BILATERAL MARKET STRUCTURES AND REGULATORY POLICIES IN INTERNATIONAL TELEPHONE MARKETS

• Author: Guofu Tan,Heng Ju
• Date: 01 May 2016
• DOI: http://doi.org/10.1111/iere.12162
• Published date: 01 May 2016

INTERNATIONAL ECONOMIC REVIEW

Vol. 57, No. 2, May 2016

BILATERAL MARKET STRUCTURES AND REGULATORY POLICIES

IN INTERNATIONAL TELEPHONE MARKETS∗

BYHENG JUAND GUOFU TAN1

Shanghai University of Finance and Economics, China;University of Southern California,

U.S.A .

We develop models of bilateral oligopoly with traffic exchanges to study the competition and regulatory policies in

the international telephone markets. Under the requirement of uniform settlement rates, the proportional return rule

(PRR) inflates the rates and hence neutralizes PRR’s effect on calling prices. Retail competition and PRR increase

net settlement payments. Market efficiency is improved when there are multiple channels for traffic exchanges. Using

a panel of 47 countries that exchanged traffic with the United States between 1992 and 2004, we test the effects of

bilateral market structures and the U.S. policies. The empirical results support our theoretical findings.

1. INTRODUCTION

The completion of an international telephone call involves two major components. A domes-

tic carrier collects the call from the caller, and then a foreign counterpart terminates the call by

delivering it to the receiver. Access to the foreign carrier’s network is an essential and comple-

mentary input for the domestic service provider. A service payment, often called the “settlement

rate” on a per-minute base, is made from the domestic to the foreign carrier. Moreover, in-

ternational telephone calls typically flow in two directions, and a carrier often provides both

originating and terminating services. In the jargon of industrial organization, a carrier in this

market typically combines the roles of both downstream and upstream players in a traditional

vertical framework, receiving two sources of revenues from retail services and input supplies.

These two revenues of a carrier can be interrelated, depending on government regulatory poli-

cies on the settlement arrangement between the interconnecting carriers. The revenues can also

be affected by the competition for providing call-originating and call-terminating services on

each side of the market. In this article, we study how such two-way bilateral market features,

combined with competition on each side of the market of facility-based message services, affects

the determination of settlement rates and calling prices. We also consider whether government

policies, particularly the policies implemented by the U.S. government, are effective to gear

the market outcomes toward its claimed goals to improve efficiency and balance the settlement

payments between countries.

1.1. Two-Way Bilateral Market Structures, Competition,and the FCC’s Involvement. The bi-

lateral market structures are evolving, and governmental policies have changed several times.

In the late 1970s, the United States unilaterally introduced competition in its domestic market

for international telephone services, whereas the markets in other countries remained monop-

olized by single national carriers. Competition on the U.S. side lowered its calling prices, but

also resulted in rising net settlement payments to other countries. Under this bilateral market

∗Manuscript received March 2013; revised December 2014.

1We thank the editor, Hanming Fang, an anonymous referee, Zhiqi Chen, Baiyu Dong, Patrick Francois, Yu-Wei

Hsieh, Michel Poitevin, Tom Ross, Scott Savage, Ralph Winter, Junji Xiao, Mo Xiao, as well as seminar participants

at the UBC, UCLA, UCSB, Colorado-Boulder, USC, Southern Methodist, and Texas-Austin for helpful comments.

Please address correspondence to: Heng Ju, School of International Business Administration, Shanghai University of

Finance and Economics, 777 Guoding Road, Shanghai, China. E-mail: hengju@gmail.com.

393

C

(2016) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

394 JU AND TAN

structure, the foreign monopolist could play one carrier against the others in order to reduce

the rates it paid to the U.S. carriers for traffic delivery in the United States and increase the

rates the U.S. carriers paid for terminating traffic in the other country, a strategy often called

“whipsawing.” Both the U.S. carriers and the Federal Communications Commission (FCC)

deemed the unequal positions in exchanging traffic to be the main reason for high settlement

rates paid by the competing U.S. carriers and henceforth the high consumer calling prices in the

United States (FCC, 1999).

This concern arising from the traffic exchanges with foreign monopolies called for government

intervention in settlement negotiations. In 1986, the FCC initiated its International Settlements

Policy (ISP),2intended to prevent foreign monopoly carriers from engaging in whipsawing.

The ISP consists of three major rules: (i) Uniformity: All U.S. carriers must pay the same

settlement rate for the outbound traffic on the same route; (ii) Reciprocity: The U.S. carriers

must receive the same rate for terminating inbound traffic as the rate paid for outbound traffic;

(iii) Proportional return rule (PRR): Traffic from a foreign country is allocated among the

U.S. carriers in proportion to their shares of outbound traffic to that country.3Limiting their

aggressive competition in providing call-termination services, those requirements tied up the

competing carriers’ interests and let them behave as a single entity when negotiating settlement

terms with foreign monopolists.

However, the ISP policy did not result in sufficiently low retail calling prices, instead in

ever-growing net settlement payments to foreign countries. In 1997, the FCC claimed that the

outcomes were due to the high settlement rates and the lack of foreign competition. It then

released its Benchmark Order (FCC, 1997), which set up tight upper bounds on settlement

rates negotiated by carriers.4Additionally, since the late 1990s, many other countries started

to introduce competition into their domestic markets. The FCC responded by relaxing its ISP

policy. As shown in FCC (2004), when a country that interconnects with the U.S. carriers is

considered to be competitive, the ISP is lifted from the negotiation of settlement agreements

on this route.

1.2. Overview of the Model and Empirical Analysis. Our main objective in this article is

to provide a framework for analyzing the impacts of competition and government regulatory

policies on equilibrium retail calling prices, settlement rates, and net settlement payments in

international telephone markets, taking into account the two-way bilateral market structure

with competition and specific settlement arrangements on each side of the markets. We adopt

two-stage games to approach the industry. In the first stage, carriers from two representative

countries choose settlement rates. In the second stage, domestic carriers on each side compete

for outgoing calls in a Cournot fashion.

In our core model, Settlement Alliances, government regulation in each country requires that

domestic carriers behave collectively in setting a uniform settlement rate for inbound traffic and

use a linear combination of the equal sharing rule (ESR, where the carriers share the incoming

traffic volume equally) and the PRR to share incoming traffic volume (or equivalently, to share

incoming settlement payments). The PRR is an important policy instrument required by the

FCC. Under this requirement, a competing carrier’s share of terminating inbound traffic is

linked with its market share of the outbound traffic. This linkage (or “bundling” the two-way

service markets) could affect carriers’ decisions on both originating and terminating services.

2See FCC (1999, 2002) for a detailed description.

3Several other countries, including the United Kingdom, Finland, Sweden, and Mexico, adopted policies similar to

the ISP, as noted by Malueg and Schwartz (2001) and Wellenius et al. (2005). The adoption of the ISP policy by the

Mexican telecommunication authority caused a dispute between the U.S. and Mexican governments through the World

Trade Organization in 2000; see Wellenius et al. (2005).

4Within a prescribed transition period, the order required all U.S. carriers to negotiate settlement rates to be less

than or equal to 15 cents for upper income countries, 19 cents for upper and lower middle-income countries, and 23

cents for lower income countries (FCC, 1997).

INTERNATIONAL TELEPHONE MARKETS 395

Essentially, in this setting, settlement rates are determined cooperatively within an alliance of

carriers in each country, but noncooperatively across countries.

One particular contribution in our article is a formal analysis of the PRR with endogenous

determination of settlement rates. The PRR adopted in a country puts downward pressure

on the domestic calling price if settlement rates are fixed. However, when settlement rates are

strategically determined, as in our model of Settlement Alliances, we show that the PRR inflates

equilibrium settlement rates, neutralizes equilibrium calling prices, and increases settlement

payments to foreign carriers. Consequently, carriers in a country jointly prefer the ESR to the

PRR. We also show that as the degree of domestic competition increases, both total payouts

and net payments from domestic carriers to foreign carriers increase. We further illustrate that

the relationship between the retail competitiveness and the settlement rate tends to differ from

the one in the traditional vertical model.

To compare the outcomes with and without the government regulations, we extend our

analysis to consider two other market settings. The first one corresponds to a “whipsawing”

situation in practice. Between this equilibrium outcome and the one in Settlement Alliances,

we find that domestic competition and the PRR introduced in one country tend to increase

settlement rates and its net settlement payments to other countries. In the next setting, we relax

the requirement for collective rate setting in the core model and allow for multiple channels

of international traffic exchanges with independent determination of settlement rates. We

conclude that the overall market efficiency can be improved without the PRR when multiple

channels are available for international traffic exchanges.

Using a panel data set covering 47 countries that exchanged international telephone traffic

with the U.S. carriers between 1992 and 2004, we test the marginal effects of bilateral market

structures on the settlement rates and calling prices—particularly, how the domestic competition

effects on those economic variables are altered by the foreign market structures. In our empirical

analysis, we control both the individual route and time fixed effects, as well as individual time

trends in those outcome variables. We argue that the effects are driven by both the feature

of traffic exchange and the regulatory policies. In exchanging traffic with concentrated foreign

markets, the FCC’s imposition of ISP would weaken the roles of domestic competition on

calling prices, whereas with unconcentrated ones, the relaxation of the policy would lead the

price more responsively to competition.

1.3. Related Literature. Our work tries to fill a gap in the industrial organization literature

on telecommunications.5Bilateral monopoly structure in the international settlement is well

studied in the literature (Carter and Wright, 1994; Cave and Donnelly, 1996), where both coop-

erative and noncooperative determinations of settlement rates are considered and compared.

There are a few papers studying the impacts of competition in international telephone mar-

kets. Yun et al. (1997) and Wright (1999) analyze the effect of competition on uniform and

reciprocal settlement rates. Assuming that symmetric domestic carriers compete `

alaCournot

in the retail market and divide the foreign inbound traffic for call-termination services evenly,

Yun et al. (1997) find that the desirable settlement rate for carriers as a group in each country

increases with both domestic and foreign competition. However, they do not formally analyze

how settlement rates are determined.6In the analysis of Wright (1999), two domestic carriers

in a Hotelling model use the PRR and jointly bargain with the foreign carrier over a uniform

and reciprocal settlement rate via Nash bargaining, where the degree of product differentiation

between the two carriers is used to measure the degree of competition in the retail market. His

simulation results illustrate that the introduction of competition in one country tends to not

only reduce the domestic retail price, but also increase the settlement rate and foreign retail

5See Armstrong (2002) and Einhorn (2002) for extensive reviews of the literature on international telephone markets.

6Motivated by the theoretical framework in Yun et al. (1997), Madden and Savage (2000) provide an empirical

study to explain the pattern of calling prices in international telephone markets between the United States and foreign

countries. In their study, they assume exogenous settlement rates and the ESR.