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Crazy cell phone contracts for crazy Americans

The way we pay for cell phone service doesn't make sense.

By Karen Datko Nov 18, 2009 5:26PM

This guest post comes from Frank Curmudgeon at Bad Money Advice.


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


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


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

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


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


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


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


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


And it’s not just the math. We don’t like moving things from one mental bucket to another, and changing from monthly to lump sum just upsets the way we think about our money. For example, ask yourself this: Which has more appeal, investing $1,000 in a CD that pays 4% or $1,000 in new appliances for your home that would save you $3.50 a month in utility bills? The appliance deal is a little better, but not as attractive to most people because swapping savings for lower ongoing payments isn’t something we like to do.


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


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


Related reading at Bad Money Advice:

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