Interconnection in international telecommunications

Interconnection in international telecommunications

¹elecommunications Policy, Vol. 22, No. 11, pp. 953—961, 1998  1998 Published by Elsevier Science Ltd. All rights reserved Printed in Great Britain 0...

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¹elecommunications Policy, Vol. 22, No. 11, pp. 953—961, 1998  1998 Published by Elsevier Science Ltd. All rights reserved Printed in Great Britain 0308-5961/98 $19.00#0.00

PII: S0308-5961(98)00062-7

Interconnection in international telecommunications An empirical investigation of United States settlement rates

Gary Madden and Scott J Savage Several national governments have expressed concern at the inability of carriers to negotiate lower accounting rates. Ergas and Patterson (1991) and Frieden (1997) argue that it is only on bilateral markets with facilities-based competition at both ends that conditions favour accounting rates reductions. In the absence of facilities-based competition, Frieden also suggests that service providers, such as resellers, may provide a second best opportunity to place downward pressure on accounting rates. This study extends the work of Ergas and Patterson by developing an econometric model of settlement rate pricing. The model is estimated on data for 27 US bilateral telephone markets for the period 1985 to 1995. Parameter estimates are used to identify settlement rate determinants, and so highlight impediments to efficient international telecommunications pricing. A novel feature of the model is the inclusion of a resale market structure variable. 䊚 1998 Published by Elsevier Science Ltd. All rights reserved. Gary Madden and Scott J. Savage are with the Communications Economics Research Program, School of Economics and Finance, Curtin University of Technology, GPO Box U1987, Perth, Western Australia

continued on page 954

International telephone services have been traditionally provided by state owned (facilities-based) monopolies who connect their local networks to designated international gateways. These segments, referred to as ‘tails’, are interconnected via the two half-circuits linking the domestic country gateway to the foreign country gateway. Cost sharing arrangements between countries in a bilateral telephone market are arranged through the international accounting rate system. The accounting rate is the basic ‘unit of account’ from which international settlement payments are made between the domestic and foreign carrier. Accounting rates are typically split evenly. The home carrier’s share, the settlement rate, indicates how much that carrier pays to access another country’s network. Agreement of a 50 : 50 settlement rate share is based on the notion that the carriers participate equally in routing the call. Recent technological advance and increased market liberalisation have substantially reduced the costs of providing international calls. However, accounting rates, initially intended to reflect the costs of terminating incoming calls, have remained high relative to falling costs. For example, whilst the per minute cost of using transAtlantic cable in 1996 is 0.05 United States dollars (USD), average 1996 accounting rates for Japan, the United Kingdom (UK), and the United States (US) are 0.70, 0.56 and 1.06 USD, respectively.  Chowdary, Einhorn and Ergas suggest the markup on the incremental cost of terminating international calls can be as high as 500%. High mark-ups can make terminating international calls highly profitable, with rents accruing to net-traffic receiving carriers. Profits so generated are often seen as a source to fund cross-subsidisation of local exchange calls and domestic postal services, develop telecommunications infrastructure, and contribute to consolidated government revenue.\


Interconnection in international telecommunications: G Madden and S J Savage continued from page 953 6845, Australia. (Tel.: #61 8 9266 7051; fax: #61 8 9266 3026; e-mail: maddeng/ savages We would like to thank Jim Alleman, Doug Galbi, Larry Spiwak, and seminar participants at the FCC, Washington DC, 10 December 1997 for their helpful discussion and comments. Data support from Linda Blake, Jim Lande, Jonathan Levy, the FCC, ITU, and TeleGeography Inc. is gratefully acknowledged, as is research assistance by Mark Bevan and Darren McCool. Any opinions, findings or conclusions expressed in this paper are those of the authors and do not reflect the views of the FCC, ITU, TeleGeography Inc., or the named individuals. 1

The half-circuit concept presumes that corresponding carriers achieve a wholecircuit by linking two half-circuits at the theoretical midpoint of a submarine cable, or at the satellite providing the transmission link (Frieden, op cit Ref 2). 2 Frieden, R., The impact of call-back and arbitrage on the accounting rate regime. Telecommunications Policy, 1997, 21, 77. 3 FCC, 1997 Trends in the US International Telecommunications Industry. Common Carrier Bureau, FCC, Washington, 1997. 4 TeleGeography Inc., TeleGeography 1996 /97: global telecommunications traffic statistics and commentary. TeleGeography, Washington, 1996. 5 Chowdary, T. H., International accounting rates. Telecommunications Policy, 1997, 21, 77. 6 Einhorn, International accounting and settlements: a review of literature, Mimeo, US Department of Justice, Washington, 1997. 7 Ergas, H., An Economic analysis of the implications of a trading system for international telecommunications services based on trade of termination services. A Report Prepared for the Department of Communications and the Arts and the Department of Foreign Affairs and Trade, Australia, 1995. 8 Cave, M. and Donnelly, M. P., The pricing of international telecommunications services by monopoly operators. Information Economics and Policy, 1996, 8, 107–123. 9 Chowdary, op cit Ref 5. 10 Frieden, op cit Ref 2. 11 It is not uncommon for countries to link their settlement rate system to domestic universal obligations programs. The system employed in Hong Kong allocates approximately half the per minute settlement rate to cross-subsidise local calls (Siochru, op cit Ref 12). 12 Siochru, S. O., The ITU, the WTO and accounting rates: limited prospects for the south. Presented at the 12th EURICOM Colloquium on Communication and Culture, Boulder, Colorado, October 1997. 13 Ergas, H. and Patterson, P., International telecommunications settlement arrange-

continued on page 955


Ergas and Patterson and Frieden argue that asymmetric market structures on bilateral telephone markets impose little discipline on monopoly carriers to pass on cost reductions to consumers. Accordingly, international collection rates diverge between countries that have actively pursued collection rate reduction policies, and those which have not. These developments have increased settlement rates relative to collection rates for ‘low price’ (‘competitive supply’) countries, which in turn, has affected the pattern of international traffic flows and settlement payments. Low collection rate countries have experienced increased outgoing traffic, whilst incoming traffic from ‘high price’ (monopoly supply) countries has either not increased at the same rate or declined. This outcome is due to users in low price countries responding to lower collection rates, and indirectly through the substitution of the higher-price incoming traffic and lower-price outgoing traffic. The outcome sees low price countries providing high price countries with increased settlement payments. Several national governments and international agencies have expressed concern at the inability of carriers to negotiate lower accounting rates.\ Frieden argues that it is only on bilateral markets with facilities-based competition at both ends that conditions favour a reduction in accounting rates. In the absence of facilities-based competition, Frieden suggests that service providers such as resellers, call-back operators and Internet service providers, may provide a second best opportunity to place downward pressure on accounting and collection rates. By leasing an international private line between a pair of countries and connecting that line to the public switched network, resellers are able to provide end-to-end international services. Facilities-based carriers face potential revenue losses as traffic routed through resellers is not subject to settlement rate and proportionate return arrangements. As more traffic is carried by resellers pressure mounts on facilities-based carriers to reduce accounting rates. ITU preliminary evidence supports this effect. Since resale was proposed on the US—UK market in 1992, accounting rates have fallen by approximately 45%, whilst UK-OECD accounting rates have declined by approximately 18%. This study examines settlement rate pricing in international telephone services markets. An econometric model is estimated on data for 27 US bilateral telephone markets for the period 1985—1995. Parameter estimates are used to identify the determinants of settlement rates, and so highlight impediments to efficient international telecommunications pricing. Attention is given to telecommunications network costs, traffic volumes, technology, market structure, and the economic development of countries in bilateral markets. A novel feature of the model is the inclusion of a resale market structure variable. The paper is organised as follows. The second section reviews the international accounting rate literature and identifies settlement rate determinants. An econometric model of settlement rate pricing is developed in the third section. Data used for econometric estimation are described, and preliminary data analysis carried out, in the fourth section. Econometric estimates are reported and discussed in the fifth section. Concluding remarks are provided in the last section.

Determinants of settlement rates Studies of the accounting rate system have several apparent themes. They include: the relationship between accounting rates, costs and market

Interconnection in international telecommunications: G Madden and S J Savage continued from page 954 ments: an unsustainable inheritance. Telecommunications Policy, 1991, 15, 29–48. 14 Frieden, op cit Ref 2. 15 An asymmetrically competitive market is defined here as a bilateral market with a monopoly market structure at one end and a oligopoly (or ‘competitive’) structure at the other end. 16 Increased outgoing traffic in several low price countries is excentuated by the entry of telecommunications service providers. For example, call-back providers supply a US dial tone to consumers in high price countries wishing to make a call to the US. 17 Dunstone, M., Telecommunications trade: a new order is needed. A Report Prepared for the Department of Communications and the Arts, Australia, 1994. 18 FCC, Policy statement on international accounting rate reform. 96-37, January 31, 1996, FCC, Washington, 1996a. 19 Hundt, R. E., Chairman of the FCC’s Speech to the Hispanic Chamber of Commerce. July 17, FCC, Washington, 1997. 20 Productivity Commission, International telecommunications reforms in Australia. Staff Information Paper, AGPS, Canberra, 1997. 21 WTO, The agreement on basic telecommunications services. February 15, WTO Publications Service, Geneva, 1997. 22 Frieden, op cit Ref 2. 23 ITU, Direction of traffic: trends in international telephone tariffs, 2nd edition. ITU/ TeleGeography, Geneva, 1996a. 24 ITU, op cit Ref 23. 25 Johnson, L., Dealing with monopoly in international telephone service: a US perspective. Information Economics and Policy, 1991, 4, 225–247. 26 FCC (1997) data show that off-peak accounting rates are being implemented on some US bilateral markets. 27 Galbi, D., Model-based price standards for terminating international traffic. FCC Staff Paper, FCC, Washington, FCC, 1997. 28 Countries with greater time difference are also more distant. Sample data reveal time difference and distance are almost perfectly correlated. Given that a distance component has been traditionally been built into accounting rates, a positive relationship between time and accounting rates may indicate that the distance effect dominates the off-peak cost saving created by time difference. In contrast, a negative relationship may indicate that costs are distance insensitive and/or the off-peak effect is dominant. 29 For instance, low income countries generally have lower labour costs than high income countries, but higher capital costs. Low income countries generally have less well developed markets. Thus, transactions costs and risks associated with business are higher for low income countries (Galbi, op cit Ref 27). 30 Ergas and Patterson, op cit Ref 13. 31 Chowdary, op cit Ref 5. continued on page 956

structure; accounting rate differentials between developed and developing countries; and the affect of the accounting rate system on collection rates and international telephone demand imbalances. The themes are reviewed below. Johnson estimates the cost of terminating international calls in the US based on AT&Ts 1985 fully distributed costs. These include access charges to AT&T, costs associated with the use of its domestic switched network to provide international service, and costs for dedicated international trunk facilities. As capacity costs dominate the total cost of supplying international services Johnson argues that scale economies largely determine both foreign country and US per minute costs. This finding may explain why countries with small traffic volumes have relatively high accounting rates with the US. With substantial differences in peak and off-peak marginal costs, many US carriers adopt time-of-day collection rate pricing. Accounting rates, however, do not usually vary by time-ofday and act as an impediment to lower off-peak collection rates. Galbi incorporates the long run incremental cost drivers, total traffic, the time difference between the domestic and foreign country, geographical size, telecommunications intensity, and income to develop a best practice pricing model for terminating US calls. Several of the determinants require explanation. Costs associated with the domestic switched network are reflected in the time difference, area, intensity and income variables. The greater the time difference the smaller the impact traffic has on network peak load. Intensity relates to economies of network size. For a given geographical area, the incremental costs of transmission are lower in countries with greater teledensity. Finally, the costs of expanding domestic network capacity depend on national economic development. The role costs, market structure and income play in determining accounting rates is examined by Ergas and Patterson. They find no correlation between accounting rates and the cost of terminating international calls for 70 Australian and 151 US bilateral markets from 1985 to 1988. An inverse relationship is found in a regression of accounting rates on per capita GDP for bilateral market partners, indicating a reluctance by developing countries to reduce accounting rates in line with costs. Chowdary provides supporting evidence by estimating large accounting rate-cost margins on Indian bilateral telephone markets. He argues for telecommunications liberalisation in the form of carrier privatisations and increased competition, with such policies emphasising efficient pricing outcomes. The growing US traffic imbalance between 1985 and 1992 is a source of concern to Frieden. As settlement rates substantially exceed cost, US carriers shift the cost burden onto consumers by maintaining high collection rates. Higher foreign country collection rates act to reduce US incoming traffic. Frieden suggests that while settlement rates exceed costs, telecommunications service providers have an incentive to route traffic in ways that avoid the accounting rate system. Such mechanisms include call-back, country-direct, leased capacity, private lines and resale, and the Internet. Under the present system, accounting rates can only be reduced when US and foreign carriers identify mutually advantageous financial opportunities for changing the status quo. Hakim and Lu develop theoretical models to examine the strategic interaction between carriers in setting collection and settlement rates. They examine technological disparities and demand imbalances in international telecommunications under both Cournot—Nash and Stackelberg


Interconnection in international telecommunications: G Madden and S J Savage

conditions. By allowing the settlement rate share ratio to be negotiable they find technological improvement by a domestic monopolist leads to reduced collection rates, increased demand for outgoing calls, and a growing demand imbalance. Demand imbalance entices the home country to revise the settlement rate down in order to minimise the settlement out-payment. This result is consistent with the behaviour of developed countries who, with stronger demand for international calls and more advanced technology, are seeking lower settlement rates. Cave and Donnelly employ a Nash bargaining model to show that accounting and settlement rates are jointly determined in both cooperative and non-cooperative settings. Both rates are higher for the noncooperative case. They suggest that common outgoing and incoming settlement rates from carrier bargaining only emerge when the demand for outgoing and incoming calls is balanced. However, further analysis shows that a single carrier, acting in collusion with the domestic administrative authority, has an incentive to insist on equal settlement rates as a precondition for negotiation. Cave and Donnelly’s findings are particularly interesting given that international telecommunications markets are dominated by publicly owned monopoly postal, telephone and telegraph (PTT) carriers. Since many PTTs operate under the direct control of government administrations, their profit maximising goals support the 50 : 50 settlement rate share to minimise possible disadvantage from imbalances. Given monopoly carriers favour the 50 : 50 rule, and the rule leads to inefficient pricing (settlement rates exceed cost), it is likely that accounting rates are higher on bilateral markets characterised by monopoly providers.

An econometric model of settlement rate pricing

continued from page 955 32 Frieden, R., International toll revenue division: tackling the inequities and inefficiencies. Telecommunications Policy, 1993, 17, 211–233. 33 Frieden, op cit Ref 2. 34 Hakim, S. R. and Lu, D., Duopolistic pricing in international telecommunications. Paper presented to the International Telecommunications Society Meeting, Sydney, July, 1994. 35 Cave and Donnelly, op cit Ref 8. 36 Ergas and Patterson, op cit Ref 13. 37 Galbi, op cit Ref 27. 38 Madden, G. and Savage, S. J., Market structure, competition and pricing in US international telephone services markets. Presented at the FCC, Washington, DC, December 10, 1997. 39 FCC, op cit Ref 18. 40 FCC, Notice of proposed rulemaking. 96261, December 19, 1996, FCC, Washington, 1996b. 41 Frieden, op cit Ref 41.


The econometric model follows Ergas and Patterson, Galbi and Madden and Savage and explains the settlement rate charged by the foreign country for terminating traffic originating from a reference country, here the US. The US provides a suitable reference country as it has a liberal telecommunications environment and is an international efficiency benchmark. The substantial growth in US net settlement payments has coincided with the introduction of competition in the US international telecommunications sector. Finally, the FCC  instigated several policy initiatives intended to amend aspects of international telecommunications markets, in particular the accounting rate system. Traffic routed along an international circuit from the US to a foreign endpoint has distinct cost segments. US carriers bear all costs associated with traffic along the US tail, US and foreign carriers share costs along the international whole-circuit, whilst the foreign carrier bears all costs along the foreign tail. Settlement rates paid by US carriers for international interconnection are intended to compensate the foreign country carrier for the marginal transmission costs along the foreign country’s half-circuit and tail, respectively. Joint ownership of the international whole-circuit means that most carriers incur approximately the same cost per unit of international capacity. It follows that most parallel routes to the same regions of the world should incur similar costs. Therefore, differences in settlement rates across countries primarily reflect market structure and variations in the tail segments of the international circuit. Domestic and foreign tail costs can vary with telecommunications network costs, technology, and traffic volumes.

Interconnection in international telecommunications: G Madden and S J Savage

By assuming US and foreign carriers share the costs of the whole-circuit evenly, the cost of transmission along the foreign country’s half-circuit and tail can be combined into the following marginal cost (MC) function: MC"f (w, ¹, Q),


where w is a vector of factors influencing the foreign country’s half-circuit and tail costs, ¹ a telecommunications technology indicator, and Q the traffic originating in the US. In a perfectly competitive market, the settlement rate charged for calls terminating in country f equals both marginal and average cost (AC): sr"MC"AC"f (w, ¹, Q).


where sr is the settlement rate paid by US carriers to foreign country carriers for terminating calls originating in the US. When markets are subject to market power, the settlement rate is higher than average cost: sr"M(MS). AC,


where M, the settlement rate mark-up, is a function of market structure (MS). Finally, the level of economic development may influence domestic network costs and excentuate inefficient pricing. The suggested general form econometric model for settlement rates is sr"g(w, ¹, Q, MS, ½),


where ½ is country f income.

Preliminary data analysis


FCC, op cit Ref 3. FCC, op cit Ref 3. ITU, op cit Ref 23. 45 ITU, World Telecommunications Indicators Database, ITU/TeleGeography, Geneva, 1996b. 46 TeleGeography, op cit Ref 4. 47 World Bank, World development indicators. World Bank, Washington, 1997. 48 This measure of market structure could be interpreted as a general measure of telecommunications liberalisation. Countries that allow ISR usually allow other arbitrage services such as call-back and country direct. 43 44

The study examines settlement rates for 27 US bilateral international telephone markets drawn from the FCC publication ¹rends in the ºS International ¹elecommunications Industry. Of the foreign countries contained in the sample, nine are Asian, one is African, nine are European, three are from the Middle East, and five are from the Western Hemisphere. Annual data for accounting rates, US market concentration, telecommunications network costs, and international traffic are obtained from the FCC for the period 1985—1995. Additional data for telecommunications employees and main lines, country f market concentration, country f area and population, country f gross domestic product (GDP) and GDP deflators, and the time difference (between US and country f ) are provided by the ITU,  TeleGeography, and the World Bank, respectively. These data are used to construct series for cost, market structure, and economic development as described in Table 1. Some discussion of the market structure variables is warranted. Two proxies for facilities-based competition are used to measure market structure: market concentration, the market share of the dominant carrier f facilities-based carrier; and carriers, the number of facilities-based carriers competing at the foreign end of the market. The impact of service providers on settlement rates is captured by the resale dummy variable. Resale equals one at time t when the foreign country allows international simple resale (ISR), and zero otherwise. Between 1990 and 1995, the average US settlement rate declined by 50% from 0.816 USD to 0.406 USD. A downward trend in settlement rates


Interconnection in international telecommunications: G Madden and S J Savage Table 1. Variable description. sr

w1 w2 w3 w4 w5 T Q MS11 MS12 MS2


Settlement rate : the real per minute settlement rate US carriers pay to foreign carriers for traffic terminating in f (1987 USD). The settlement rate is assumed half the accounting rate. Investment cost : real per minute investment cost of transAtlantic cable systems, a proxy for the cost of capital employed on the international half circuit (1987 USD) (expected sign: positive). Area : country f geographical size in (km2) (expected sign: positive). Time difference : the time difference in hours between Washington, DC to the capital city of f. Teledensity: a proxy for domestic telecommunications network intensity. The number of country f main telephone lines per 100 persons (expected sign: negative). Labour productivity : country f main telephone lines divided by telecommunications employees, a proxy for telecommunications input costs (expected sign: negative). Telecommunications technology : a linear time trend proxy for technological progress (expected sign: negative). Traffic : minutes of international message telephone service (IMTS) from the US to f (expected sign: negative). Market concentration : the dominant country f facilities-based carrier’s share of outgoing telephone traffic from f to the US (the percentage of total IMTS minutes) (expected sign: positive).a Carriers : the number of country f facilities based carriers (expected sign: negative). Resale : a dummy variable that equals one at time t when the foreign country allows ISR, and zero otherwise (expected sign: negative). Income : country f real GDP per capita (1987 USD).


As carrier specific traffic data are unavailable for many foreign countries, country f dominant carrier’s share of world outgoing traffic is used as a proxy for the share of outgoing traffic to the US. The proxy assumes that world market share roughly corresponds to country f PUS (traffic from f to the US) market share. Source. FCC (1997), ITU (1996a, b), TeleGeography (1996), World Bank (1997).

Table 2. Foreign country descriptive statistics 1985–1995. Variable


Standard deviation



Settlement rate correlation

Settlement rate (USD) Labour productivity Investment cost (USD) Area (million km) Time (h) Teledensity (%) Traffic (million minutes) Facilities-based market concentration (%) Facilities-based carriers Income (USD)

0.807 112.9 0.075 1.465 7.296 23.60 142.2 97.87 1.155 7438

0.376 72.89 0.040 2.642 4.601 19.64 152.2 7.090 0.536 7460

0.125 6.74 0.013 0.001 !1.000 0.297 3.242 66.10 1.000 209.7

2.085 299.5 0.163 9.571 15.000 61.30 102.5 100.0 6.000 27820

1.000 !0.376 0.678 0.262 0.225 !0.371 !0.511 0.346 !0.293 !0.278

Source. Bali Online Corporate Information, 1997, HTTP://–online.html, FCC (1997), ITU (1996a,b), TeleGeography (1996), World Bank (1997).

across all regions from 1990 is observed. Settlement rates for traffic to Europe and the Western Hemisphere appear relatively low. For instance, the lowest settlement rate over the sample period is 0.125 USD in 1995 for USPNetherlands traffic. The highest settlement rate is 2.085 USD for USPChina traffic in 1987. Switzerland and the Netherlands both experienced the greatest proportionate decline in settlement rates. USPSwitzerland and USPNetherlands settlement rates decreased by 89 and 88%, respectively. The smallest decline in settlement rates occurred for USPSaudi Arabia traffic, 32% over the sample period. The mean, standard deviation, minimum and maximum values for the variables described above are reported in Table 2. In real terms, the average US bilateral settlement rate for the period 1985—1995 is 0.807 USD. Given a 50 : 50 split of accounting rates, the average accounting rate over the period is approximately 1.61 USD.


Interconnection in international telecommunications: G Madden and S J Savage Table 3. US descriptive statistics 1985–1995. Variable


Standard deviation



Settlement rate correlation

Labour productivity Teledensity (%) Traffic (million minutes) Facilities-based market concentration (%) Facilities-based carriers Income (USD) Traffic deficit (% of total traffic)

196.5 55.00 73.44 78.52 3.364 19245 38.52

34.85 3.882 104.7 15.30 0.482 886.5 21.01

146.2 49.40 1.000 39.90 3.000 17739 1.340

264.0 62.70 690.7 100.0 4.000 20716 94.95

!0.672 !0.671 !0.424 0.571 -0.584 !0.658 0.024

Source. Bali Online (1997), FCC (1997), ITU (1996a,b), TeleGeography (1996), World Bank (1997).

For the purpose of comparison, descriptive statistics for the reference country (US) are provided in Table 3. US real per capita GDP and teledensity are substantially higher than the foreign country average, as is US telecommunications labour productivity. US outgoing telephone traffic averaged 142 million minutes per annum, compared to 72 million minutes of incoming traffic. The US runs an average traffic deficit equivalent to 39% of total two-way traffic for each bilateral market. Inspection of market concentration data show that foreign markets are clearly more concentrated than US markets. The market share of the dominant foreign country facilities-based carrier averaged 98% of total traffic, whilst the market share of the dominant US carrier averaged 79%. These data reflect the prevalence of monopoly carriers at the foreign end of US bilateral markets, with the average bilateral market characterised by one facilitiesbased carrier at the foreign end compared to three such carriers at the US end. For the sample of 27 countries, ISR has been lawful at both ends of the US—UK route since 1992. Further insight into the determinants of settlement rates is gained by examining pairwise correlations. Such correlations indicate pairwise movements of settlement rates and the various cost, market structure and income variables. The sample correlations confirm the relationships described in the second section. However, the results do not allow for interactions in a multivariate environment and are treated with caution.

Econometric results Assuming (log) linearity, the settlement rate for an international call from the US to country f, in the bilateral market i at time t, is 49

Two-way ISR has since been authorised for Canada, Finland, New Zealand and Sweden. An application is currently pending for Australia (ITU, op cit Ref 23). 50 Correlation coefficients do not control for all determinants of settlement rates, and are subject to bias. Thus, to avoid bias in estimated correlations, it is important to estimate an econometric model that allows for the many interactions between settlement rates, costs, market structure and income variables. 51 Kmenta, J., Elements of Econometrics. Macmillan, New York, 1986.

sr "a#b w #b w #b w #b w #b w                 #b ¹ #b Q #b MS #b MS #b ½ #e , (5)              where a is a constant, bs are slope parameters, and e is a white noise disturbance term. Diagnostic testing of OLS residuals indicate the disturbances are heteroskedastic. The model is estimated using Kmenta’s Generalised Least Squares (GLS) procedure to correct for the presence of groupwise heteroskedasticity. Coefficient estimates and t-ratios are reported in Table 4. The sensitivity of model estimates to alternative measures of market concentration is examined by estimating alternate regressions. In regression (5a), the market share of the dominant (facilities-based) foreign carrier is used to


Interconnection in international telecommunications: G Madden and S J Savage Table 4. GLS estimates. (5a) Estimated coefficient

Independent variables Constant

Cost Investment cost Area Time difference Teledensity Labour productivity Technology Traffic

An alternative explanation is that developing countries typically have low teledensity. As such, settlement rates may be kept relatively high in order to raise foreign currency to finance network development. 53 Galbi, op cit Ref 27. 54 Johnson, op cit Ref 25.


2.775 a


0.283 a 0.014 b 0.026 a !0.086 a 0.269 a !0.049 a !0.134 a

9.162 1.915 4.904 !2.701 8.090 !6.515 !6.144

0.283 a 0.014 b 0.026 a !0.083 0.262 a !0.050 a !0.128 a

9.183 1.844 4.964 !2.606 7.854 !6.696 !5.731

0.473 a



Economic development Income

!0.098 a


t -ratio




(5b) Estimated coefficient

2.818 a

Market structure Facilities-based market MS11 concentration Facilities-based MS12 carriers Resale MS2



w1 w2 w3 w4 w5 T Q

t -ratio









!0.102 a


Denotes significance at the 5% level. Denotes significance at the 10% level.

measure market structure, whilst (5b) employs the number of (facilitiesbased) carriers operating at the foreign end of the bilateral market. In regression (5a) the coefficients for all variables accord with prior expectations, with the exception of labour productivity. The effects of investment cost and area on settlement rates are positive. Given that investment cost is a proxy for the cost of capital employed on the international half-circuit, a percent reduction in the cost of telecommunications capital suggests a 0.283% reduction in settlement rates. The estimated coefficient for area suggests that domestic network costs are greater in countries of larger geographical size. The estimated time difference parameter is positive. This indicates that the impact of distance related costs outweigh cost savings from terminating traffic during offpeak hours. Since the cost of carrying traffic does not increase proportionately with time (distance), the inelastic parameter is reasonable and suggests international transmission costs are becoming increasingly less sensitive to distance. Model estimates for teledensity indicate economies of network size, with settlement rates lower for partner countries with higher levels of network penetration. An increase in productivity is expected to lower settlement rates in the long run through efficiency gains. However, such a finding is most likely to be realised in a competitive environment. The positive estimate suggests that carriers maintain high settlement rates in the face of productivity gains for other reasons than strict economic rationality, given the relatively small share of labour costs in the total cost of provision. The negative parameter estimate for traffic confirms the presence of scale economies in international telecommunications transmission. Galbi and Johnson suggest scale economies in international fibre optic transmission and satellite transponder leasing and loading are important. A per cent increase in traffic to foreign countries generates a 0.134% reduction in settlement rates. Finally, improvements in technology are captured in the negative parameter estimate for technology, which suggest that technological change contributes to the reduction in settlement rates.

Interconnection in international telecommunications: G Madden and S J Savage

Settlement rates are higher the more concentrated is the foreign end of the bilateral market. Controlling for other factors, a percent decrease in market share for the dominant facilities-based foreign carrier decreases settlement rates by 0.473%. Comparison of market shares for the average dominant US and foreign country carrier can provide an interesting interpretation of the market concentration parameter. The US end of bilateral markets are less concentrated and provides a competitive benchmark. Should the market structure at the foreign end of the market change so that the dominant foreign carrier’s market share decreases to the benchmark level, settlement rates would decline by nine percent. Examination of the resale coefficient shows that settlement rates are approximately 39% lower for US—UK markets, where two-way ISR has been permitted since 1992. This finding is qualitatively similar to ITU estimates and provides empirical support for the premise of Frieden. Model estimates show that settlement rates on US bilateral markets decline with real GDP per capita, which is consistent with the findings of Ergas and Patterson. A percent increase in foreign country income provides a 0.098% decrease in settlement rates. Several explanations for this relationship are offered here. High income countries devote more investment funds to network development, leading to cost efficiencies. We also expect high income countries to place greater emphasis on cost efficiencies and settlement rate reductions from increased competition, and to be less reliant on settlement rate revenue for funding telecommunications investment. Finally, some discussion of regression (5b) is warranted. The results are qualitatively similar to those reported for (5a). The negative parameter for the market structure proxy, carriers, indicates that an increase in the number of facilities-based carriers operating at the foreign end of the market may lead to settlement rate reductions. When bilateral markets are characterised by competitive market structures at either end, carriers are more likely to negotiate lower settlement rates.



ITU, op cit Ref 23. Ergas and Patterson, op cit Ref 13. According to the World Telecommunications Development Report, ITU, Geneva, 1997, 13 of the 16 nations that permit facilities-based competition in 1997 are either upper middle or high income countries. Siochru (op cit Ref 12) argues that settlement rate payments are highly selective, and less developed countries are by no means the largest beneficiaries. For instance, he estimates that 30% of the 5.1 billion USD settlement rate deficit (in 1995) went to developed countries, including Germany, and a further 20% to Mexico alone. 58 ITU, op cit Ref 23. 59 FCC, op cit Ref 18. 60 FCC, op cit Ref 40. 61 WTO, op cit Ref 21. 56 57

The accounting rate system and concentrated telecommunications markets have contributed to the distortion in international carrier traffic and revenue flows. Higher collection rates for consumers, and higher interconnection charges for carriers also have resulted. Pressure is mounting within the international telecommunications community to revise the system of bilateral accounting rates. This pressure has come mainly from carriers and government agencies in those countries which make substantial net settlement payments. Accounting rate reductions in line with the declining cost of providing service are advocated. Mechanisms that promise to deliver the desired reductions include accounting rate benchmarking and market liberalisation. Increased competition provides carriers with incentives to cut both collection and settlement rates, rewards innovation, and encourages the establishment of new services. This study develops an econometric model to identify key determinants of settlement rates. Study findings support FCC  and WTO initiatives to achieve more efficient international telecommunications pricing through market orientated policy. Model estimates show that facilitiesbased competition does provide reductions in settlement rates. Finally, resale competition generates similar outcomes to those obtained from facilities-based competition.