European telecoms regulations to reduce the cost of calls on mobile networks have improved both industry efficiency and consumer wellbeing. But while mobile users get better value for their money (more minutes of calls) as a result of this regulation of so-called ''termination charges'', their overall total bills have not changed much since monthly subscription fees have increased. These are among the findings of research by Sjaak Hurkens and Ángel López, published in the September 2014 issue of the Economic Journal.

Whenever a subscriber to a mobile network (Vodafone, for example) calls someone on a rival network (Orange, perhaps), the originating operator (Vodafone) must pay the terminating operator (Orange) a fee (''termination charge'') per minute. These fees affect consumers because they are passed through in retail prices.

Over the last 12 years, European regulators have lowered mobile termination charges from roughly 20 to 2 cents per minute, based on the firm belief that such reductions improve social welfare through lower prices for consumers. But mobile network operators have strongly opposed the reductions, even arguing that in fact they hurt consumers because of the ''waterbed effect'': firms would be forced to increase monthly subscription fees drastically.

Who is right? Traditional academic wisdom says that reducing termination rates improves efficiency and raises industry profit but is prejudicial to consumers. But both regulators and firms ignore academic wisdom – and important decisions that affect hundreds of millions of consumers and a multi-billion euro industry have been taken without a thorough and sensible economic foundation.

This study re-examines the theory and concludes that both firms and regulators are acting optimally and defending their interests. Regulators do well in lowering termination rates (although they probably should have done this much faster) as it improves efficiency and consumer wellbeing. Firms are correct in their opposition (but not in their arguments) because lowering termination rates leads to much lower profits.

Firms compete for customers by offering contracts specifying prices for on-net calls (those to subscribers to the same network), off-net calls and monthly subscription fees. Consumers choose the contract that is best for them, but their choice is not easy because of ''network externalities'': if off-net calls are more expensive than on-net calls, a consumer will prefer to join the operator with the larger market share because more calls will be on-net. The market share of each operator depends in turn on the subscription choices made by consumers.

To break the circular reasoning, traditional analysis assumes that consumers are sophisticated and can predict market shares perfectly. In particular, consumers have said to have ''responsive'' expectations: they change their expectations about market shares whenever a firm changes its price just a tiny bit. Competition in monthly subscription fees becomes more intense as the wedge between on-net and off-net call prices becomes wider. Lowering termination charges reduces the wedge, and thus softens competition and leads to higher profits for firms.

Hurkens and López do not believe that consumers are that sophisticated: they break the circular reasoning by assuming that consumers hold ''constant'' (or ''passive'') expectations about market shares (for example, based on market shares in previous months), which in fact turn out to be correct. Firms are thus unable to influence consumers'' expectations and competition in monthly subscription fees is not intensified when the wedge becomes larger.

In short, the waterbed effect is very strong under the assumption made in traditional analysis but modest under the alternative assumption made in this new study. The empirical evidence produced by Christos Genakos and Tommaso Valletti (in the Journal of the European Economic Association, 2011) supports the finding of a modest waterbed effect.

In a related study (in Telecommunications Policy, 2012), Hurkens and López have calibrated their model with data from the Spanish market. They show that even the small actual reduction in termination rates from 4.95 to 4.00 cents per minute between 2010 and 2012 increased consumer surplus by €220 million (on a yearly basis). A further reduction to 2.45 cents per minute would have led to an additional saving of €360 million. Industry profits decreased by 5.5% and 17%, respectively.

Their results illustrate that call prices are reduced and monthly subscription fees are increased but overall total bills do not change much. Hence, consumers get better value (more minutes of calls) for their money as a result of termination regulation.


''Mobile Termination, Network Externalities and Consumer Expectations'' by Sjaak Hurkens and Ángel Luis López is published in the September 2014 issue of the Economic Journal. Sjaak Hurkens is at the Institute for Economic Analysis (CSIC), Barcelona GSE and the Public-Private Sector Research Center (IESE Business School). Ángel Luis López is at the Universitat Autònoma de Barcelona and the Public-Private Sector Research Center (IESE Business School).