The Public Policy

In Defense of Early Termination Fees

They ensure we have the best cell phones money can't buy.

By 8.11.08

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Cell phones have really come into their own in the last few years. Even relatively Spartan phones can now take pictures, send text messages, and ease the pain of commuting with a game of Brickbreaker. These technological marvels can even send and receive telephone calls.

It gets better. Smart phones, such as BlackBerries and Treos, can browse the Internet, send email, juggle your schedule, and even warn of upcoming traffic jams with Google Maps. Apple's iPhone adds a sense of style to the mix. Every year new features come out that make people's lives easier.

They're affordable, too. There are now more than 3.3 billion cell phones in use around the world.

That's amazing. But what would it take for all this progress to come screeching to a halt? Alameda County Superior Court Judge Bonnie Sabraw has one answer: abolish early termination fees.

Consumers and consumer advocates alike have hailed her recent decision, which declares the fees to be in violation of California state law. Sprint now has to pay $73 million to former customers.

Of course, Judge Sabraw's precedent could have unintended consequences. They would not be pretty.

BUT FIRST, what are early termination fees, anyway? And why do people hate them so much?

People probably hate early termination fees for the simple fact that they are fees. Perfectly understandable. Less forgivable is the tendency for many people to not read the contracts they sign. Some people get a rude surprise when they switch carriers before their contract is up.

Early termination fees must accomplish something for companies to continue to wield them in the face of widespread public resentment -- not to mention judges pretending to be legislators.

As it turns out, early termination fees help more people afford better phones. They are a democratizer of technology. They also give phone companies more incentive to innovate and add new features.

It works like this: phones are expensive. They can cost several hundred dollars. A lot of people can't afford that kind of upfront cost. But spreading that cost out over time can help people of limited means afford quality phones, just as mortgages make home ownership possible for people who don't happen to have $200,000 lying around.

Service providers will typically sell their phones at a loss, then make their money back by charging more for monthly service. It's a little bit like Gillette's famous strategy of selling razors cheaply and making their money back on the blades.

Since it takes time for phone companies to recoup their initial losses, they'll often require customers to commit to, say, two years of service.

Customers can opt out early if they like. But they'll have to pay an early termination fee to do it, which can be upwards of $200. That's pretty steep. But it does make sure that customers pay back the subsidy they received for their cheap phones, one way or another.

Put another way, early termination fees reduce risk. As long as the risk is low, service providers will continue to make their products as affordable as they can. That's good for business and consumers alike.

STILL, CRITICS allege that early termination fees are anti-competitive, because they make it harder to switch carriers. That ignores the intense competitive effects that the fees have on innovation.

When something is cheap, people buy more of it. By making the upfront cost of phones as inexpensive as possible, early termination fees vastly increase sales.

That's why companies are racing furiously against each other to come out with new and better phones. A new widget that your competitor doesn't have can bring in millions of dollars of new contracts.

If early termination fees reduce competition in the cell phone marketplace, then why is there so much of it?

Don't expect to see an answer in Judge Sabraw's next verdict.

The next time someone grumbles about early termination fees, tell them what the fees do to make phones affordable and to ensure a competitive, innovative marketplace. And remind them to read that contract before signing it.

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About the Author

Ryan Young is Fellow in Regulatory Studies at the Competitive Enterprise Institute.