“The cost of smart phones is considerably higher than feature phones for which the early termination fees were created years ago at $175,” said Verizon spokesman Jim Gerace. He added that the new $350 ETF declines by $10 per month through the life of the contract and customers can avoid it by buying their devices off contract and paying full retail price.

An interesting move for Verizon (VZ), which just last year agreed to pay $21 million to settle a class-action lawsuit filed by California consumers over the very early-termination fees it is now increasing. The plaintiffs in the suit alleged that Verizon’s ETFs were illegal under California law and that they were designed to unfairly lock consumers into long-term contracts and prevent them from switching carriers. When Verizon settled the suit, it denied any wrongdoing, insisting that early-termination fees are simply a means of recovering legitimate costs. And to some extent Verizon does have a point.

Full retail price for the Motorola’s (MOT) new Droid is $559.99. With a two-year contract, Verizon sells the handset for $199.99. Theoretically, that’s a $359.99 subsidy (I have no idea at what price Verizon purchases Droid from Motorola). So if Verizon allowed subscribers to break their contract after a month without paying an early-termination fee, the company would stand to lose money. And subscribers who did so could subsequently sell the device online and potentially make a profit, though a small one.

So it’s certainly understandable that Verizon and other carriers want to protect the subsidies they dole out for these new smart phones. And as noted earlier, Verizon’s new ETF drops by $10 each month a subscriber remains under contract. But at this rate, subscribers are still bound to pay a $110 termination fee in the 23rd month of a two-year contract. The contract is nearly over, the subscriber obligation to Verizon almost fulfilled, yet the company can still slap its customers with nearly a third of the full ETF if they break it at that time.

By month 23 of a two-year contract, does Verizon really stand to lose $110 if subscribers decide to switch carriers? Doesn’t seem likely if subscribers can walk away just a month later without consequence, taking their handsets with them.

Since Verizon is pro-rating the ETF, why isn’t it doing so in such a way that it zeroes out by the end of the contract?

And isn’t the fast pace of innovation in the smart-phone sector such that prices–for both component and device–are dropping so quickly that high ETFs aren’t really justified? Remember, you can get Apple’s (AAPL) iPhone for $99 today. When the iPhone debuted in 2007, it commanded a price of $499/$599, depending on model.

I’ve put those same questions to Verizon and will update here when I hear back. In the meantime, here’s what Consumers Union policy analyst Joel Kelsey has to say on the matter: “When people want to switch wireless services, the biggest cost they face is early termination fees. These fees are designed to lock people into long-term contracts and stop them from getting better deals. Early-termination fees make the marketplace less competitive. Verizon’s move is painful proof that it’s time for lawmakers to crack down on these fees.”

UPDATE: Verizon Wireless spokesperson Nancy Stark offers the following answers to the questions I posed above:

Your first question regarding the balance at month 23 or 24 assumes that, at that point, we have recovered all of our subsidy and up-front costs for every device. That simply is not so.

On your second question, while the pace of innovation plays a role in prices coming down somewhat, it also plays a role in driving up costs as more and more complexity that customers want is added to phones–from premium HTML browsers to high-resolution MP cameras with optical zoom; videoplayers; music players; dual processor chipsets; WiFi; very high display resolution, operating systems such as BlackBerry, Windows Mobile, Palm, Android–ALL with the added value (vs a desktop) of mobility, and ALL in one tiny device that ALSO allows you to talk to anyone from anywhere. phew! (by comparison, I recently paid $200 for a camera and all it can do is take pictures, and it has only middle of the road capabilities.)

But getting back to ETFs specifically. The most important point is that Verizon Wireless customers do not have to have an ETF at all if they do not want to. ETFs allow customers to have it either way: They can have no ETF and pay full retail for their device. OR, they can get a greatly discounted device by having an ETF.

There is “no sign of the sort of sellout reception that greeted the smart phone at its introduction in other countries,” The Wall Street Journal reported, adding that there were no lines for the iPhone at the Apple store in Beijing, the company’s only location in China.

Sounds like a lackluster launch, and with Apple (AAPL) and China Unicom, the only carrier authorized to sell the device in the country, declining to disclose sales figures, it’s difficult to argue that it was otherwise. It clearly wasn’t the rousing success to which we’ve become accustomed. That said, it probably wasn’t quite the bust it’s been made out to be, either.

Why? Well, consider this: There were launch ceremonies in 30 provinces. To date, we’ve heard anecdotal reports from–as best I can tell–one of them. And while it’s admittedly concerning to learn that a China Unicom store in Beijing sold just 10 iPhones last Saturday, that’s just one store. The device was on sale in many, many others (1000, according to Apple COO Tim Cook) across 30 provinces and 285 Chinese cities in a nation with 710 million mobile-phone subscribers.

Finally, while it’s true that the prices Apple and China Unicom are charging for the iPhone are heady, they’re not quite as bad as we’ve been led to believe. “I think the western media has misconstrued the iPhone pricing in China,” Dan Butterfield, editor of iPhonAsia told me.

“Nine out of 10 reports that I’ve seen have simply repeated the ‘too expensive’ mantra,” Butterfield explained. “They then quote the contract free price point–4,999 yuan ($730) to 6,999 yuan ($1,025) for the iPhone 3GS. They argue that you can buy a gray-market iPhone cheaper and it has WiFi….The truth…the gray-market price is marginally cheaper for those who want to go ‘prepaid.’ But when you examine the full matrix of China Unicom price/plans, you quickly realize that you can save big by going on contract vs. prepaid (pay as you go). There are even four price/plans where your iPhone if free. The iPhone subsidy increases for those who opt for more expensive monthly plans.”

Butterfield elaborates: “Moreover, if you want to access ‘3G,’ there is no good carrier option other than China Unicom. You can run at 2G speeds on China Mobile or China Telecom. But neither of these two networks support the chipset in iPhone. China Mobile runs TDSCDMA 3G and China Telecom runs CDMA2000 3G. So you are left with China Unicom’s WCDMA 3G–a world-standard 3G protocol fully supported by iPhone 3G/3GS. Why not go on contract and get a subsidized iPhone that is well below the ‘too expensive’ (contract free) prices that the media is shouting about?”

And in the end, does it even matter? As Butterfield noted, an iPhone sale is an iPhone sale–whether it’s made by a gray-market vendor or an authorized one. And either way, it’s good for Apple.

So was the iPhone’s launch in China really a bust? “Probably not,” said Butterfield. “Was it a rousing success? Probably not. The truth is somewhere in the middle.”

UPDATE: Well what do you know: China Unicom just coughed up some first weekend sales numbers for the iPhone and … well, they’re not much to look. The carrier sold just 5,000.

That’s the word from Broadpoint AmTech analyst Brian Marshall, who believes Apple (AAPL) will bring the iPhone to Verizon (VZ) in the second half of 2010 and forfeit AT&T’s “sweetheart” carrier subsidy as a result.

“While [Apple] started off with exclusive arrangements in 2007 with the original iPhone launch, the company has since migrated towards multiple carriers per region,” Marshall wrote in a note to investors. “In our view, diverse carrier support is a key element to driving global penetration of the iPhone. Therefore, we believe the chances are high the iPhone will find its way onto the [Verizon] network in 2H10.”

Of course, should things play out that way, the iPhone will no longer be the powerful subscriber-retention tool it is today. And Marshall believes that will lower the subsidy it commands from an estimated $450 to around $300.

This might seem to imply a nasty hit to Apple’s bottom line, but Marshall figures any losses Apple might suffer would be more than made up in volume. He sees Verizon selling roughly 14 million iPhones in the 2011 calendar year. And with an average selling price of $500, that’s another $7 billion in revenue for Apple.

The device, intended as a replacement for the Centro, Palm’s last PalmOS smartphone, is expected to feature a 2.6-inch multitouch display, inline keyboard, two-megapixel camera and 4GB of internal storage, among other features. Word on the street has it priced at $99 with contract, rounding out the lower end of Palm’s new webOS lineup.

And when will it arrive at market? No one seems to know, though Tavis McCourt and Justin Patterson at Morgan Keegan & Company speculate that we’ll see it sometime this fall. “We believe initial Pixie shipments will begin in the November quarter, although timing is still uncertain (we believe the goal would likely be a holiday launch),” the analysts wrote in a research note today.

“Although Pixie is unlikely to be a ‘hero’ product with massive advertising and subsidy support, its $99 price point should drive substantial volumes and we believe distribution can be broader initially if not exclusive. In general, we have used the Centro as a benchmark for the Pixie. At a $99 retail price point, the Centro peaked out at about 1 million units shipped/quarter with distribution at all of Palm’s significant historic customers. We have the Pixie ramping quickly to these levels in calendar 2010 as distribution ramps.”

That seems a reasonable expectation, especially if the Pixie isn’t exclusive to a single carrier. And at present, it’s thought that the device will be available, at least initially, from both AT&T (T) and Sprint (S).

So, as McCourt and Patterson note, Palm (PALM) could be poised for some significant gains in market share. “We expect Pre shipments of 2.2 million in 2010 (May 2010) and Pixie shipments of 1.2 million,” the analysts write. “Based on our bottoms up estimate, we forecast Palm will ship just over 7 million smartphones in fiscal 2011, which would likely represent about 4 percent of smartphone share, but a more meaningful–10 percent share of its core N. America market.”

[Image credit: Engadget]

So what was AT&T’s reason for agreeing to pay it–other than the warm glow it felt during subsidy negotiations with Apple CEO Steve Jobs? AT&T’s faith in the iPhone’s ability to attract new subscribers, apparently. Not to mention those subscribers’ penchant for running up a $100 tab each month in data and calling services.

One last point worth noting here. That $425 Apple (AAPL) is said to be collecting is even more impressive when one considers the fact that the iPhone 3G costs about half as much to make as its predecessor. Tear-down specialist Portelligent put the new model’s bill of materials at somewhere around $100.

Last week Piper Jaffray (PJC) analyst Gene Munster said the company’s new App Store could end up generating $1.21 billion in revenue. And now Morgan Stanley (MS) is predicting Apple will sell 27 million iPhones in 2009. “We believe the market generally expects a doubling of iPhone units with the lower price point ($199) and we believe this is realistic, if not conservative,” the investment bank said in a note.

At $200 a phone that would generate roughly $5 billion in revenue. And that’s not accounting for whatever subsidy Apple’s collecting from its carriers.