Econ 101 For Operators

There’s been quite a bit of talk lately about how mobile networks are creaking under the strain of increased data usage. The CTO of Verizon in the US says that flat-rate data plans aren’t sustainable, echoing similar comments from the head of AT&T Wireless; over in the UK, O2’s head honcho says smartphones are bogging down its network, while the BBC’s Spinvox-slayer Rory Cellan-Jones is talking up a “3G traffic jam”.

These comments from operator execs often focus on one aspect of the situation: flat-rate pricing plans. Like many of their colleagues at fixed broadband carriers, they talk up a bandwidth crunch as a segue into talk about the need for some form of usage-based pricing, typically either capped plans or per-unit charges. Things are made that black and white — if we have flat-rate (ie cheap) data plans, the networks are rendered useless; if we have usage-based (ie more expensive) pricing, everything will be dandy.

d1To understand the thinking here, let’s go back to the first day of Economics 101, when the prof introduced the demand curve (as skillfully illustrated here). The vertical axis is price, the horizontal axis is quantity demanded. As you can see, the law of demand says that all other things equal, as price decreases, quantity demanded increases, giving the demand curve a nice downward slope. For every price of a good, there’s a corresponding quantity of that good demanded. In our graph here, you can see that at price P1, quantity Q1 is demanded.

This makes intuitive sense for most people: if something gets cheaper, people will buy more of it. A good example of it could be affordable flat-rate data plans. As they became more widely available and decreased the price of using mobile data, consumption increased. An important, and often overlooked part of the law of demand is that “all other things equal” bit, or, as economists like to say, ceteris paribus. Holding everything else equal, price changes simply force movement along the same demand curve. If something else changes — consumer preference, consumer income, prices of related goods, and so on — the demand curve shifts.

D2It’s easy to see that over the last few years, all other things aren’t equal when it comes to mobile data. Consumer tastes and preferences have definitely changed as usage has become more pervasive. Related goods — ie smartphones — have become cheaper, either in real or relative terms. The demand curve has shifted, as shown in green here. This shift to the right means that at every price level, the quantity demanded has increased. Keep in mind that price times quantity demanded equals total revenue. So if price stays constant and quantity increases, revenues increase.

D3But what operators are more interested in is the change shown in red on our third graph, a change in which the quantity demanded remains the same, but price increases. Price times quantity equals revenue. When there’s movement along a demand curve, both price and quantity change, and the effect on total revenue depends on the slope of the curve, or the price elasticity of demand. But if the demand curve has shifted, and an operator can now sell the same amount of goods for a higher price, total revenue will increase.

So now, after seeing the demand curve shift resulting in selling more data services and plans at constant prices (which, of course, also increases total revenue), operators are eyeing a shift in which they can raise prices but keep quantity demanded constant. The thinking is that by raising prices, they’ll be able to reign in the small number of heavy users (AT&T’s CEO says just 3 percent of its smartphone users account for 40 percent of its data traffic) without significantly hurting demand overall — because we’ve all grown so accustomed to checking our email and Facebook and whatnot on our phones, using our 3G dongles and downloading books to our Kindles.

They’re betting that the overall effect on aggregate demand will be small, but the price increases will deliver a nice big bump in revenues. The idea is to take advantage of all other things not being equal, that a shift in consumer tastes and preferences means they can now wring higher prices out of their customers. But the operators don’t get to choose which other things are equal; they don’t operate in a vacuum. There’s pricing pressure from other operators, for one thing. For instance, in the US, from operators like MetroPCS which offer unlimited voice, text and data for $40 per month, including all taxes and fees.

But the biggest question is whether customers will just swallow the price increase, that their need to stay connected on their mobile can support increased data prices, even as the price of voice and text falls. That’s a risky proposition, given that it can be argued that lower prices led to increased uptake. (As an aside, this sort of use-low-price-to-get-them-hooked-then-jack-em-up business model brings to mind a great scene from the TV show The Wire, in which Stringer Bell, the number 2 of a Baltimore drug gang learns about elasticity and spreads the knowledge throughout his organization.)

The black-and-white choice we’re presented with is a false dilemma, one the cynics among us might say is designed to help us swallow price increases: you can choose between cheap data, on a useless network, or paying higher prices for the same great service you’ve come to expect. But as the name indicates, it’s a false dilemma. There’s more than one way (or in this case, two ways) to skin the mobile data cat. My next post will take a look at what’s driving the huge increase in mobile data use, and how operators can deal with it.

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