Journal of Regulatory Economics; 20:1 2141, 2001

# 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.

On the Impact of ``Callback'' Competition on
International Telephony
*
FABIO M. MANENTI
University of York (U.K.),
Department of Economics,
Universita di Padova (Italy)
{
. Dipartimento di Scienze Economiche ``M. Fanno''
Abstract
In this paper we build a simple three-country model to evaluate the impact of ``callback'' on international
telephony. The effects on both accounting rates and collection prices are studied. Callback rms exploit
arbitrage opportunities in collection prices among countries, rerouting calls that originate in countries
with high prices for international phone calls via countries with low prices. Contrary to what is commonly
perceived, we show that callback tends to magnify the distortions associated with the current accounting
rate regime. In particular, callback puts upward pressure on low price countries' accounting rates and on
collection charges. Callback companies are assumed to enjoy a volume price discount on each rerouted
call; we show that the larger the price discount offered to callback companies, the higher the prices for
international calls in the country hosting callback.
1. Introduction
The aim of this paper is to analyze and evaluate the impact of ``callback'' on retail and
interconnection charges in international telecommunications. Callback is an alternative
way of placing international calls (alternative calling procedure
1
in the industry jargon)
that new technologies have made available to customers for international voice
communications. Until recent market liberalization decisions by many national
* Paper presented at the 25th EARIE conference, Copenhagen and at the 1998 ASSET Meeting, Bologna. I
would like to thank Gianni De Fraja for his continuous and constructive help. Gabriella Chiesa, Riccardo
Faini, Indrajit Ray, Carlo Scarpa, Paola Valbonesi, Julian Wright and the seminar audiences at the
University of Brescia and Pavia provided many helpful comments on earlier versions of the paper. Two
anonymous referees and the editor, Michael Crew, are also acknowledged. I am particularly indebted to
the Alcuin college of the University of York (U.K.) for the nancial support for my studies.
{ Address for correspondence: Dipartimento di Scienze Economiche, Universita di Padova, Via del Santo
33, 35123 Padova (Italy). E-mail: manenti@decon.unipd.it
1 ACP hereafter.
governments are effectively put in place, ACPs, and callback in particular, are one of the
main challenges to the monopolistic power of national carriers.
2
Callback is based on a very simple idea: suppose a customer in Italy wants to speak with
a friend in a different country (the U.S.). If the price of a call from the U.S. to Italy is lower
than the price of a call in the opposite direction, then it may be cheaper for the Italian
resident to be called rather than to call the friend located in the U.S. He will then
compensate the friend for the cost of the call. Instead, he can use a public callback service
and get a computer to do the call-rerouting.
In the typical callback call, rst a customer in one country places a free call to the
callback operator equipment (usually just an automated system) in a second country. The
operator, which detects the caller's identity without answering the call, calls the customer
back at a predesignated number providing the customer with a dial tone in the second
country and connects the customer to a number in the second or third country. The original
call is now ``rerouted'' via the country where the callback rm operates.
Most callback enterprises are located in the U.S. where lower prices for international
phone calls provide wide margins for arbitrage opportunities; callback calls are usually
provided at a rate 2050% cheaper then that of the carriers. Unfortunately, the FCC does
not compile explicit data on callback trafc. Callback falls under the umbrella of ``resale''
trafc and there is no way for the FCC to track callback trafc versus other types of resale
trafc.
3
Although price competition and deregulation together with the emerging of new
services, namely voice over IP, have made callback less protable than it was when this
service was introduced in 1992, global callback generated in 1999 estimated revenues of
around $800 million.
4
It is widely accepted that the demand for callback services will
remain high in developing nations where international calls are still expensive. Nowadays
customers place their calls using callback services in more than 200 countries.
5
Despite its growth, callback is still a very controversial phenomenon. On the one hand
the FCC, the U.S. regulatory authority that provides the licenses to U.S.-based callback
rms, and international organizations such us the OECD and, more recently, the ITU
(International Telecommunications Union) have argued in favor of callback.
6
Accordingly, callback should be encouraged because it would engineer downward
pressure on prices for international phone calls. On the other hand, 100 countries around
2 An exhaustive description of the ACPs is provided in OECD (1995). The most common practices of
ACPs are: reverse charge calling, credit card calls, country direct service, country and beyond service,
callback, international free-phone service, international leased lines and rele (hubbing).
3 In 1997 pure-resale trafc accounted for 15% of the whole outgoing U.S. trafc; this gure is expected
to grow even more with time. See Lande and Blake (1997).
4 See Nye (1999).
5 See Choi et al. (1999).
6 After more than two years of legal disputes, the FCC gave its nal assent to the provision of callback
services in 1995 (10 FCC Rcd 95-40). See Propp (1996) for a discussion of the legal issues related to the
FCC decision to authorize callback operators in the U.S. But note that not all types of callback are
allowed: the so called ``call-bombardment'' and ``answer suppression'' are fraudulent since they interfere
with the billing mechanism of the national operators.
22 FABIO M. MANENTI
the world, mainly developing countries, have so far prohibited callback in their territories
7
and are putting pressure on the FCC to stop licensing of new callback operators. These
countries perceive callback as a problem because it deprives the local operator of revenues
from the international telecommunications sector.
8
This controversy has been, and still is,
a source of strong debate among operators.
The surprising growth and development of this particular form of competition has been
made possible by the way in which international telecommunications is organized. The
typical method of governing interactions among national telecom operators is the
accounting rate system. Consider, for example, a call from Italy to France: the Italian
carrier keeps the revenue for this call but, for this call to be terminated (i.e., received by a
user in France), it must pay an access fee to the French operator for the use of its network.
The same fee applies to each call that goes from France to Italy; this fee (called the
accounting rate or the interconnection charge) is arranged in bilateral negotiations
between the two operators. As suggested by Frieden (1997), under this regime, carriers
have failed to negotiate adequate interconnection charges. Even though accounting rates
are falling over time, they are still well above the cost of providing interconnection.
9
This
distortion in the access charges has kept prices for international phone calls at an
articially high level, preventing them from reecting the dramatic costs reduction
implied by the development of new technologies.
Callback advocates, such as the OECD, argue that this form of competition between
international operators creates downward pressure both on retail prices and accounting
rates. According to Frieden (1997), the more nations authorizing callback, the more
accounting rates and collection charges
10
decrease in consequence.
In a recent paper, Choi et al. (1999) provide a formal treatment of the callback
phenomenon. Interestingly, they show that one of the main reasons for the existing of
callback services is the inefciency of the accounting rate system. Nonetheless, in their
paper, the inefciency is not fully explained; in addition, the authors use a two country
model, while most callback operators reroute calls between two high price countries and
are located in a third country with low international rates. We use a three country model in
order to capture the basic structure of a callback call; furthermore, by making endogenous
the determination of the accounting rates between countries, we are able to highlight the
consequences of callback both on accounting and retail charges. We show that with
callback, accounting rates and collection prices on different routes, otherwise
uncorrelated, become interconnected. As a consequence, the effects of the accounting
rate regime are no longer restricted to a few specic routes, but rather are extended to the
interconnection agreements between the countries involved in the calls rerouting.
This paper demonstrates that callback puts upward pressure on the accounting rates
between ``high price'' countries (called target countries), which in turn pushes up
7 The list of these countries is kept up-to-date on the ITU web-site (http://www.itu.int/).
8 Arguments for and against callback are summarized in Kelly (1996).
9 Data about accounting rates are condential and, apart from the U.S. and the U.K., they are not
published; estimates of the accounting rates can be found in OECD (1997).
10 According to the industry jargon, the price for a phone call is also dened as ``collection charge''.
IMPACT OF ``CALLBACK'' COMPETITION 23
collection prices for calls between the same countries. In addition, it is shown that the
impact of callback on the prices charged by the low price carrier (called the host carrier)
depends upon the price discount offered to callback rms. Quite surprisingly, it is found
that the larger the discount, the higher the host carrier mark-up.
Although in a different context, these results conrm similar arguments presented in
Alleman (1998) and are easily understood once the effects of the reciprocal accounting
rate regime are fully considered. Indeed, instead of undermining it, callback exacerbates
the distortions that this regime has on accounting rates and collection charges. Consider
target countries: carriers in target countries may nd it optimal to push up prices for
international calls placed between their customers by raising the reciprocal interconnec-
tion fee; this stimulates alternative callback rerouting and increases trafc imbalances
between target and host countries. According to the accounting rate regime, this implies
that carriers in target countries receive higher settlement payments from the country
hosting the callback rms. On the other hand, also the host country carrier may be induced
to increase its tariffs for calls directed to target countries; this is to reduce the amount of
calls rerouted via callback and to lower the settlement payment due to the carriers in target
countries.
These results must be evaluated considering the evolving context of the market for
international telephony. Many factors are inducing a decline in prices for international
phone calls; technologies are more efcient, in many countries markets are now open to
competition and new communications services (typically, the Internet) are eroding the
market for traditional telephony;
11
our main argument is that callback instead of
accelerating the decline of collection prices has indeed prevented them from converging
down to costs.
The paper is organized as follows. In section 2 we present the model of callback. Section
3 evaluates and discusses the solution of the game and section 4 concludes the paper.
2. The Model
We model a world with three countries A, B and C. For the sake of simplicity, we assume
that in each country, telecommunications services are provided by only one operator
(carrier). This assumption may appear rather unrealistic, especially in relation to the
country hosting the callback rms. In the real world, price differences occur mainly
because some countries have opened the market to competition. Nonetheless, as it will
become clear later, the main arguments of the paper are not affected by this assumption. In
this stylized world only international telephone services are provided, that is, calls
originating in one country and terminating (i.e., received by a user) in another country. We
make the following assumptions:
11 In Manenti (2000) it is estimated that the demand for international telecommunications in Italy for the
period 199197 is signicantly and negatively affected by the dimension of the Internet; this suggests
that the new Internet-based communications channels are substitutes for standard telephony services.
24 FABIO M. MANENTI
(i) National carriers in countries A and B have the same cost conditions. We denote
with c the cost incurred by these operators in collecting a call on their local
network and sending it to the ``half-way point''.
12
Instead, carrier C (C for
cheaper) is more efcient: it incurs a lower cost per outgoing call: c
c
5c. Given its
superior technology, carrier C can set lower prices for calls directed to countries A
and B: prices for international calls differ according to the direction of the call (i.e.
a call from C to A costs less than a call in the opposite direction).
(ii) Each call directed to a country must transit on that country's network in order to
reach the nal user. The transmitting carrier pays an access fee for each call to the
receiving carrier for the use of its network. This fee, called the ``accounting rate'',
is reciprocal (i.e. the same access charge for a call from A to B applies to a call
from B to A) and is negotiated between the carriers involved in the call
transmission. The accounting rate is determined according to a Nash-bargaining
process.
(iii) The cost of providing access (the cost of delivering other carriers' calls) is c
o
and is
the same across countries.
(iv) Callback rms (CB hereafter) are located in country C. The CB sector is
characterized by price competition with free-entry. CB enterprises exploit
arbitrage opportunities based on calls rerouting: a CB rm located in C, the
cheap country, can reroute a call from A to B (or vice versa) transforming it into
two outgoing calls from C. For these reasons, we denote A and B as target
countries and C as the host country.
2.1. The Demand for International Telecommunications
Our main purpose is to investigate the impact of CB on high price countries' reciprocal
accounting rates and tariffs. For this reason we assume that CB services are provided only
on the main route AB: a customer located in a target country can place his calls to users in
the other target country either by demanding the services of his national operator or via
callback. In order to differentiate these two kinds of calls, we dene the former as
``standard calls'' and the latter as ``callback calls''.
We rule out the possibility that CB rms offer to reverse calls from A or B to C. This is a
simplication because, usually, once the customer located in the target country (for
example A), is connected with the CB terminal equipment, he can then place a call either
in the host country C or to a foreign destination (B).
13
CB rms act symmetrically with respect to the target carriers: each CB rm offers to
reroute calls both from A to B and from B to A. This is what happens in practice in the CB
market: unless a country has banned CB, then CB rms provide connection in both the
directions of the call.
12 This is called the imaginary point of interconnection between national networks.
13 However, if markets are separated and there are no economies of scale, the introduction of CB even
between target and host countries would not affect our results. For an analysis of CB between target and
host countries, see Choi et al. (1999).
IMPACT OF ``CALLBACK'' COMPETITION 25
There are n CB rms, indexed by h = 1; . . . ; n, all located in the host country C. They
have two main effects: on the one hand they compete with networks A and B by lowering
the amount of calls that they place with each other and, on the other hand, they increase the
number of calls originating in C.
We model standard calls and CB calls as imperfect substitutes: the demand for CB
services increases with the price for standard calls charged by the national operator.
Formally, denoting by Q
j
i
the demand for standard calls from i to j, by Y
j
i
the demand for
CB services on the same route, and by p
j
i
and v
j
i
the prices for these calls, the following
assumption is made:
Assumption 1:
(a)
qQ
j
i
(p
j
i
;v
j
i
)
qp
j
i
50
qY
j
i
(v
j
i
;p
j
i
)
qv
j
i
50
qY
j
i
(v
j
i
;p
j
i
)
qp
j
i
40 i; j = A; B and i ,= j.
(b) The demand for standard calls and the demand for callback calls are the same
across countries and have constant price elasticity, denoted by Z and E respectively:
Z =
qQ
j
i
qp
j
i
p
j
i
Q
j
i
i; j = A; B; C and i ,= j
e =
qY
j
i
qv
j
i
v
j
i
Y
j
i
i; j = A; B and i ,= j
(c) e4Z41.
The assumption of imperfect substitutability (1a) is taken on practical grounds: on the one
hand, although CB is becoming a very popular telecommunication service, its use is still
conned to a restricted share of well informed customers. In addition, calls placed via CB
are often of a lower quality when compared to standard calls (delays in the conversation,
echoes, noise etc.): quality considerations may reduce the attractiveness of these services
affecting customers' demand. According to these observations, it is even natural to assume
that the demand for CB calls is more reactive to change in prices than the demand for
standard calls (assumption 1c): although we cannot empirically support this assumption,
we believe it is reasonable to think of CB users more concerned with changes in prices
than the customers of standard calls.
14
2.1.1. Trafc Flows
Only standard calls are placed between target countries but, as explained, the demand
for calls between target carriers depends not only on the collection price p
j
i
charged by the
local monopolist, but also on the price for a CB call v
j
i
: Q
j
i
= Q
j
i
(p
j
i
; v
j
i
).
For each call that is rerouted from the main line AB via C, two outgoing calls from C
are placed, one directed to each country. This implies that the amount of calls delivered on
14 The condition Z41 is necessary to guarantee positive equilibrium prices and is supported by some
studies of elasticity of demand for international calling. See OECD (1997) or Lande and Blake (1997).
26 FABIO M. MANENTI
carrier C's network and directed to country i is the combination between the amount of
standard calls Q
i
c
and CB rerouting Y
j
i
. Therefore, the trafc ow between host and target
carriers is given by
Traffic Flow
TF
i
c
( ? ) =
standard calls
Q
i
c
(p
i
c
)
callback rerouting
Y
j
i
(v
j
i
; p
j
i
) Y
i
j
(v
i
j
; p
i
j
)
with i = A, B and i ,= j.
According to our simplication, CB rms reverse calls only on the route AB. This
implies that the trafc of calls from countries A and B to country C is not affected by CB.
It is useful to provide a graphical representation of the trafc ows between the three
countries; see gure 1.
2.2. Fundamentals of the Reciprocal Accounting Rate Regime
The current system of multilateral collaboration in the transmission of international
calls is the accounting rate regime. According to this regime, the transmitting carrier pays
for each call sent to the foreign carrier an access fee (the accounting rate) for the use of its
network and receives an equal payment for each incoming call from this operator. The
accounting rate is negotiated at bilateral meetings between telecom carriers.
We assume that these negotiations take the form of a Nash-bargaining process in which
the contracting parties have the same bargaining power.
15
Formally, the accounting rate
between country i and j (a
i; j
) is given by
a
i; j
= argmax p
1=2
i
p
1=2
j
h i
(1)
where p
i
is the carrier i's prot function. For the sake of simplicity, we assume that the
disagreement point of this bargaining process is that there is no interconnection agreement,
namely the carriers cannot provide international services between the two countries and
both their prots are zero. This is a simplifying assumption since each carrier always has
the option of rerouting calls through the third country.
16
a is the accounting rate between target carriers (A and B) while t
i
is the accounting rate
between carrier C and carrier i. Table 1 summarizes the adopted notation.
The analysis of the current accounting rate regime is beyond the scope of this work.
Nonetheless, as it will become clear later, since CB is intrinsically related to the process
15 This is realistic in this framework, in which international telephony services are supplied by monopolies
but it applies even when competition is considered. In this case we can think of a regulatory policy that
assigns to a representative carrier a monopoly equivalent bargaining power.
16 We wish to thank an anonymous referee for this observation. Nonetheless, taking into account for each
carrier the option of rerouting calls via a third country would require modeling transit tariffs for rerouted
calls and also the additional bargaining processes between the countries of transit in which these tariffs
are determined. This would make the analysis much more complicated without, at the same time, adding
any new relevant insight to the model. The assumption of zero prot disagreement point is frequently
adopted in the existing literature; see Wright (1999) and De Fraja and Valbonesi (2001).
IMPACT OF ``CALLBACK'' COMPETITION 27
through which collection charges are determined, it is important to recall briey how this
regime works; in particular two main effects are worth noting:
17
(1) When carriers face the same demand and cost conditions ( perfect symmetry), trafc
ows between countries are balanced (outgoing traffic = incoming trafc) and the
bargained access price is set equal to the cost of providing access. In our case, since
carriers A and B are identical, then a = c
o
.
(2) When there is asymmetry between countries either at the demand or at the cost
level, trafc is no longer balanced and the bargained access price is shown to be
above the cost of providing access. In this model, due to the technological
asymmetry, trafc ows between host and target countries are unbalanced; this
implies that t
i
4c
o
.
Perfect symmetry is a very special situation. In more general cases trafc ows among
countries are unbalanced. That is, due to the reciprocity of the accounting rate regime, the
carrier that terminates more calls than it originates receives more than it pays to the foreign
carrier for interconnection to its network.
18
When the trafc is unbalanced, carriers fail to set the reciprocal access charge at the cost
level. This is considered one of the reasons why international calls charges are higher
when compared to national long distance calls. The accounting rate is ``de facto'' an
additional cost per call that each carrier must pay to deliver its calls. The higher the
accounting rate, the higher the cost per call and the higher the collection prices.
19
Figure 1. Trafc ows.
17 For a formal treatment, we refer to an earlier version of this paper; in Manenti (1997) we study the
consequences of demand and cost asymmetries on bargained accounting rates.
18 The growing imbalances in trafc ows between countries have generated large decits in countries like
the U.S., Sweden or Australia and large surpluses in other countries such as Mexico or Germany. Data on
trafc ows are in ITU (1999).
19 For these reasons many governments and organizations are promoting the introduction of new
interconnection arrangements. See De Fraja and Valbonesi (2001) for a discussion of the proposed
reforms of the accounting rate regime.
28 FABIO M. MANENTI
2.3. Firms' Prots
2.3.1. Callback Firm's Prot
CB rms are assumed to be identical and, as stated above, they are established in
country C. For each rerouted call from one target country to the other, they must pay the
hosting carrier for the price of two outgoing calls. In practice, CB rms enjoy lower prices
than residential customers since they fully exploit the volume discounts offered by the host
carrier: assuming that CB rms do not face additional costs for each call, the CB cost per
call is equal to a discounted sum of two outgoing calls from C. We denote the price
charged to CB companies by p
cb
, with p
cb
= y(p
a
c
p
b
c
), where y [ [0; 1[ represents the
volume discount. For the moment, let us assume that y is exogenous. Note that p
cb
is
independent of the direction of the rerouted call.
Since each CB rm reroutes calls both from A to B and from B to A, the prot function
for the h CB rm is then
p
h
CB
=

i; j =A;B
[v
j
i;h
p
cb
[Y
j
i;h
( ? ) h = 1; . . . ; n and i ,= j (2)
where v
j
i;h
is the price for calling from i to j charged by the h CB operator and Y
j
i;h
is the
demand it faces.
2.3.2. Carriers' Prots
The prot functions for each established carrier are given by
p
i
= p
j
i
c a
h i
Q
j
i
( ? ) (a c
o
)Q
i
j
( ? ) p
c
i
c t
i
[ [Q
c
i
( ? )
(t
i
c
o
)[Q
i
c
( ? ) Y
j
i
( ? ) Y
i
j
( ? )[ i; j = A; B and i ,= j (3)
Table 1. Notation
Name Description (i ; j = A; B and i ,= j , h = 1; . . . ; n)
a Accounting rate between A and B
t
a
Accounting rate between C and A
t
b
Accounting rate between C and B
p
j
i
Price for a call from country i to country j via domestic carrier
p
i
c
Price for a call from the host country C to country i
v
j
i ;h
Price for a callback call from country i to country j via operator h
Q
j
i
( ? ) Demand for standard calls from target country i to target country j
Q
i
c
( ? ) Demand for standard calls from country C to target country j
Y
j
i ;h
( ? ) Demand for callback calls from country i to country j via operator h
IMPACT OF ``CALLBACK'' COMPETITION 29
p
c
= p
cb
2c
c
t
a
t
b
[ [(Y
b
a
( ? ) Y
a
b
( ? ))

i; j =A;B
p
i
c
c
c
t
i

Q
i
c
( ? ) (t
i
c
o
)Q
c
i
( ? ) (4)
where p
j
i
is the price for a call between target countries via established carriers (i; j = A;
B), while p
i
c
and p
c
i
are the prices for Cs outgoing and incoming calls respectively. a and t
i
are the bargained accounting rates between target countries and between the host country
and country i respectively. In (4), the rst term represents the prot from selling calls to
CB operators. Each rerouted call implies two outgoing calls from C; each pair of calls is
charged p
cb
and costs (2c
c
t
a
t
b
) to the host carrier.
Using the denition of trafc ow between host and target countries, TF
i
c
, and
rearranging, it is useful to rewrite carriers A and B prot as follows:
p
i
= [p
j
i
(c c
o
)[Q
j
i
(a c
o
)[Q
i
j
Q
j
i
[
[ p
c
i
(c c
o
)[Q
c
i
(t
i
c
o
) TF
i
c
Q
c
i

where the rst and the third terms represent the revenues from collecting standard calls and
sending them to the called country, while the second and the fourth terms represent the net
interconnection payments with the other national operators. These are known as the
``settlement payments''.
Note that if the access charge exceeds the marginal cost of giving access c
o
, then the
carrier makes money on access (accounting revenues) only if it terminates more calls than
it originates. When volumes of incoming and outgoing trafc are unbalanced, then the
operator which generates more trafc pays for the difference to compensate the
terminating carrier, namely the settlement payment. For example, if a4c
o
then carrier A
receives from B a positive settlement payment if Q
a
b
Q
b
a
40. The reciprocal accounting
rate regime implies that part of the ``high trafc'' carrier's prot is ``stolen'' by the ``low
trafc'' rm through the bargaining process.
It is therefore clear how this system reduces the incentives for a rm to cut its prices:
lower prices imply more outgoing calls and, as a consequence, a lower (even negative)
settlement payment.
2.4. The Timing
We model CB competition as a four stage game; the timeline is in gure 2.
In the rst stage, each monopolist negotiates the reciprocal accounting rates with each
of the other carriers. At this stage a, t
a
and t
b
are determined.
Figure 2. The timing.
30 FABIO M. MANENTI
Given these values, collection prices are dened in the second stage. This sequence of
events is justied on practical grounds: accounting rates are negotiated during periodical
meetings between telecom operators. Retail prices are then adjusted accordingly. In the
third stage CB competition occurs. CB rms exploit arbitrage opportunities between
carriers' prices. This means that CB rms observe the retail prices for international phone
calls charged by carriers and then compete in the market for CB calls. In the last stage,
rms' prots are realized.
3. The Impact of Callback Competition
CB is a textbook example of a market with no cost of entry. Indeed, to set up a CB rm and
to start competing, only switched equipment terminals are required. For this reason, in the
last few years there has been a proliferation of CB companies, especially in the U.S.
Accordingly, we analyze CB assuming price competition with free entry.
3.1. t = 2: Callback Competition
Starting from the last stage of the game, we solve the model by backward induction. At
date t = 2, CB competition occurs: CB rms observe the collection prices charged by the
carriers at t = 1 and then compete in the market for rerouted calls.
CB rms compete on prices: given the collection prices set by domestic carriers, each
company sets its prices v
j
i;h
, with h = 1; . . . ; n. The prot function for the h CB rm is
given in (2). Note that at this stage of the game, carriers' collection prices are determined:
Y
j
i;h
( ? ) is now function only of the prices charged by CB rms.
Since the CB industry is characterized by price competition, then CB calls are priced at
marginal cost. The cost for each rerouted call is a discounted sum of the prices of two
outgoing calls from C; this implies that at the equilibrium:
v = v
j
i;h
= y(p
b
c
p
a
c
) i; j = A; B and h = 1; . . . ; n: (5)
We note that: (i) the equilibrium price for a CB call is independent of the direction of the
call, and (ii) since p
i
c
is a component of the marginal cost of the CB rms, then an increase
in Cs outgoing prices implies, for given y, a reduction in CB rerouting:
qY
j
i
qp
i
c
=
qY
j
i
qv
dv
dp
i
c
50:
3.2. t = 1: Second Stage Collection Charges
At date t = 1 carriers set their prices given the reciprocal access charges a and t
i
that
they have bilaterally negotiated at t = 0. The following proposition presents the second
period mark-ups at the symmetric equilibrium.
IMPACT OF ``CALLBACK'' COMPETITION 31
Proposition 1: At the symmetric equilibrium p = p
b
a
= p
a
b
, p
c
= p
a
c
= p
b
c
, p
c
= p
c
a
= p
c
b
and t = t
a
= t
b
; the equilibrium mark-ups are
p (c a)
p
=
1
Z
1
t c
o
p
r
Y
Q
!
(6)
p
c
(c t)
p
c
=
1
Z
(7)
p
c
(c
c
t)
p
c
=
1
Z
1 2
Y
Q
c
y e(1 y) ( )
1 2
e
Z
Y
Q
c
4 5
(8)
where r is the cross elasticity of the demand for CB calls to target carriers prices.
20
Since
for customers located in target countries CB calls and standard calls are substitutes, then
r40.
Proof: See the Appendix. &
Note that without CB (Y = 0) these mark-ups all reduce to
p
j
i
(c
i
a
i; j
)
p
j
i
=
1
Z
c
i
= c; c
c
(9)
that represents the standard monopoly's pricing formula where the marginal cost per call is
the sum between the collection cost and the accounting rate. Without CB, telecom
operators act as monopolies that price according to the inverse of the elasticity rule.
21
Observing the results given in proposition 1, it is clear that the presence of CB rms
makes collection charges and accounting rates for calls on the different routes more
correlated. This is an important result. In particular, note that optimal second stage prices
for calls on the route AB given in expression (6) depend not only on the amount of calls
rerouted by CB on each route (Y) but even on the accounting charge t between target
carriers and the host carrier C. Without CB, the trafc on each route is independent of the
20 r = (qY
j
i
=qp
j
i
)(p
j
i
=Y
j
i
).
21 Nevertheless note the peculiarity of the international telecommunications industry with respect to a
standard monopoly case. Each monopolist produces an input (the access) that is necessary to the
production of the foreign monopoly and vice versa. This is called ``symbiotic production'' (Carter and
Wright 1994). In addition, since each carrier is restricted to operate in its own country, customers cannot
choose which operator to use. For an analysis of competition among networks, see Armstrong (1998),
Carter and Wright (1999) and Laffont et al. (1998a and b).
32 FABIO M. MANENTI
trafc on any other route. With CB part of the trafc ows on one route is moved to a
different route; this makes prices and quantities of calls more correlated than otherwise.
Nevertheless, since at date t = 1 retail prices are dened as functions of the negotiated
accounting rates, in order to analyse the impact of CB services on carriers' collection
prices it is necessary to characterize the behavior of the interconnection charges between
networks. This analysis is conducted in the following section.
3.3. t = 0: Accounting Rates
3.3.1. The Accounting Rate Between Target Countries
Interconnection charges (or accounting rates) are dened at date t = 0 according to a
Nash-bargaining process. We assume that rms have equal bargaining power. The
following proposition presents our main result:
Proposition 2: When callback rms reroute calls between target countries, the
interconnection charge between these countries increases with respect to the solution
without callback:
a4c
o
:
Proof: See the Appendix. &
This is a surprising result: the presence of CB enterprises located in C pushes up the access
price between A and B. Proposition 2 has a clear explanation. Consider rst the solution
without CB. This situation is close to the analysis of ``symbiotic production'' reported in
Carter and Wright (1994). In this case, perfect symmetry between operators A and B
occurs; these carriers have identical demand and cost conditions which implies that, at the
equilibrium, trafc on the route AB is perfectly balanced (Q
b
a
= Q
a
b
). As a consequence,
the access is not an issue for the carriers: with reciprocal access price, the interconnection
payment that one monopolist pays to the other is exactly the same it receives for delivering
the other carrier's calls.
Nonetheless the interconnection rate a matters since, according to expression (9), it
affects collection prices. Without CB rms A and B set it equal to the cost of providing
access (a = c
o
); in doing so each carrier enjoys the highest level of prot (monopolistic
level) charging the monopolistic price
p
M
= (c c
o
)
Z
Z 1
:
As explained in Carter and Wright (1994), collusion over the access price lowers
collection charges: both the rms increase their prot by lowering the access price. The
cost of providing interconnection c
o
represents the lower bound below which it is not
optimal for both the carriers to set the accounting rate.
Consider now the solution with CB. Since CB acts symmetrically towards target
carriers, the relationship between networks A and B is still symmetric: trafc ow is
perfectly balanced and there is no settlement payment; the accounting rate is still a means
IMPACT OF ``CALLBACK'' COMPETITION 33
of collusion. Nevertheless now target carriers deal with the new CB effect: the higher the
price they charge for a call on the route AB, the more the calls rerouted via callback and
the higher the settlement payment that they receive from carrier C.
In other words, since t4c
o
, rerouted calls are attractive because they increase the target
countries settlement payments. Target carriers may agree upon a higher interconnection
charge and, as a consequence, a higher collection price thus stimulating CB and increasing
their access revenues. Moreover, (12) implies that, other things being equal, the
accounting rate between countries A and B increases the more calls are rerouted via
callback.
This result gives evidence on how CB rerouting exacerbates the inefciency of the
current accounting rate regime: CB puts upward pressure on accounting rates that,
otherwise, would have been set at the cost level.
3.3.2. The Accounting Rate Between Host and Target Countries
The characterization of the impact of callback on the interconnection charge between A
(or B) and C is much more complex and cannot be unambiguously dened.
Given the asymmetry between host and target countries, we know from the previous
analysis that the reciprocal interconnection charges t
a
and t
b
are set above the cost of
providing access; at the symmetric equilibrium t
a
= t
b
= t and t4c
o
.
Nevertheless the interactions between prices, accounting rates and prots are very
complex. The presence of CB affects both the prices between target countries and between
target and host countries making the overall impact of Y on t undetermined.
22
3.4. The Impact of Callback on Collection Prices
3.4.1. The Price for a Standard Call Between Target Countries
Applying the results of the previous section to the second stage prices given in section
3.2, we now discuss the impact of CB on retail prices. Let us start with the price for a
standard call between A and B; the following corollary holds:
Corollary 1: The collection price for a call between target countries is increased by
callback:
p = (c c
o
)
Z
Z 1
(t c
o
)r
Y
Q
Z 1
Z 1
4p
M
: (10)
22 In an extended version of this paper, we show that, under very mild conditions, the accounting rate
increases with the asymmetry in the size of demand faced by the countries involved in the bargaining
process. This argument is conrmed in Wright (1999) where it is shown that the accounting rate between
two countries is higher the more the two countries differ in per capita income: other things being equal,
higher differences in income imply higher trafc imbalances which translate into higher accounting rates.
According to this argument, since CB rerouting increases the asymmetry in the size of demand between
host and target countries, then the bargained accounting rate should be xed at a higher level when CB
rms are in the market.
34 FABIO M. MANENTI
Proof: See the Appendix. &
On the one hand, with CB, both the interconnection charges a and t put upward pressure on
A and B collection prices. As stated in Proposition 2, the access charge between A and B is
higher when CB rms are in the market: the cost per call incurred by each target carrier is
increased with respect to the equilibrium without CB thus putting pressure on retail prices.
In addition, now, even the interconnection charge between target and host countries
enters in the determination of the equilibrium price: all the other things equal, the higher t,
the higher the price for a call from A to B (or vice versa). On the other hand, CB reduces
the demand faced by target carriers thus pushing down collection prices; this effect is more
than compensated by the effect of t on both accounting and collection charges and the
equilibrium price increases with respect to the solution without CB. These arguments are
strengthened by the presence of the term Y/Q in expressions (12) and (10). The term Y/Q
represents the ratio between the amount of CB calls and the amount of standard calls on the
route AB. Ceteris paribus, the larger this ratio the higher the accounting rate bargained by
target carriers and, therefore, the collection price they charge for calls on the route AB.
Together with Proposition 2, this result is the central message of the paper. CB does not
put downward pressure on the accounting rate a between target countries and it does not
put pressure on collection prices p
j
i
(i; j = A; B) either. Instead of undermining the
accounting rate regime, the presence of CB tends to expand its distortions. Our conclusion
provides a formal support to the intuition presented in Alleman (1998); in his paper,
Alleman raises many concerns about the widespread view of CB as a device to induce a
reduction in foreign collection rates and accounting charges. For this reason, the author
claims that foreign countries should welcome CB, not make it illegal because it can
improve their monopolists' revenue and prot.
3.4.2. The Price for a Call From Country C to Target Countries
Consider now the impact of CB on the price for calls from host to target countries;
although we don't know the exact impact of CB on the bargained accounting rates between
host and target countries, t
i
, we can still say something relevant on the impact of CB on
carrier C's mark-up.
Corollary 2: For a given accounting rate between target and host country, the mark-up
for calls that originate in C and terminate in A or B tends to decrease with the price
discount offered to CB rms; in particular:
(i) with full price discount, y = 0, CB competition increases the mark-up;
(ii) without any price discount, y = 1, CB competition reduces the mark-up.
Proof: See the Appendix. &
By offering a large price discount to CB companies (low y), the contribution of CB to
carrier C total prot is relatively small. At the same time, a large discount implies that
more calls between A and B are rerouted via C by CB companies. This entails an increase
in the trafc imbalance between C and foreign countries and, as a consequence, a higher
IMPACT OF ``CALLBACK'' COMPETITION 35
settlement decit for the host carrier. By increasing p
c
, the carrier limits the number of
outgoing calls; this reduces the trafc imbalance and the payment due to foreign carriers
for interconnection. However, with little or no volume discount (y close to 1), CB becomes
protable for carrier C, which now fully exploits the increased demand by reducing the
price for a call.
23
These observations might become useful in a competitive marketplace. As mentioned,
in some countries, and in the U.S. in particular, prices are lower because of the pressure of
competitive forces. This creates the ideal environment for callback to proliferate. What
could become relevant in a competitive context, is the relationship between the price
charged by the host country carrier and the volume discount offered to CB companies.
Competition in the country C has two main effects. Firstly, it lowers the host country
collection prices which accentuates further the trafc imbalance between host and target
countries. Secondly, as discussed in Choi et al. (1999), it increases the price discount
offered to CB companies: rival rms compete not only for standard market shares but even
to attract CB trafc: competition reduces y.
24
According to our discussion, larger
discounts translate into higher equilibrium prices; this might prevent competition from
achieving its goal, namely driving prices down to costs.
Finally, our model does not say anything about the impact of CB on the price for calling
from target to host country. By assumption, there is no CB service for calls from country A
(respectively B) to country C and the retail price is the standard monopoly price given in
expression (9). Everything now depends on the impact of CB on the accounting rate t
which, as already discussed, is not dened.
4. Conclusions
Callback is an alternative calling procedure that allows customers located throughout the
world to place international calls at lower rates by rerouting calls via foreign and cheaper
23 For the sake of completeness, the endogenous choice of y by the host carrier is
y
+
=
e
e 1
1 2e
Y
Q
c
Z 4e
Y
Q
c
It is easy to see that y
+
40. For sufciently high levels of the elasticity of demand for CB services, e, a
corner solution occurs, y = 1.
24 We must note that competition does not necessarily affect the bargaining process over the
interconnection terms. In the U.S., the market for incoming trafc is divided up in proportion to the U.S.
carrier's own share of outgoing trafc with the corresponding country. This follows the FCCs rules called
proportional return rules. These rules were introduced to prevent U.S. carriers competing against each
other for calls termination, when dealing with a monopoly foreign carrier. Such competition could
decrease the bargaining power of the U.S. carriers and it could also lead the incumbent U.S. carrier to
reach an exclusive deal with the foreign carrier, to prevent entry of other carriers into the U.S. market
(wipsawing). As discussed in Wright (1999), these rules imply that U.S. carriers act jointly in the
bargaining over the accounting rate; similarly, a representative host country operator can be assigned
with a monopolistic bargaining power thus keeping the process equivalent to the monopolistic case.
36 FABIO M. MANENTI
phone lines, usually located in the U.S. Although the international callback market has
been growing at a fast pace in the last ten years, it is still one of the least understood
telephony markets.
The use of a three country model allows us to evaluate the impact of callback rms that
reroute calls between two high price countries via a low price country. Contrary to what
has been claimed by many inuential observers, we show that callback puts upward
pressure on the interconnection rates between the high price carriers; furthermore, we
show that this form of call rerouting might induce a general increase in collection prices.
Transferring this into a real world scenario, we demonstrate that callback is slowing down
the fall in retail and termination charges induced by all those factors, basically
competition, deregulation and new technologies, that currently characterize the
market.
This is the effect of the reciprocal accounting rate regime, which is the current system
used for charging and settling inter-country telecommunications. It is now widely
recognized that the reciprocal accounting rate system is inefcient and prevents the
providers of international telephony services from setting adequate interconnection tariffs
and, therefore, retail prices.
Callback rms move telephone trafc from one route to different ones; this makes
trafc and tariffs on different routes more correlated than otherwise. As a consequence,
callback expands the distortions induced by the current accounting rate regime. Our results
are easily understood once the full effects of callback are considered; with callback, the
carriers in target countries receive an extra settlement revenue from the carrier where
callback rms are located. In order to maximize these extra revenues, the carriers agree on
higher reciprocal accounting rates which in turn pushes prices up and stimulates call
rerouting.
The effects on prices charged by the carrier of the country where callback rms are
located depend upon the price discount offered to callback rms.
Callback proponents argue that callback helps to bring settlement rates, and therefore
retail prices, more closely in line with costs. We show that the opposite is true.
Paradoxically, the inadequacy of callback rerouting is the effect of what callback was
originally intended to correct: the distortions of the reciprocal accounting rate regime.
Rather then promoting trafc rerouting to bypass the accounting rate regime, it would be
preferable to speed up the current process of reform of the accounting rate regime towards
the introduction of new interconnection arrangements.
Our approach is highly simplied; further research should be devoted to analyzing less
restrictive models in order to provide a more general support to our results and to test
empirically the impact of callback on retail prices. An interesting area for future research
would be to study the other forms of call rerouting, such as hubbing and reling. These are
additional alternative calling procedures that are frequently considered as instruments to
reduce the inefciencies of the international interconnection system. Other issues that
deserve to be studied concern the impact on traditional telephony ( pricing and
interconnection) of the new forms of communications based on the use of the Internet
and characterized by partially or completely circumventing the current interconnection
regime.
IMPACT OF ``CALLBACK'' COMPETITION 37
Appendix
Proof of Proposition 1: Let us rst consider the prices for standard calls on the route
AB. From the denition of p
i
the rst order condition with respect to p
j
i
is
qp
i
qp
j
i
= Q
j
i
(p
j
i
c a)
qQ
j
i
qp
j
i
(t
i
c
o
)
qY
j
i
qp
j
i
= 0:
Due to the symmetry of the game,
25
we can rewrite this expression as follows
[ p (c a)[
qQ
qp
= Q (t c
o
)
qY
qp
recalling the denition of the cross-elasticity r and rearranging
p (c a)
p
=
1
Z

t c
o
p
r
Z
Y
Q
and expression (6) follows immediately.
The collection price for calls form A (or B) to C solves the following f.o.c.
qp
i
qp
c
i
= Q
c
i
[p
c
i
(c t
i
)[
qQ
c
i
qp
c
i
= 0:
This is a standard monopoly's prot maximizing condition. Given the symmetry it is easy
to derive expression (7).
Finally let us consider the price for an outgoing call from country C; using the fact that
p
cb
= y(p
i
c
p
j
c
) and rearranging, (4) becomes:
p
c
= [y(p
i
c
p
j
c
) 2c
c
t
i
t
j
[(Y
j
i
( ? ) Y
i
j
( ? ))

i; j =A;B
[ p
i
c
c
c
t
i
[Q
i
c
( ? ) (t
i
c
o
)Q
c
i
( ? )
differentiating, the rst order condition is:
qp
c
qp
c
= [y(p
i
c
p
j
c
) 2c
c
t
i
t
j
[
qY
j
i
qv
j
i
qv
j
i
qp
i
c

qY
i
j
qv
i
j
qv
i
j
qp
i
c
2 3
y(Y
j
i
Y
i
j
) Q
i
c
(p
i
c
c
c
t
i
)
qQ
i
c
qp
i
c
= 0
25 At the symmetric equilibrium p
j
i
= p
i
j
= p; p
i
c
= p
j
c
= p
c
and v
j
i
= v
i
j
= v. These conditions imply that
Q
j
i
= Q
i
j
= Q; Q
i
c
= Q
j
c
= Q
c
.
38 FABIO M. MANENTI
since qv
j
i
=qp
i
c
= qv
i
j
=qp
i
c
= y, and given that, at the symmetric equilibrium,
qY
j
i
qv
j
i
qv
j
i
qp
i
c
=
qY
i
j
qv
i
j
qv
i
j
qp
i
c
= 2y
qY
qv
and that v = 2yp
c
, this expression reduces to
qp
c
qp
c
= Q
c
[p
c
(c
c
t)[
qQ
c
qp
c
2yY 4y
2
p
c
qY
qv
4yp
c
qY
qv
[p
c
(c
c
t)[4y
qY
qv
= 0
rearranging:
p
c
(c
c
t)
p
c
1 2
e
Z
Y
Q
c
!
=
1
Z
2
y
Z
Y
Q
c
2
e
Z
(1 y)
Y
Q
c
and expression (8) is obtained.
Second order conditions are assumed to hold. &
Proof of Proposition 2: Using second stage prices provided in Proposition 1, carriers'
prots can be expressed in terms of the access carges only. Therefore, according to
expression (1) the accounting rate between carriers A and B is given by
a = argmax log p
a
p
b
a
(a); p
a
b
(a); a

log p
b
p
b
a
(a); p
a
b
(a); a

:
Differentiating the argument of the above expression and using the fact that, by the
envelope theorem, qp
i
=qp
i
= 0, the bargained accounting rate solves the equation
qp
a
qp
a
b
dp
a
b
da

qp
a
qa
!
p
b

qp
b
qp
b
a
dp
b
a
da

qp
b
qa
!
p
a
= 0:
In our symmetric environment, this expression reduces to
(a c
o
)
qQ
qp
(t c
o
)
qY
qp
= 0 (11)
rearranging
a c
o
= (t c
o
)
r
Z
Y
Q
: (12)
Where t is the interconnection charge between host and target countries.
26
By
construction, the trafc ow between the host country C and target country i is
IMPACT OF ``CALLBACK'' COMPETITION 39
unbalanced. Then, as we saw before, the negotiated accounting rate between the host
carrier C and the target carrier i is set above the cost of interconnection: t4c
o
; given that
CB calls and standard calls are substitutes (r40), it follows from expression (12) that
a4c
o
.
Without CB, Y = 0 and therefore a = c
o
. This proves the proposition.
27
&
Proof of Corollary 1: Without CB, the price for a standard call between A and B is the
monopolistic price p
M
. Instead, from expression (6), the price for the same call when CB
rms are in the market is
p = c c
o
(a c
o
) (t c
o
)r
Y
Q
!
Z
Z 1
using expression (12), then p4p
M
if
(t c
o
)r
Y
Q
Z 1
Z 1
40
which is always satised for t c
o
40. &
Proof of Corollary 2. When y = 0, (8) becomes:
p
c
c
o
t
p
c
=
1
Z
1 2e
Y
Q
c
1 2
e
Z
Y
Q
c
: (13)
Without CB, the monopolist sets the standard mark-up 1=Z, which is clearly smaller than
(13).
For y = 1, (8) becomes:
p
c
c
c
t
p
c
=
1
Z
1 2
Y
Q
c
1 2
e
Z
Y
Q
c
(14)
which, for e4Z, is always lower than the mark-up without CB. &
26 Recall that, given the symmetry of the game, at the solution t
a
= t
b
.
27 To guarantee the existence of an internal equilibrium (Y40), we implicitly assume that CB rms enjoy a
price discount y, such that there is always room for CB services. In reality the presence of competition in
the host country, which we do not model here, justies this assumption. Competition has two effects: on
the one hand it implies lower prices for standard calls in the host country thus providing bigger arbitrage
opportunities; on the other hand, it induces carriers in country C to compete for rerouted trafc (namely,
by offering greater volume discounts). This additional form of competition drives down further the price
charged to CB companies, hence reducing their marginal cost.
40 FABIO M. MANENTI
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IMPACT OF ``CALLBACK'' COMPETITION 41