Welfare Analysis of Equilibria With and Without Early Termination Fees in the US Wireless Industry

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At the end of 2015, all major US wireless carriers eliminated their long-term contracts that included early termination fees (ETFs). To assess the implications of this change for consumer well-being and operator profits, we use both a theoretical and a structural empirical model. Our theory suggests two potential scenarios in the wireless market: one where all firms impose ETFs and one where no firm does. We find that due to consumer expectations, ETFs may intensify competition between wireless service providers and impose substantial downward pressure on prices.

Interestingly, ETFs are not necessarily harmful to consumers and beneficial to the firms. High switching costs restrict consumer’s ability to respond to changes in product quality or prices by changing service providers. This reduces perceived differences between the competing products, making them closer substitutes and restricting firms’ ability to mark up their fees. Equilibrium prices can be so low that consumers may be better off in a situation where ETFs restrict their choice. By the same logic, firms can set higher prices and collect higher profits when there are no ETFs.

Our analysis suggests that eliminating ETFs while maintaining the level of service fees would significantly increase consumer well-being. Service fees would have to increase by at least 30 to 40 percent to reduce consumer well-being to the original level. Instead, we estimate that, without ETFs, firms would increase prices by only about 2 to 5 percent, making consumers unambiguously better off. Even though eliminating ETFs results in higher monthly service fees, the overall effect on firm profits is less clear because they no longer collect revenues from ETFs. We conclude that if the cost to process ETF payments is sufficiently high, the new equilibrium with no ETFs will benefit both consumers and wireless operators.

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