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This paper explores how consumers react towards price differentiation between on-net and off-net calls in mobile telecommunications – a pricing policy that is common in many mobile telecommunications markets. Based on a survey of 1044 students it is demonstrated that some consumers may suffer from a "price differentiation bias", i.e., a fair number of consumers may overestimate the savings that result from reduced on-net and/or off-net charges, as they do not appear to weigh the prices with the probabilities of placing off-net and on-net calls. This may help to explain why it have been the smaller operators in various countries who have introduced on-net/off-net price differentiation. The paper also discusses the implications that such a consumer bias may have for market competition.

In July 2007, KPN lodged a complaint with the European Commission that T-Mobile and Vodafone would have a position of collective dominance in the German mobile telecommunications market (KPN, 2007). According to the reasoning of KPN, the main source of that allegedly dominant position was the price differentiation between on-net and off-net calls, which leads to tariff-mediated network effects. As T-Mobile and Vodafone entered the market two years prior to E-Plus (KPN's mobile subsidiary in Germany) and six years prior to O2 (the fourth and still the smallest mobile network operator in Germany), the two early movers were able to build a customer base which, in combination with differentiation between on-net and off-net prices, enabled the two larger firms to act largely independent from their smaller rivals, so the argument. While the Federal Cartel Office in Germany has discontinued its investigations by the end of 2009 (Bundeskartellamt, 2010), similar complaints against price differentiation between on-net and off-net calls have been made in other countries such as Austria and Italy (ERG, 2008, p. 43), Turkey (Atiyas & Dogan, 2007) or New Zealand (Commerce Commission, 2010). The argument that the combination of a large initial market share and tariff-mediated network effects can be strategically used to foreclose the market and to secure market power sounds initially rather reasonable and has also been explored in the academic literature (Cabral, 2009, Harbord and Pagnozzi, 2010, Hoernig, 2007, Hoernig, 2008 and Lopez and Rey, 2009). In addition, there has also been some empirical support for this hypothesis by Kim and Kwon (2003). Based on a consumer survey for the Korean mobile telecommunications market, their conditional logit analysis reveals that consumers prefer carriers with a larger number of subscribers other things being equal. As Kim and Kwon (2003) argue that intra-network call discounts are, among other factors, one likely source of that effect. While the anticompetitive use of on-net/off-net retail price discrimination is certainly an issue if practiced by an incumbent in response to market entry (as recently happened in New Zealand), an interesting observation in this context is, however, the fact that in a number of European mobile telecommunications markets they have been the small entrants who started to price differentiate between on-net and off-net calls. In Germany, it was in fact E-Plus (the complainant's own subsidiary) who started to price differentiate between on-net and off-net calls when it entered the market in 1994 (Frontier Economics, 2004). Similarly, it has been reported by Frontier Economics (2004) that in the UK, on-net/off-net differentials were first introduced in late 1993 by One2One and in early 1994 by Orange when the two new networks launched their services, while the two incumbents only introduced such differentials in their charges in October 1998 (Vodafone) and in spring 1999 (BT Cellnet). In Ireland, Digifone entered the market in May 1997 with on-net/off-net differentials while incumbent operator Eircell only responded with similar differentials in May 1999 (Frontier Economics, 2004). Finally, in Austria it was tele.ring who first introduced on-net price discounts on its market entry in 2001 (Dewenter, Haucap, & Kruse, 2004). In other countries, however, the combination of on-net discounts and high off-net prices has apparently been used by incumbents to stifle competition. The most dramatic example may have been the case of the third mobile network operator in Slovenia, Vega, which exited from the Slovenian mobile market in 2006 after five years of operations, reportedly at least partly due to the aggressive on-net/off-net price differences offered by the two incumbents (Trilogy International Partners, 2009). Similarly, the third mobile operator that entered the New Zealand mobile market in 2009 (called 2degrees) has lodged complaints against anticompetitive on-net/off-net differentials by the two incumbent operators (Commerce Commission, 2010). However, even though in some instances (such as recently in New Zealand) incumbents appear to have clearly used on-net discounts to foreclose the market against competitive entry, the above observation that, at least in a fair number of countries, entrants have initiated on-net discounts appears to be at odds with the idea that on-net price discounts are only used as a tool to foreclose the market by large incumbent operators. One potential explanation may be based on the so-called "calling club" argument, formulated among others by Gabrielsen and Vagstad (2008). According to this line of reasoning, consumers are grouped into social networks or "calling clubs", the members of which call each other more often than people outside the network. Therefore, customers are less interested in the absolute size of a mobile network than in the number of friends and family members associated with a given mobile operator. In fact, many European operators offer tariff options with discounts for calls to "family and friends". Moreover, based on UK survey data, Birke and Swann (2006) find that the proportion of off-net calls falls as mobile operators charge a premium for off-net calls, but even in the absence of any price differential between on-net and off-net, there is still a form of pure network effect, where a disproportionate number of calls are on-net. In addition, they find that the choice of operator is heavily influenced by the choices of others in the same household. The utility that an individual consumer derives from using mobile telecommunications heavily depends on which of her potential calling partners has already subscribed and to which network. More precisely, Birke and Swann (2006) estimated that roughly 9.2 million subscribers to a network have the same impact as one additional member from the same household being on the same network. Similarly, Corrocher and Zirulia (2009) have found that local network effects (among partners, friends, and family) play a role for customers in Italy. Their paper investigates the extent to which consumers take account of their contacts' mobile operators when choosing a provider for themselves. For this purpose Corrocher and Zirulia (2009) rely on a survey of 193 high-school and university students in Italy and show that these consumers are highly heterogeneous with respect to the importance they give to the operators chosen by their friends/family members in choosing which provider to use. Against this background, discounting on-net calls may be seen as a tariff innovation in order to compete for families or other "calling clubs". This paper offers another, complementary explanation, which is based on recent observations from marketing science and behavioral economics. Starting from the observation that, in reality, many consumers are choosing calling plans that are not cost minimizing for them (Lambrecht & Skiera, 2006), it is argued that the bounded rationality of mobile telecommunications consumers may be exploited to some degree by operators, and that it may be more attractive for new entrants to offer plans with discounted on-net calls than for incumbents with a large installed customer base. If customers fail to weigh prices with the appropriate call minutes or probability of placing a certain call, but base decisions on unweighted prices, discounting certain call prices may be more attractive for newcomers than for incumbent operators, as will be argued below. This observation also offers a new perspective on the competitive effects of on-net price discounts. The rest of the paper is now organized as follows: The next section reviews the related literature on consumer choice of multi-part tariffs and tariff choice biases as well as the literature on price discrimination between on-net and off-net calls. Section 3 describes the survey and presents the empirical analysis, before section 4 draws out policy conclusions. Finally, section 5 summarizes the main findings.

This paper has explored how consumers react towards price differentiation between on-net and off-net calls in mobile telecommunications – a pricing policy that is common in many mobile telecommunications markets. Based on a survey of 1044 students it is demonstrated that some (but not all) consumers may suffer from a "price differentiation bias", i.e., a fair number of consumers may overestimate the savings that result from reduced on-net and/or off-net charges, as they do not appear to weigh the prices with the probabilities of placing off-net and on-net calls. In contrast, consumers who understand the mechanics of on-net/off-net price differences have lower mobile phone bills and are better in choosing expenditure minimizing tariff options. In addition, a learning effect has been identified showing that consumers who have switched more often to other network operators in the past pay, on average, less for mobile telecommunications services. The same result holds for participants who take more time collecting information about the tariff options best suitable for their telecommunications behavior. Furthermore, students reporting that they are aware of differences in on-net/off-net charges in their own mobile phone tariffs do better in the experiment resulting in lower expenditure per minute for their hypothetical mobile phone calls. Another important result is the finding that a large share of students does not correctly incorporate the structure of on-net and off-net calls in their calculations to find optimal tariffs. This may help to explain why it have been the smaller operators in various countries who have introduced on-net/off-net price differentiation. For competition authorities these findings suggest that the presence of on-net/off-net price differentiation does not automatically raise competition concerns. Hence, a per se prohibition of on-net/off-net price differentiation would most likely constitute a case of over-regulation, also against the evidence that small entrants sometimes use on-net discounts as a tool for competitive entry. Having said this, it should be nonetheless clear that a combination of low on-net and high off-net prices can still be used for anticompetitive purposes. For example, this was apparently the case in New Zealand when Vodafone New Zealand reacted to the entry of the third mobile operator, 2degrees, with an offer of 0,06 NZ$ for on-net calls, while charging 0,89 NZ$ for off-net calls (Pullar-Strecker, 2010). Under such circumstances, a temporary ban or limitation of on-net/off-net price discrimination may well be warranted. More generally speaking though, a rule-of-reason approach to on-net/off-net pricing appears to be warranted where cases are judged on an individual basis, taking into account consumers' behavior towards such pricing policies. More generally, it is suggested to carefully study consumer behavior towards complex pricing schemes before reaching conclusions about their anti- or pro-competitive effects.