note 74.

226. See 15 U.S.C. § 45(a)(2) (2006) (giving the FTC authority to prevent “unfair meth-

ods of competition in or affecting commerce and unfair or deceptive acts or practices in or

affecting commerce.”).

227. Id.

228. See FTC v. Verity Int’l, Ltd., 194 F. Supp. 2d 270, 275 (S.D.N.Y. 2002). Thus, a

wireless carrier is beyond the reach of the FTC at least insofar as it engaged in providing

telecommunications services. See id. at 274.

229. 47 U.S.C. § 201(b) (2006).

230. See In re Bus. Disc. Plan, Inc., Order of Forfeiture, 15 F.C.C.R. 14461 (2000), aff’d

in relevant part, In re Bus. Disc. Plan, Inc., Order on Reconsideration, 15 F.C.C.R. 24396,

24398 (2000).

231. In arguing that 47 U.S.C. § 201(b) gave it the authority to assess a forfeiture against

Business Discount Plan for using unjust and unreasonable telemarketing practices in con-

No. 1] Mobile Misperceptions 111

providers is mainly regulated at the state level. Consumers have been

using state tort law, specifically fraud and misrepresentation, contract

law, and deceptive advertising laws to hold providers accountable for

service that fell short of what the provider’s advertisements prom-

ised.

232

c. Challenging ETFs

On one important dimension, early termination fees, the law has

moved beyond the regulation of information provided by carriers.

Class action lawsuits against cellular service providers have been ini-

tiated across the United States by customers alleging that ETFs are not

proper liquidated damages provisions and violate various state laws as

a result.

233

In one such lawsuit, the Alameda County Superior Court

found that Sprint’s ETF was an unlawful penalty under California

Civil Code 1671(d) and ordered Sprint to pay $18.25 million to class

members who paid their ETFs and credit $54.75 million to those who

nection with its “slamming” violations, the FCC cited only two instances in which it had

invoked § 201(b) for a similar purpose in the past, suggesting that the FCC does not fre-

quently invoke this authority. See In re Bus. Disc. Plan, Inc., Order of Forfeiture, 15

F.C.C.R. at 14469.

232. See, e.g., Pac. Bell Wireless, LLC v. Pub. Utils. Comm’n, 44 Cal. Rptr. 3d 733,

753–54 (Cal. Ct. App. 2006) (upholding multimillion dollar fine against wireless service

provider for, inter alia, failing to disclose to customers known network problems and mis-

leading customers regarding network’s coverage and service in violation of state law); Un-

ion Ink Co. v. AT&T Corp., 801 A.2d 361, 365–67, 378 (N.J. Super. App. Div. 2002)

(holding that plaintiff’s state law fraud and negligent misrepresentation claims arising from

AT&T’s alleged misrepresentations of the quality and reliability of its cellular phone service

were not preempted by federal law). Providers have been pushing for broad preemption of

such regulation on grounds that it constitutes regulation of “entry or rates charged” which is

prohibited under § 332(c)(3)(A). Specifically, they have argued that “any determination of

monetary liability [under state consumer protection, tort, or contract claims] is equivalent to

a finding that the service was inadequate for the price charged and therefore necessarily

constitutes a finding that the rates originally charged were unreasonable.” In re Wireless

Consumers Alliance, Inc., FCC Memorandum Opinion and Order, 15 F.C.C.R. 17021,

17035 (2000). However, the FCC rejected this argument, holding that state law claims must

generally proceed, unless the particular facts and circumstances of the case indicate that

they amount to rate or entry regulation. In particular, the FCC reasoned that in calculating

damages arising from breach of contract or false advertising claims, a court need not rule on

the reasonableness of the carrier’s charges in order to calculate compensation though it may

take price into account; rather, it is assessing the difference between promise and perform-

ance. Id. at 17035–36, 17040–41; see also Fedor v. Cingular Wireless Corp., 355 F.3d 1069,

1074 (7th Cir. 2004) (holding that breach of contract claim based on allegation that carrier

deferred billing for calls to later period was not preempted); DeCastro v. AWACS, Inc., 935

F. Supp. 541, 550 (D.N.J. 1996) (holding that claim about failure to disclose a particular

billing practice was not preempted); Tenore v. AT&T Wireless Servs, 962 P.2d 104, 115

(Wash. 1998) (holding that deceptive advertising claim that carriers failed to disclose prac-

tice of rounding up to nearest minute was not preempted).

233. See, e.g., Greene v. T-Mobile USA, Inc., No. C07-1563RSM, 2008 WL 351017

(W.D. Wash. Feb. 7, 2008); Waudby v. Verizon Wireless Servs., LLC, No. 07-470(FLW),

2007 WL 1560295 (D.N.J. May 25, 2007); In re Cell Phone Termination Fee Cases, No.

A115457, 2008 WL 2332971 (Cal. Ct. App. June 9, 2008).

112 Harvard Journal of Law & Technology [Vol. 23

were charged but did not pay their ETFs.

234

Verizon Wireless recently

settled a set of early-termination lawsuits for $21 million.

235

Other

state actions have been stayed pending the outcome of FCC proceed-

ings,

236

which have been initiated to determine whether these state law

claims are preempted by federal law on the grounds that ETFs consti-

tute “rates charged” within the meaning of § 332(c)(3)(A) of the

Communications Act.

237

The FCC public hearings on ETFs began on

June 12, 2008.

238

In the wake of this litigation, carriers have moved to prorate their

termination fees over the life of the contract and now some form of

time-sensitive ETF applies to new postpaid contracts initiated with

any of the major carriers.

239

B. New Proposals: Rethinking Disclosure

1. From Product Attributes to Use Patterns

As we have seen, consumers in the cellular service market learn,

often quite effectively, to appreciate the implications of their biases

and mistakes. Competition then pushes carriers to respond with prod-

ucts that reduce the resulting costs to consumers. While these market

solutions are imperfect, the market’s responsiveness suggests that the

regulation best suited for the cellular service market would facilitate

rather than inhibit market forces. It is, therefore, not surprising that

many of the existing and proposed laws and regulations have focused

on the provision of information. We too focus on rules governing in-

formation provision, specifically, on disclosure regulation.

Our proposals, however, deviate from existing disclosure regula-

tion and from other proposals for heightened disclosure regulation in

an important way. Current disclosure regulation focuses on the disclo-

sure of product attribute information, i.e., information on the different

234. Ayyad v. Sprint Spectrum LP, No. RG03-121510, 2008 WL 2937047 (Cal. App.

Dep’t Super. Ct. July 28, 2008).

235. Lavallee, supra note 126.

236. See, e.g., Greene, 2008 WL 351017; Waudby, 2007 WL 1560295.

237. Waudby, 2007 WL 1560295, at *1.

238. Materials from the public hearing are available at

FCC, Public Hearing on Early

Termination Fees (ETF), http://www.fcc.gov/realaudio/presentations/2008/061208/; see

also Amy Schatz, FCC May Set Cell-Termination Fees, W

ALL ST. J., May 24, 2008, at A2.

Schatz discusses the possible preemption effect of FCC regulation.

Wireless-phone companies could erase hundreds of millions of dol-

lars in potential liability under a plan being weighed by federal regu-

lators, who are considering overseeing fees charged to consumers

who cancel cell phone contracts early. The plan could deal a fatal

blow for lawsuits, pending in several states, brought by consumers

angry about fees of as much as $175 that wireless companies charge

to break contracts.

Id.

239. See supra notes 128–29 and accompanying text.

No. 1] Mobile Misperceptions 113

features and price dimensions of cellular service.

240

Our proposal, on

the other hand, emphasizes the disclosure of use-pattern information,

i.e., information on how the consumer will use the product.

The proposed Cell Phone User Bill of Rights illustrates the cur-

rent exclusive focus on product attribute information. It requires com-

prehensive disclosure of fees and charges.

241

However, a truly

informed choice cannot be based on product attributes alone. To fully

appreciate the benefits and costs of a cellular service contract, con-

sumers must combine product attribute information with use-pattern

information. To assess the costs of overage fees, it is not enough to

know the per-minute charges for minutes not included in the plan, as

proposed in the Bill; consumers must also know the probability that

they will exceed the plan limit and by how much. Likewise, to assess

the benefit of unlimited night and weekend calling, consumers must

also know how many “night” and “weekend” minutes they will use as

well as the precise contractual definition of “night” and “weekend.”

The essence of our proposal lies in the recognition that use-pattern

information can be as important as product attribute information. The

disclosure regime should be redesigned to ensure that consumers have

both categories of information.

2. Disclosing Use-Pattern Information

Conventional wisdom assumes that sellers have better informa-

tion about product attributes while buyers have better information

about use patterns. If a buyer has better information about how she

will use the product, then it makes no sense to require sellers to dis-

close use-pattern information. The best that sellers can do is to pro-

vide general statistical information on product use. The buyer, on the

other hand, has specific information on how she, not the average con-

sumer, will use the product, or so the conventional account goes.

While in many markets the conventional wisdom is correct, it is

not true of the cellular service market. Carriers have valuable statisti-

cal use-pattern information that is not available to subscribers. More

importantly, they have individualized use-pattern data, collected over

the course of their relationships with their subscribers. As suggested

below, disclosing this information can empower consumers and facili-

tate the efficient functioning of the cellular service market.

a. Average-Use Disclosures

Carriers collect and analyze enormous amounts of use-pattern in-

formation. They know how the average subscriber will use her cell

240. See supra Part III.A.

241. See supra note 221 and accompanying text.

114 Harvard Journal of Law & Technology [Vol. 23

phone. More importantly, the heterogeneity of the subscriber base

allows carriers to provide average-use information for subgroups of

consumers who are similar — in terms of demographic characteris-

tics, product choices made, etc. — to the consumer receiving the use-

pattern disclosure. As the subgroup over which the averaging takes

place becomes smaller, the consumer heterogeneity problem de-

creases, and the value of the average-use information to the individual

consumer increases. However, excessively small subgroups may also

be undesirable. Averaging over large numbers has the benefit of re-

ducing randomness. Reducing the size of the subgroup reduces this

benefit. The optimal size of a subgroup is the product of a tradeoff

between the benefit of reducing heterogeneity and the benefit of re-

ducing randomness.

One potentially beneficial average-use disclosure would target

the misperception of use levels that underlies three-part tariffs by re-

quiring carriers to disclose the average overage charges that consum-

ers pay. Carriers could also be required to disclose the percentage of

consumers who use, for example, 50% or less of their allotted minutes

or the percentage of consumers who would save money if they

switched to a lower fixed-fee, lower limit plan. Consumers’ underes-

timation of the cost of lock-in could be targeted by requiring carriers

to provide information about the percentage of consumers who stop

using their phones but continue paying for them before the end of the

lock-in period. Carriers could also be required to disclose the percent-

age of consumers who broke the contract and paid the exit penalty.

242

b. Individual-Use Disclosures

Despite their potential benefits, average-use disclosures suffer

from important shortcomings. Even when averaging across smaller

subgroups of consumers, substantial heterogeneity remains. Hetero-

geneity limits the value of average-use information to any individual

consumer. Moreover, heterogeneity allows optimistic consumers to

further discount the value of average-use information. Most people

think that their driving skills are above average (but of course, most

people cannot be better than others given a symmetrical distribution

of ability about the mean).

243

Similarly, optimistic consumers might

all think that they will never exceed the plan limit, even when pro-

vided with information that the average consumer pays $50 a month

242. Both of these disclosures are incomplete measures of the cost of lock-in since they

do not capture consumers who continue using their phones only because they are locked in.

243. See David A. Armor & Shelley E. Taylor, When Predictions Fail: The Dilemma of

Unrealistic Optimism, in H

EURISTICS AND BIASES: THE PSYCHOLOGY OF INTUITIVE

JUDGMENT 334, 334 (Thomas Gilovich et al. eds., 2002); Neil D. Weinstein, Unrealistic

Optimism About Future Life Events, 39 J. P

ERSONALITY & SOC. PSYCHOL. 806, 818–19

(1980).

No. 1] Mobile Misperceptions 115

in overage fees. Fortunately, use-pattern disclosure in the cellular ser-

vice market need not be limited to average-use information. The long-

term relationship between carriers and consumers allows for the pro-

vision of individualized use-pattern information.

244

Individual-use disclosure can reduce consumers’ misperceptions

of their use levels. Carriers already provide consumers with individu-

alized information on overage charges. Arguably, this disclosure re-

duced consumers’ underestimation of use and contributed to the

demand to eliminate overage fees — a demand that is now met by

unlimited calling plans. We propose a parallel disclosure requirement

that would help reduce the costs consumers incur due to overestima-

tion of use. Carriers should be required to disclose the number of

minutes used. (Some carriers already do so voluntarily.) Moreover,

they should be required to disclose the actual per-minute price, calcu-

lated as the monthly fixed-fee divided by the number of minutes

used.

245

Individual-use disclosure can also help consumers evaluate the

costs and benefits of other plan features. Carriers could be required to

disclose the number of night and weekend minutes used and the costs

saved by the unlimited nights and weekends feature. They could also

be required to disclose the number of minutes used in in-network call-

ing and the associated savings. Likewise, Verizon, which offers

unlimited calls to five numbers, could be required to disclose the

number of minutes used calling these five numbers, and the costs

saved by this feature.

The existing and proposed disclosures could be further supple-

mented by information on alternative service plans and add-on fea-

tures that would reduce the total price paid by the consumer given her

current use patterns.

246

The proposed individual-use disclosures, in-

cluding the comparison with other plan and add-on combinations,

should be provided on the monthly bill, but also in aggregate form on

a year-end summary to account for month-to-month variations in use.

Thus, by highlighting the importance of individual-use disclosures,

we urge lawmakers to revisit another key feature of the proposed Cell

244. Of course, consumers have access to the same use-pattern information. But while

providers save the information and analyze it, consumers tend not to notice it and even if

they do notice it, they tend to forget it.

245. A related disclosure is now voluntarily implemented by T-Mobile which offers

“overage alerts” when subscribers get close to their monthly limit.

246. Utility companies in Germany have voluntarily adopted an even more pro-consumer

policy. At the end of the year they retroactively match each consumer to the service plan

under which the consumer pays the lowest total price given her use over the past year. See

Ian Ayres & Barry Nalebuff, In Praise of Honest Pricing, 45 M.I.T.

SLOAN MGMT. REV. 24,

27 (2003). A similar idea is already being applied by cell phone companies in other coun-

tries. See, e.g., Orange.fr, Forfait Ajustable Pro, http://sites.orange.fr/boutique/

files/html/pe_packpro_forfait_ajustable.html (last visited Dec. 20, 2009) (Orange in France

offers to charge the subscriber at the end of the month according to the plan that best fits

the subscriber’s usage during that month).

116 Harvard Journal of Law & Technology [Vol. 23

Phone User Bill of Rights. This Bill focuses on disclosures provided

at the time of contracting, which makes perfect sense when carriers

are disclosing product attribute information. Individual-use informa-

tion, on the other hand, is not available to carriers when a new sub-

scriber signs up for service. Continuous disclosures throughout the

life of the contract are equally important.

c. Individual-Use Disclosures in Real Time

In addition to after-the-fact disclosure of individual-use informa-

tion in the monthly bill or in a year-end summary, individual-use in-

formation can sometimes be provided in real time. The challenge of

keeping track of cumulative use has increased with the invention of

multiple-limit plans. For example, plans with different limits for peak

and off-peak minutes, have increased the chance that consumers inad-

vertently exceed their plan limits. To help consumers avoid this, carri-

ers could be required to notify their subscribers when they are about

to exceed the plan limit.

247

A consumer receiving such notification

may well decide to cut the conversation short, switch to a land line, or

postpone the conversation until off-peak hours.

3. Combining Use-Pattern Information with Product Attribute

Information

In describing our proposals, we have focused on the disclosure of

use-pattern information as opposed to product-attribute disclosures.

But, in fact, the more appealing proposals argue for total cost disclo-

sures, which combine both. For example, the disclosure of actual per-

minute prices combines product attribute information, i.e. the monthly

fixed-fee, and use-pattern information, i.e. the number of minutes

used. Taking total cost disclosure one step further, carriers could be

required to disclose a comprehensive total cost of ownership (“TCO”)

figure for their calling plans — the total amount paid, or to be paid, by

a consumer, including overage charges and ETFs, over the duration of

a plan, or on a yearly basis. For new subscribers, this TCO figure can

be based on average-use information. For existing subscribers, who

are considering whether to renew their plan, switch plans, or even

switch carriers, the TCO figure can be based on individual-use infor-

mation.

TCO information for a single plan, specifically for the sub-

scriber’s current plan, may be insufficient. To effectively compare

different plans, the subscriber needs TCO information on all plans.

Carriers could be required to provide TCO information for their entire

247. Such a disclosure is now voluntarily implemented by T-Mobile. See supra note 245.

No. 1] Mobile Misperceptions 117

menu of plans or, at least, for several main offerings. Perhaps a better

solution would be to require carriers to disclose only the plan with the

lowest TCO for the prospective subscriber and for the existing sub-

scriber whose use patterns have changed. For example, the monthly

bill or yearly summary can include a notice if an alternative plan

would have a lower TCO than the subscriber’s current plan. An even

better solution would utilize the emerging market for comparison-

shopping services. Companies like BillShrink.com

248

and

Validas

249

promise to find the right plan for each consumer. But they

currently do this based on minimal, usually self-reported, use-pattern

information.

250

If carriers were required to provide comprehensive

use-pattern information in electronic form, websites such as Bill-

Shrink.com or Validas would be better able to provide useful recom-

mendations.

Consumer choice should be guided by information about the total

cost of the product. Conventional wisdom assumes that consumers

have better information about their own use patterns and thus need

only product attribute disclosures to calculate total cost. We have

shown that carriers may well have better use-pattern information, as

well as better product attribute information. They can more easily

combine the two categories of information into a total cost disclosure.

Therefore, there is a prima facie case for mandating total cost disclo-

sures.

251

4. Mobile Disclosure

Traditional disclosure mandates require sellers to provide infor-

mation printed on a piece of paper. Mobile technology opens the door

to a variety of innovative disclosure methods. In particular, carriers

can provide information via voice messages, via text messages, and

even via multimedia messages. These modes of disclosure may be

more effective than the traditional paper disclosure because of their

immediacy.

248. BillShrink.com, We Empower and Inspire People to Save Money, http://

billshrink.com/about/ (last visited Dec. 20, 2009).

249. Validas, Personal Report: How It Works, http://fixmycellbill.com/personal.aspx?

section=how (last visited Dec. 20, 2009).

250. See id.

251. We concede that our arguments only establish a prima facie case for total cost dis-

closures, since our analysis did not consider all the costs and benefits of revamping the

current disclosure regime. At the very least, however, our analysis suggests that the current

debates, e.g., over the Cell Phone User Bill of Rights, should consider total cost disclosures.

118 Harvard Journal of Law & Technology [Vol. 23

5. From Description to Prescription

A final clarification is in order: we developed a behavioral eco-

nomics theory of contractual design in the cellular service market. We

then proposed an enhanced disclosure regime to improve the opera-

tion of the cellular service market. It is important to note that our pol-

icy prescription does not depend on our behavioral description. Even

if all consumers were perfectly rational but imperfectly informed

about their use patterns, our disclosure regime would still be benefi-

cial. But imperfect information coupled with systemic biases gener-

ates greater costs than imperfect information alone. Hence, the

benefits of our proposed disclosure regime are likely to be greater in

light of our behavioral story.

VIII. CONCLUSION

The cellular service market, boasting annual revenues exceeding

$150 billion, is one of the largest and most important consumer mar-

kets in the United States. While cell phones provide obvious benefits

to consumers, cellular service contracts are designed to exploit the

cognitive biases of many consumers. Using a unique dataset of sub-

scriber-level, monthly billing and usage information for 3,730 cell

phone users, we show that 65% of consumers choose the wrong ser-

vice plan — mistakes triggered by a key contractual design feature,

the three-part tariff, that preys on consumers’ misperception of use

levels. These mistakes, we show, cost consumers almost $12 billion

annually. Consumer welfare and market efficiency are further reduced

by the ETF-enforced lock-in feature and by the sheer complexity of

the cell phone contract, which also respond to the imperfect rationality

of consumers. Since consumer mistakes often result from consumers’

misperceptions about their own future use patterns, disclosure man-

dates that would require carriers to provide consumers with use-

pattern information could greatly reduce these costs.