Why Economists Love to Study Cellphone Pricing

By SAUL HANSELL

Have I tragically underestimated the ability of foreign cellphone companies to come up with devilishly complex pricing plans and the skill of economists to convert those schemes into pat theories that can be illustrated with neat charts and graphs?

The many people who have written me over the last two days about my Sunday article on the method behind the madness of cellphone pricing say I have.

The article began quoting Barry Nalebuff, a Yale economist, saying cellphone pricing plans were “weird.” Alex Kaufman, a doctoral candidate in economics at Harvard, wrote to chastise me for my “characterization of economists as throwing up their hands in confusion over this problem.”

Indeed, he pointed me to the work of Michael Grubb, now a professor at M.I.T.’s Sloan School of Business. I had spoken to Mr. Grubb for the article, in fact, on the recommendation of Mr. Nalebuff. His research seemed interesting, but a bit too involved to describe in the article, given how many other topics I had to cover.

Mr. Grubb told me that as a grad student he too was perplexed by pricing plans with big bundles of included minutes and high charges for extra minutes, what economists call three-part tariffs. After investigation, he wrote a paper arguing that phone companies were exploiting overconfidence by consumers about their ability to predict how many minutes they would use.He summarized this in an e-mail message to me:

Three-part tariffs optimally exploit overconfident consumers because overconfident consumers both underestimate the likelihood of very high usage, and the need to pay high overage charges, and underestimate the likelihood of very low usage, and the likelihood of not getting a refund for included “free” minutes.

Consumers certainly do make bad predictions about their own behavior. Studies show that people buy gym memberships, rather than paying per gym use, because they believe they will work out more than they really do. And when I wrote about the credit card industry, I saw studies that showed people thought they paid off their bills in full, and thus avoided interest charges, far more often than they actually did.

That’s not the only factor here, though. Andrew M. Odlyzko, a mathematics professor at the University of Minnesota, wrote me with a very interestingpaper he co-wrote in 1979 which argued that consumers often preferred flat-rate pricing to paying by usage even if it would save money. It cited data from phone companies that showed half the people who chose local phone plans with unlimited calling would have saved money choosing a pay-per-call plan. The paper listed three reasons:

(i) Insurance: It provides protection against sudden large bills. (What happens if my son comes back from college,and starts talking to his girlfriend around the clock?)
(ii) Overestimate of usage: Customers typically overestimate how much they use a service, with the ratio of their estimate to actual usage following a log-normal distribution.
(iii) Hassle factor: In a per-use situation, consumers keep worrying whether each call is worth the money it costs, and it has been observed that their usage goes down. A flat-rate plan allows them not to worry as to whether that call to their in-laws is really worth $0.05 per minute.

The second factor there matches up with Mr. Grubb’s idea that consumers are overconfident of their ability to predict how to save money. The cellphone executives I spoke to believed that the desire for stable prices, encouraged by their pain-inducing overage charges, was a better explanation for consumer behavior.

On another topic, several readers outside of the United States chastised me for oversimplifying cellphone pricing structures in the rest of the developed world. (And I didn’t even talk about emerging economies like India, where wireless service is much cheaper, mainly because of lower costs.)

One important difference is that in most other countries, the person who calls a cellphone pays the bill. Receiving wireless calls is free. This seems very attractive to consumers, especially when rates are high, and it helped explain the rapid deployment of cellphones in Europe and Asia.

But as it has developed, the caller-pays system has inhibited the use of cellphones. The rate to call a cellphone in many countries can be quite high and can vary depending on the carrier of the person you are calling (which you may not know). That means that calling one cellphone from another can lead to nasty charges. This, some say, explains why people in caller-pays countries talk on cellphones far less than people in the United States.

The article also didn’t make it clear that carriers in many countries offer subsidized handsets for people willing to commit to a service contract. Indeed, such plans are becoming more common in many countries as people try to afford expensive smartphones. But it is also true that it is far, far more common in many countries for people to buy phones at retail stores and then to buy prepaid blocks of minutes from carriers as they need them.

Spend a minute looking at the various options available in Britain, and you wouldn’t say that things are any less complicated there. Here is the page, from Carphone Warehouse, a large retailer, for the iPhone 3GS and for theBlackBerry Curve 8520.

One footnote I left out: A few people asked for citations for the effective average price of 5 cents a minute and 1 cent a text message I cited. The voice statistic came from the CTIA, a wireless industry trade group. The text figure came from a study of monthly cellphone bills conducted by Nielsen.

http://bits.blogs.nytimes.com/2009/11/17/why-economists-love-to-study-cellphone-pricing/?partner=rss&emc=rss

Judging Presidents

A reader asks a good question:

What are some useful and objective measures which we can use to judge the performance of President Obama and his new team? How would Greg Mankiw judge Obama four years from now?

Consider a related question: How would you judge the competence of a doctor if you could observe him treating only a single patient?

What you would not do is judge him by the outcome. Even the best physicians have patients die. And even witchdoctors can have patients recover. Randomness is a fact of life (and death). In the case of a medical doctor, the answer seems clear: Instead of looking at the outcome, you would judge him by the decisions he makes and treatments he prescribes. That is, you would examine whether he followed best practices for the circumstances he faced.

Similarly, randomness is a fact of economic life, and it would be a mistake to judge a president by the economic outcome during his administration. It is better to look at the decisions the president made, and to acknowledge that the outcome is a function of those decisions and many other factors not under his control. As an economist, I have views about what best practices are for economic policy, and I judge presidents by how closely they adhere to those principles.

Unfortunately, that evaluation process is not quite as simple and objective as the reader might have hoped for. But I don't think there is a better alternative.

Now some people may be tempted to read the above commentary and call it self-serving. After all, the economy looks pretty bad right now, so maybe I am trying to excuse President Bush and, indirectly, myself as one of his economic advisers.

Not so. If you want to judge presidents and their economic advisers by outcomes, that would be all to my benefit. I arrived in Washington to head the CEA in February 2003 and left in February 2005. (Harvard has a two-year rule for faculty leave). During that time, the economy grew at a healthy annualized rate of 3.6 percent, and the unemployment rate fell half a percentage point. As judged by outcomes, I look pretty good! But I will be the first to admit that this argument is deeply silly.

http://gregmankiw.blogspot.com/2009/01/judging-presidents.html

Cross my palm with euros

WORRIES about the dollar’s dominance of the global monetary system are not new. But debate about replacing the beleaguered dollar, whose trade-weighted value has dropped by 11.5% since its peak in March 2009, has resurfaced in the wake of a global financial and economic crisis that began in America. China and Russia, which have huge reserves that are mainly dollar denominated, have talked about shifting away from the greenback. India changed the composition of its reserves by buying 200 tonnes of gold from the IMF.

None of this threatens the dominance of the dollar yet, particularly as a dramatic shift out of the currency would be damaging to the countries (such as China) that hold a huge amount of dollar-denominated assets. But a new paper by economists at the IMF, released on Wednesday November 11th, acknowledges that the global crisis has reignited the debate about anchoring the world’s monetary system on one country’s currency.

Some say that America’s role as the principal issuer of the global reserve currency gives it an unfair advantage. America has a unique ability to borrow from foreigners in its own currency, and wins when the dollar depreciates, since its assets are mainly in foreign currency and its liabilities in dollars. By one estimate America enjoyed a net capital gain of around $1 trillion from the gradual depreciation of the dollar in the years before the crisis.

In a sense the world is hostage to America’s ability to maintain the value of the dollar. But as the IMF points out, the currency’s primacy arises at least partly because China and other emerging countries have chosen to accumulate dollar reserves. The depth of America’s financial markets and the country’s open capital account have made the dollar attractive. So some of the advantage has been earned.

But large and persistent surpluses in countries like China mean continued demand for American assets, reducing the need for fiscal adjustment by either country. This, in turn, has contributed to the build-up of the macroeconomic imbalances that many blame for the financial crisis.

Dealing with these imbalances could begin by finding ways to reduce reserve accumulation in emerging countries. The IMF reckons that about two-thirds of current reserves (about $4 trillion-$4.5 trillion) are held by countries as insurance against shocks, including sudden reversals of capital flows, banking crises and so on. In theory, groups of countries could pool reserves, so that a smaller amount would suffice than if countries each maintain their own buffers. Other alternatives include precautionary lines of credit, such as the American Federal Reserve’s with the central banks of Brazil and Mexico, or the IMF’s flexible credit line.

But what are the alternatives to relying on the dollar? One possibility is a system with several competing reserve currencies. Over time, the euro and China’s yuan (if it became convertible) could emerge as competitors. This would require a great deal of policy co-ordination among issuing countries. But by having several reserve currencies the “privilege” that America now enjoys would be available more widely, providing an incentive to compete to attract users to different currencies.

Another alternative is a greater reliance on SDRs, the IMF’s quasi-currency, which operates as a claim on a basket of currencies: the dollar, euro, sterling and yen. Because the SDR’s value depends on several currencies, it shares many of the benefits of a multiple-currency system. But even the IMF says that using SDRs seems “doubtful unless the system…fails in a major way”.

The most radical solution of all is a new global currency that could be used in international transactions and would float alongside domestic currencies. The fund argues that this would have to be issued by a new international monetary institution “disconnected from the economic problems of any individual country”. This currency could serve as a risk-free global asset.

Radical as this may sound, it is not a new idea. John Maynard Keynes had something similar in mind when he proposed an International Clearing Union. This global bank would issue its own currency, called the bancor, in which all trade accounts would be settled. In the absence of such a bank the world will have to make do with the current system. So worries about the dollar’s value aside, its global dominance is secure for now.

http://i-connectx.net/node/125