Telephone companies should not be allowed to negotiate the prices they charge for delivering each other”s calls, according to Mark Armstrong of Nuffield College, Oxford. Writing in the May 1998 issue of the Economic Journal, he shows that if rival telecoms operators are free to agree the mutual ”interconnection terms” for connecting users of their different networks, those charges will excessive, leading to higher prices for everyone.
These findings are important for public policy towards the telecoms industry, particularly since many countries allow networks to negotiate these charges, only intervening in the event of a breakdown. Armstrong argues that even when the market is judged to be fairly competitive (as with cellular phones), it is a reasonable policy for networks to be required to set interconnection charges roughly equal to the cost of delivering calls from rival networks. Otherwise, those charges can be used as a collusive device for raising the prices charged to final consumers.
Interconnection is becoming a key issue in the telecoms industry as increasing numbers of countries have competition in all parts of the sector. This implies that several firms each have their own subscribers. In the UK, for example, consumers have a choice between BT, cable TV companies, Ionica, as well as the cellular companies, to provide their service. This means that network A must arrange with network B for B to deliver calls from A”s subscribers to B”s subscribers, and B will wish to be compensated for this service (and similarly for calls in the reverse direction).
In most industries, competition acts to bring down retail prices because each firm has a strong incentive to try to undercut rivals in order to gain market share: the market is balanced when prices are so low that firms find it too costly to reduce prices further. But this mechanism works much less effectively in telecoms. When the market is roughly symmetric, so that the number of calls from A to B is similar to the number of calls in the reverse direction, the two networks have the same incentives to set the interconnection (or ”call termination”) charge. Each firm has an incentive to set a high charge because this will be passed on to consumers in the retail market.
With a high interconnection charge, firms no longer behave as in most industries and do not have an incentive to try to undercut rivals in the retail market. If one network chooses to undercut its rival, it will certainly gain market share, which is good for profits. But this action will also cause the net number of calls to rival networks to increase, and since it must pay rival networks a large amount to deliver these extra calls, this effect will outweigh the benefits of gaining market share.
The net result is for retail prices to remain high, even if there is strong competition in the retail sector.
”Network Interconnection in Telecommunications” by Mark Armstrong is published in the May 1998 issue of the Economic Journal. Armstrong is based at Nuffield College, Oxford.