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Carrier subsidies are increasingly standing in the way of innovation.

“We’re drunk off the subsidy model,” IDC analyst Ramon Llamas told VentureBeat last week.

The lure of cheap, subsidized phones underwritten by massively long two-year contracts stands in the way of competition and innovation. The big carriers use their contracts to lock in profits and help limit the customer “churn” that would otherwise make their revenues too unpredictable. But those two-year contracts keep people from upgrading as quickly as they would otherwise, stifling handset makers’ ability to get the latest models in our hands.

Carriers also stifle OS upgrades, keeping you from upgrading to the latest version of Android because they don’t want to invest the time to make it work with a string of older phones: They’ve already got you locked in to a contract, so why would they want to make your phone any better than it already is?

The U.S. is not unique in its dependence on carrier subsidies, but it’s not the only way: In many European countries, for instance, people buy their phones and SIM cards separately, without long, onerous contracts.

Some carriers are starting to see this as a wedge issue. T-Mobile, for instance, promises to do away with contracts and subsidies altogether. The carrier sees it as a more honest, direct model, and I agree: I’m done with contracts. I recently paid $245 to get out of my contract with a large carrier after I had endless problems with its service and its phones.

In an earlier column, I blamed Microsoft for not being able to solve these problems. It was an unfair criticism, but it does reveal an opportunity for the Redmond, Wash.-based software company.

We need someone to break the logjam. Could it be Microsoft?

Instead of standing by and playing the same ballgame as every other mobile phone maker, Microsoft should take a page from Apple’s book and rewrite the game. It’s got the leverage, it’s got the installed base, and it’s got a powerful weapon: cash.

In short, Microsoft should subsidize its own phones. Google currently offers the Nexus 4 for $299, unlocked and off contract. That’s a subsidized price, although the actual amount of the subsidy is probably far less than you might think. When you buy an unsubsidized iPhone for $650, only about $200 of that goes to the iPhone’s  component parts. Let’s be generous and assume that another $200 goes to manufacturing, shipping, and the manufacturer’s profit. That subsidized price is still higher by $250 than the actual cost to the carrier.

In other words, assuming that it, too, can get phones made for $400 apiece, it would cost Microsoft $100 to $200 each to subsidize unlocked, off-contract Windows phones to a sales price of $200 or $300.

That’s a small price to drive its currently anemic Windows Phone OS deeper into the mobile ecosystem.

It would cut out the carriers — those that depend on subsidies, anyway. A small benefit might be helping out the carriers like T-Mobile and Virgin Mobile that have a big incentive to take on the incumbents, and they’d in turn help Microsoft with aggressive, edgy advertising campaigns.

Now, Google can afford to subsidize Nexus 4s because it knows it will eventually make money from advertising and location services for Android users. Microsoft might make some small amount of money from Bing, but that’s not its real payoff.

The real benefit would be enabling Microsoft to sell directly to the large companies that make up the backbone of its revenues. It wants to tie Windows 8 closely together with Windows Phone 8, and this is one way to do it: With volume sales of corporate phones that are off-contract, work seamlessly with your corporate Windows 8 laptop or tablet — and, by the way, which are far more useful and hipper than anything Research in Motion is likely to produce.

Why I keep harping on Microsoft

I’ve been writing about Microsoft a lot this year because it’s one of the most interesting companies in tech right now.

With a market cap around $225 billion, annual revenues of $73 billion as of the fiscal year that ended in June, and net income around $17 billion, it remains a mighty company, one to be reckoned with.

Microsoft still outstrips IBM, Cisco, Intel, and many other giants of the tech world in size and revenues.

Microsoft’s research and development arms are unparalleled, with armies of Ph.D.s that few other companies can match. Even a long-time startup guy like Rahul Sood, who joined Microsoft over a year ago, can’t stop raving about how much talent the company has.

Microsoft’s financial power pales next to Apple, which still has a market cap of about $500 billion despite sudden (and rather inexplicable) losses last week, on about twice the revenue and more than twice the profits — over $41 billion for the last fiscal year.

It stands eye-to-eye with Google, which has almost exactly the same market cap on half the revenues and profits. Google is worth more on a P/E basis because its star is still rising, while Microsoft is a mature sun, and no one knows if it will keep burning for another billion years or if it’s going to blow up next year and obliterate its entire solar system.

Slide 24 from Mary Meeker's 2012 State of the Internet year-end reportMake no mistake, Google is Microsoft’s biggest threat. One glance at this slide from KPCB partner Mary Meeker’s annual Internet trends report, and you’ll see that mobile devices — led by Google’s Android OS — have rapidly blown away Microsoft’s dominance of the computing market in the past few years. (See that green triangle in the right corner: That’s Android.)

That’s why Microsoft’s mobile strategy is so critical. It’s going to do everything it can to regain control over the computing world. It may already be too late. But it’s certainly been interesting to watch.

I’d love to see Microsoft start tackling that by mining one of the areas most ripe for disruption today: our broken carrier subsidy model.

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