Regulated Pricing for PSTN Termination on Non-

Dominant Carriers

by

Joshua S. Gans
University of Melbourne

12th December 1999

 Executive Summary
This paper considers the issues involved in the regulation of termination services to
non-dominant networks. These issues arise in an environment where one or more
dominant networks (i.e., those with the greatest market shares) have regulated
termination charges.

In the absence of regulation, non-dominant networks set:

• termination charges above the marginal cost of providing those services

regardless of the regulated termination charge on the dominant network.

• higher termination charges to regulated dominant networks than they set to

each other.

• higher termination charges, the lower the regulated termination charge of

dominant networks.

Given this, the case for regulation of non-dominant networks depends on the
strength of substitution between services offered in the industry. If networks’
customer bases are distinct (say because of differing technologies or coverage areas),
then regulating all networks termination charges is unambiguously welfare
improving. Specifically, regulating non-dominant networks termination charges will
lower call prices by increase competition between them.

On the other hand, for networks whose services are closer substitutes, the case for
regulation depends upon the market share of the non-dominant carrier. When a non-
dominant network has a sizeable market share, regulation of its termination charge
to the dominant network may reduce call prices overall. However, if a non-dominant
network has a very low market share relative to the dominant network, regulating its
termination charge may increase call prices.

This suggests that termination services of non-dominant networks should be

regulated on similar terms to those of dominant networks; particularly as the latter
become more established. This will result in more competitive call pricing.
Contents Page

1 Background .............................................................................1

2 Economic Characteristics of Termination .........................3

3 Unregulated Non-Dominant Networks ............................5

4 Regulated Pricing...................................................................7
4.1 The Case for Regulation .................................................7

4.2 Benchmark Pricing for Termination...............................8

4.3 Pricing Options Given Dominant Firm Regulation.......9

5 Conclusion ............................................................................ 11

References......................................................................................... 12

December 1999 i
Section 1 Background

1 Background

In 1999, the Australian Competition and Consumer Commission

(ACCC) accepted Telstra’s undertaking to supply domestic PSTN
originating and terminating services at prices that reflected the Total
Service Long Run Incremental Costs (TSLRIC) of supplying the service.
Being the historical monopoly, Telstra had by far the largest network
and broadest customer base and was likely to continue to have this in
the short to medium term. Consequently, it would be reasonable to
characterise Telstra as the dominant network in the market.

Nonetheless, with increasing network competition, other

networks do and are likely to have sizeable customer bases in the
prevision of local call services. This has raised questions as to whether
their wholesale services should be subject to regulation on a similar
basis as the dominant network. One argument put against regulation is
that with network competition, PSTN services will be subject to
competition and hence, there is no need for price regulation. However,
this argument is incomplete. While network competition may lower
prices to end users, it is unclear why such competition would be
effective in lowering the price of access to a customer when that
customer has already chosen to subscribe to a particular network.
Being able to increase interconnect charges in this context will raise a
rival’s costs of serving its own customers and consequently, potentially
diminish competition.

To see this, it is useful to begin by describing the role of

termination. A terminating service is essentially the carriage of a call
from a point of interconnection between two networks to the consumer
for whom the call is intended. Thus, the terminating network bears the
trunk and connection costs from that point of interconnect to the
consumer while the originating network bears the costs from the caller
to the point of interconnect. Under the caller-pays principle of
charging, however, the caller is charged for both the originating and
terminating services. The originating network collects the call charge
and that network and the terminating network must, in turn, transact
for the terminating service. It is the price that the terminating network
charges the originating one that is the focus of the present paper. Not
surprisingly, as that price becomes part of the marginal cost of the call
service, it also an important factor in the overall price of the call.

December 1999 1
Section 1 Background

This report focuses on termination charges that arise for calls

made from one fixed line network to another fixed line network. Each
fixed line network will have an associated termination charge for calls
and the originating network pays this charge. The originating network
then recovers this charge together with its own costs by charging the
calling party who is a subscriber to their network. The setting of these
terminating charges raises a number of regulatory concerns. First, if
one party wishes to call another specific person who is connected to a
different fixed network, then the terminating network has an effective
monopoly on incoming calls for that particular customer. The network
that has attracted a customer, as a subscriber for outgoing calls,
effectively ‘owns’ the termination revenues associated with that
customer. The ability to exercise market power over termination
charges might give rise to socially inefficient outcomes that are not in
the long-term interest of network customers. Secondly, a dominant
fixed line network owner might be able to use termination charges to
limit the growth of competitors. Consumers value their ability to ring
any customer connected to a fixed line network . By setting a high
termination charges a dominant network might be able to undermine
the ability of its competitors to attract customers. At the same time,
asymmetric regulation that is limited to a dominant carrier might not
lead to socially optimal outcomes.

Given this, the purpose of this paper is to evaluate the case for
regulating access to PSTN terminating services provided by non-
dominant networks. In addition, the paper will also consider whether
such interconnect charges should be symmetric across networks. That
is, if Telstra’s termination is regulated on the basis of TSLRIC pricing,
should the same regulated price apply to other networks?

The remainder of this paper is organised as follows. In Section 2,

the economic forces that underlie the setting of termination charges are
described in more detail. Section 3 then considers what outcomes arise
when non-dominant networks are left unregulated while the dominant
network is regulated. Section 4 then reviews the case for regulation of
non-dominant networks in this light and proposes alternative pricing
rules for termination on those networks. A final section concludes.

December 1999 2
Section 2 Economic Characteristics of Termination

2 Economic Characteristics of Termination

It is useful to begin by summarising the economic factors that

determine how fixed network owners will set termination charges.
There are five key characteristics of terminating services that drive
their value and use. These are: (1) market power over access to a
consumer; (2) consumer ignorance regarding the network called; (3)
horizontal separation; (4) vertical separation; and (5) tariff-mediated
network externalities. These are summarised briefly below.1

Telecommunications involves a two-way network, where the

party that makes and pays for the call is not the same as the party that
chooses which company will terminate the call. Consequently, if one
customer wants to contact another specific customer then they have no
alternative but to buy terminating services from the network who has
the B-party as a subscriber. This means that all fixed line networks
have some degree of market power when setting termination charges.

This market power over call termination will be exacerbated if

the A-party cannot easily identify which network is terminating their
call. In such a situation, the A-party’s decisions over whether or not to
make the call, and over the length of the call, will be based on an
average call price relating to all networks. This customer ignorance
means that networks have an increased ability to raise termination
prices without facing an adverse customer reaction.

Customer ignorance means creates a horizontal externality

between the potential terminating networks. One network can raise its
termination price and this only affects the average call price form the
consumer's perspective. All terminating networks share any reduction
in call numbers or length. This provides each network with an
incentive to inflate its termination charges as it shares any customer
response with its competitors. This is referred to as the problem of
horizontal separation.

1 A more detailed discussion is found in the companion paper, Gans (1999). See also Gans and King
(1999a).

December 1999 3
Section 2 Economic Characteristics of Termination

An end-to-end PSTN service is constructed by using inputs from

one network (termination) that is purchased by another network (the
originating network) and sold to the consumer. This vertical separation
can lead to well-known problems of double marginalisation where call
prices can exceed the integrated monopoly price.

Finally, differential termination charges can create network

externalities between PSTN customers. If it is less expensive to make
intra-network calls rather than inter-network calls, and all consumers
potentially make calls to any other consumers, then it is cheaper for all
consumers if they all belong to a single network. A carrier might be
able to artificially create these externalities, particularly if it is
dominant. For example, suppose one carrier initially has almost all
customers. Entry by competing carriers will be unlikely if the dominant
carrier sets very high termination charges for these new entrants. No
customer will join the entrant if this means that they face a high er
expected price when they ring other customers.

Given these characteristics, termination charges are an issue for

all carriers, not just for a dominant carrier. Termination to a particular
customer is a ‘bottleneck’ to reach that customer. Because the cu stomer
receiving the call does not pay for incoming calls, termination charges
will not be fully constrained by competition, even for small PSTN
networks. This is reflected in the issue of customer ignorance and
horizontal separation. In this sense, call termination differs from a
standard access problem. Instead of having a single ‘essential’ facility
that requires regulated access, termination creates competitive
problems even with relatively small networks or where networks are of
comparable size. In fact, some problems created by termination are
exacerbated when there are more competing networks. As a result, it
will often be expected that regulation of termination charges would
apply to all carriers, not just to say a single dominant carrier.

December 1999 4
Section 3 Unregulated Non-Dominant Networks

3 Unregulated Non-Dominant Networks

It is useful to consider the need for regulation of non-dominant

networks by examining what is likely to happen in the absence of such
regulation. It will be assumed throughout this discussion that a single
dominant network has reg ulated termination charges.2

In this situation of asymmetric regulation, all other things being

equal, the regulated network faces higher costs than the unregulated
one. This is because the termination charge it pays to other networks is
higher than the charge they pay to the regulated network and to each
other. If, because of consumer ignorance, networks charge the same
price for on and off network calls, then the regulated network will face
high relative costs than unregulated networks. Hence, it will find it
more difficult to compete aggressively on price. The end result of this
is to relieve competitive pressure on other networks. Consequently, the
lower regulated charge will not be fully passed on to consumers.

In addition, the unregulated networks are likely to raise

termination charges to the regulated network and exacerbate this
effect. This result follows from a number of effects. First, if networks
sell highly differentiated products, lowering one network’s termination
charges will flow through into the prices charged by other networks.
The double marginalisation effect is reduced and average call prices
fall. But at the same time, non-dominant networks have an incentive to
partially undermine this flow through and seize some of the benefits
for themselves by raising their termination charges. Second, as
networks become closer substitutes, the reduction in termination
charges will tend to alter the way each network, including the
dominant carrier, sets its prices and attracts subscribers. With uniform
prices, reducing a dominant firm’s termination prices tends to lower
non-dominant firms’ prices, as noted above, and this leads to a
competitive response from the dominant carrier. But this is partially
offset by the reduction in the dominant network’s termination
revenues. Carriers use these revenues to compete more vigorously for
subscribers, and reducing these for one carrier reduces that network’s

2 The formal statement of these results can be found in Gans and King (1999b).

December 1999 5
Section 3 Unregulated Non-Dominant Networks

competitive position. Because the regulated carrier is dominant, the

overall effect is lower call prices.

What termination charges will unregulated networks set? Not

surprisingly, given their market power, unregulated termination
charges will be set above the marginal cost of providing those services
regardless of the regulated termination charge on the dominant
network. Such pricing of termination charges will lead to prices for
calls that strictly exceed the monopoly price. This follows directly from
the effects of vertical and horizontal separation.

Greater network competition may encourage greater retail price

competition. However, it will also exacerbate incentives to raise
termination charges. Indeed, if networks sell differentiated products,
both termination charges and call prices will tend to rise if there are
more relatively small networks. Once again this is a consequence of
consumer ignorance and horizontal separation. A small network has a
relatively small effect on the average price of calls and so has a greater
incentive to raise termination charges relative to a larger network.
Overall, a system with many small networks will have higher average
termination charges than a system with fewer large networks.

December 1999 6
Section 4 Regulated Pricing

4 Regulated Pricing

The previous section argues that simply regulating a dominant

network is unlikely to result in socially optimal outcomes. A key
question, however, is whether further regulation will improve upon
the dominant network regulated outcome? In this section, the case for
regulating non-dominant networks is considered and possible pricing
options are proposed.

4.1 The Case for Regulation

The first key issue is whether non-dominant networks’

termination charges should be regulated at all. When those networks
offer products that are highly differentiated or operate in different
markets, 3 then the need for regulation is clear. In this case, regulating
all networks termination charges is unambiguously welfare improving.
Such regulation simply eliminates the anti-competitive effects of
horizontal and vertical separation. That is, unregulated termination
charges were set above marginal cost. This leads to call prices above
their monopoly levels, reducing both consumer and producer surplus.
When only a single dominant network is regulated, this problem is
alleviated to some degree but does not necessarily lead to lower call
prices for consumers. Instead, it has the main effect of helping
competitors rather than helping competition. However, when each
networks’ charge is reduced, this has a positive external effect on other
producers and, by lowering their costs, allows a flow through to
consumers in terms of lower call prices.

If networks sell products that are closer substitutes then the case
for regulating non-dominant networks’ termination charges is more
difficult. One has to distinguish between the termination charges non-
dominant networks set for each other and the charge they would set
for termination of calls from the dominant (regulated) network.
Certainly, between two non-dominant networks, a regulated

3 This would apply for networks operating from different modes (e.g., fixed line and wireless) but are
otherwise interconnected.

December 1999 7
Section 4 Regulated Pricing

termination charge can increase competition and lead to lower prices. 4

Regulating non-dominant networks termination charges will lower call
prices by increasing competition between them. The reason call prices
are reduced is that, in the absence of regulation, termination charges
are set too high – once again due to the problems of horizontal and
vertical separation – and competition between networks only partly
alleviates the consequent double marginalisation effect. Regulating
non-dominant networks in this way will reduce their profits but only
to the extent that they were earning monopoly rents. It will, therefore,
have the effect of securing lower call prices without the additional
costs of over-investment in duplicate networks.

4.2 Benchmark Pricing for Termination

Before considering the effect of alternative regulated pricing

rules it is important to consider what level the regulated termination
charges should be set – regardless of whether the network is dominant
or not. Optimal termination prices would be set below the marginal
cost of termination. If regulated termination charges are set at marginal
termination cost, with highly differentiated products, call prices will be
at their monopoly level. The social goal should be to reduce them to
competitive levels; consistent say with average cost pricing.5 A simple
way of achieving this would be to institute a ‘bill and keep’ system of
termination pricing. In this system, termination charges are, in fact, set
at zero. It is well known that asymmetries in network market shares
would not mean that this caused an undue burden to small or larger
networks. Instead, it is likely that flows to and from networks will be
roughly symmetric regardless of size. 6 This is because, from a large
network’s perspective, it has more customers who could make calls off
net but there are fewer consumers who could receive th em. As such,
the savings they would realise by not having to pay another network
for termination would offset any losses networks would incur.

4 See Armstrong (1998), Laffont, Rey and Tirole (1998a) and Carter and Wright (1999).

5 This is sometimes referred to as TSLRIC in telecommunications regulation. However, note here that
this is the goal for call prices. The prices for the termination service itself should lie below marginal (and
hence, average) cost to achieve this. In this respect, the benchmarks of TSLRIC are far too relaxed a
standard for termination or interconnect charges. Only when regulated prices and call prices are a two -
part tariff could this perhaps be used (see Gans and Williams, 1999b).

6 See Williams (1995).

December 1999 8
Section 4 Regulated Pricing

4.3 Pricing Options Given Dominant Firm Regulation

The previous sub-section described the socially optimal price for

termination for all networks. However, in the present environment, the
dominant carrier has a regulated termination charge above marginal
termination cost. Given this, what is the effect of reductions in the
termination charges for non-dominant networks?

As discussed above, when two networks have services that are

not close substitutes, regulation of termination is unambiguously
desirable in order to reduce the cost of calls to a given network. This is
because that network has market power over termination that is not
tempered by network competition. This suggests that the regulated
price should be as low as possible – certainly no higher than the
marginal cost of termination.7

On the other hand, when the dominant and non-dominant

networks have services that are close substitutes, the effect of
regulating the non-dominant carrier is ambiguous. On the one hand,
regulation will lower the overall costs of the dominant network and
enable it to profitably lower call prices. However, regulation will
reduce the non-dominant network’s benefits from attracting customers
away from the dominant network. Without regulation, if a customer
switched to its network, it would receive the termination revenues
from calls made to that customer. However, with regulation, those
revenues are reduced and hence, so are the potential benefits from
attracting marginal customers. This will tend to put upward pressure
on call prices.

Nonetheless, when a non-dominant network has a sizeable

market share, regulation of their termination charge to the dominant
network may reduce call prices overall. In this situation, regulating its
termination charge will put upward pressure on its call price but it will
put downward pressure on the dominant network’s call prices. This
may lower prices on average. In contrast, if a non-dominant network
has a very low market share relative to the dominant network,
regulating their termination charge to the dominant network may
increase call prices. This is because the dominant network may actually

7 See Gans (1999) and Gans and King (1999a) for a complete discussion of pricing options for this case.

December 1999 9
Section 4 Regulated Pricing

raise its call price in response to the higher price by the non-dominant
network.

This suggests that while a network need not have its termination
charge regulated immediately upon entry, as it becomes more
established it should be subject to regulation. The level of
‘establishment’ of a network could be determined with respect to
factors such as market share, stability of customer base and length of
time in the market. Nonetheless, new entrants would receive the
benefits of regulated termination charges for calls made from their
network to other established carriers.

If a non-dominant carrier is to be regulated, the next key

question is whether its termination charge should be above, equal to,
or below that of the dominant network. If it were above the
termination charge of the dominant network, this would soften the
dominant network’s response to its price competition and, as noted
above, is likely to lead to higher call prices than if it were more tightly
regulated. On the other hand, if its termination charge were below that
of the dominant carrier, the non-dominant carrier would be at a cost
disadvantage relative to the dominant carrier. While this may lower
call prices, this could also send an undesirable signal to new entrants
that they will face harsh competitive conditions if they were to become
established. Consequently, long-term competition in the industry may
be compromised.

This suggests that symmetric regulation of dominant and non-

dominant networks is likely to result in a (second8) best outcome. This
means that termination charges in the industry would be the same
regardless of the particular cost characteristics of the carrier involved.
This solution retains the benefits of competitive neutrality as neither
the dominant or non-dominant networks are at a cost disadvantage
relative to the other. This means that consumers will be able to select
networks on non-price terms that are distortion free and also that the
incentives of incumbents to upgrade infrastructure and new entrants to
enter with cost effective technologies are balanced. This balance is
precisely the outcome that a competitive neutral environment should
engender.

8 The outcome is second best because the dominant network’s termination charge is regulated above
marginal termination cost. Hence it is not possible to achieve socially optimal call prices. Nonetheless,
given this commitment, a regulated price equal to other regulated termination charges will be the optimal
solution for that environment.

December 1999 10
Section 5 Conclusion

5 Conclusion

This paper has examined the principles and issues behind the
setting of termination charges for non-dominant networks. It has found
that there is a case for regulating non-dominant networks and that
such regulation is likely to lead to lower call prices for services that use
PSTN termination; particular, as networks become more established.

It should be noted that such regulation may diminish incentives

to enter the industry. This is because when the dominant network is
regulated while an entrant is left unregulated, the entrant faces cost
advantages that will lead to non-competitive call prices in the long-run.
In other words, an unregulated entrant is able to enter without
dissipating monopoly profits. Consequently, entry does not produce its
socially desired outcome of more competition and lower prices in an
industry. Instead it distorts investment toward new entrants and away
from the dominant carrier. This may result in excessive investment in
duplicate facilities and consequently social losses.

In this respect, it should be remembered the facilitating entry is

should only be a goal of competition policy where it is consistent with
the overall call of more efficient pricing in the industry. When
regulation of dominant and non-dominant networks is asymmetric, the
usual link between entry and lower prices is potentially broken. Hence,
it is more appropriate for regulators to focus on the pricing that will
result from regulation rather than intermediate considerations such as
the number of competitors and the degree of concentration.

December 1999 11
Section 0 References

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December 1999 12