To connect or not to connect? A tale of network access

switchboard

If I call your Vodafone mobile from my Orange mobile, who should pay the cost of termination incurred by Vodafone? You, me, Orange or Vodafone? For that matter, which has the better business model – Europe with a “caller pays” system, or the US with an “everyone pays” system?

Sjaak Hurkens and Angel L. López analyze an oligopoly of telecom networks in their Barcelona GSE Working Paper, (No. 774), “Who should pay for two-way interconnection?” (July 2014). In the paper, they show how termination charges play a role in off-network usage and whether efficiency and profitability are achieved with current business models.

What are termination charges and the current practices…?

Essentially call termination is a wholesale service that the terminating network provides to make an off-net call possible. The termination charge is the price paid by the originating operator to the terminating operator in exchange for this service. But how is this price determined? In Europe the European Commission (EC) regards an operator as having monopoly power over their network for termination services, and is thus subject to regulation. On the other hand, the Federal Communications Commission (FCC) in the US allows network operators to negotiate bilaterally reciprocal charges for network termination; only in certain instances of disagreement do US regulators intervene. This leads to a difference in the way termination charges are applied: in Europe, the EC recommends that national regulators reduce termination charges to the true cost; while in the US the bilateral agreements generally result in low or even no termination charges (where the zero charge case is known as Bill & Keep).

…and the existing business models?

Operators across the Atlantic also differ in the business models they implement. In Europe, the Calling Party Pays (CPP) model is in place, where only the caller is charged for a call. Meanwhile, the Receiving Party Pays (RPP) system is used in the US, where both the caller and the receiver are charged. Since Bill & Keep is the principal practice in the US, this variant of the RPP business model has operators recover their costs from their own customers rather than from the competitor. It implies that consumers are only willing to receive a call if they value the benefit of doing so in RPP, with a similar concept for placing calls in the CPP scenario. The concept of consumers benefiting from engaging in calls plays an important role in the authors’ analysis. Since regulators can only influence the adoption of business models and not force it upon firms, it is necessary to study how termination charges affect both efficiency and profitability in the retail market.

Talk to me about efficiency.

So what is efficiency? Efficiency in the current context is the socially optimal amount of calls that consumers want to make, and presumably attaining this is the objective of the regulator. This may stand in contrast with firm practices, where operators may set prices that maximize their profits (firm surplus) at the cost of reaching the social optimum.

The results of the authors’ analysis are underpinned by the concept of passive expectations: consumers form an expectation of network size before tariffs are set, and firms take these expectations into account when setting tariffs. They also tackle the problem from an oligopolistic setting as this minimum of three firms prevents connectivity breakdown – the incentive a firm may have to prevent off-network traffic by setting high prices for off-net calls, which may arise in a duopoly – and allows for efficiency to arise.

Going back to the original question of who should pay and how much, the results are quite clear. The efficient equilibrium requires that prices for placing and receiving a call be such that the total cost of the call is shared in proportion to the benefit derived from it by callers and receivers. And since operators set retail prices equal to strategic marginal cost, they must likewise share the total cost of termination in the same proportion. The optimal termination charge is thus a fraction of the termination cost where the size of the fraction is a function of this proportion. For example, if there were no value at all for receiving a call, the originating operator should pay the full cost; if the value of placing and receiving a call were the same, the originating operator should pay only half.

So, is efficiency possible?

Unfortunately, even if regulators could identify and set the socially optimal termination charge it is not necessarily the case that firms set prices for placing and receiving calls that result in the efficient outcome. Regulators, after all, don’t set retail prices; firms do. A first problem is that firms face a coordination problem because there are multiple equilibria, basically because firms have too many instruments (both a price for placing and a price for receiving calls). And even if this coordination problem were to be solved in a satisfactory manner, there is a second problem: In practice national regulators set a ceiling on charges (for example in Europe), but the authors show that firms could have an incentive to charge or negotiate (as in the US case) termination charges that are below the regulator’s. This arises because in the resulting equilibrium, profits are higher but call volume is lower . So while efficiency is possible in theory, it probably will not occur in practice.

How do the US and European business models compare?

The different business models represent different solutions to the coordination problem. In Europe the CPP equilibrium is played (with zero price for receiving calls) while in the US the RPP equilibrium (with the same price for placing and receiving calls) is chosen. The authors show that full efficiency is impossible in either case precisely because those business models are incompatible with the caller and receiver sharing the cost in the right proportion. They therefore compare the two scenarios on which leads to higher consumer surplus and profitability. The results depend on the relative benefit consumers have for placing versus receiving a call, the number of firms, and consumer sensitivity to prices on demand.

They generally conclude that the European case with CPP (and termination regulated at cost as recommended by the EC) may outperform the US case with RPP (and termination negotiated at Bill & Keep) in terms of consumer and total welfare when consumers don’t place much value on the benefit from receiving calls. The results for profitability is that firms will be able to grab a larger share of the pie vis-à-vis the US scenario if: consumers place relatively low value on the benefit of receiving calls and are very sensitive to price changes; or on the other extreme when consumers highly value the benefit of receiving calls and are much less sensitive to price changes. It is therefore beneficial to have a greater understanding of how much value consumers have on placing/receiving calls to better grasp the policy implications of this analysis and whether and if one business model should be implemented over the other.