Review of Industrial Organization 14: 1–25, 1999.
© 1999 Kluwer Academic Publishers. Printed in the Netherlands.
Interconnection in Network Industries
MICHAEL CARTER and JULIAN WRIGHT
Department of Economics, University of Canterbury, Private Bag 4800, Christchurch, New Zealand
Abstract. Recent deregulation of telecommunications in the U.S. and elsewhere has highlighted
the importance of interconnection in network industries. In this paper, we analyse interconnection
in a deregulated network where the participants compete in the ﬁnal retail market. We consider
both the case of a mature industry as well as one where a new entrant challenges the incumbent.
In the later case, network externalities allow the incumbent to use the terms of interconnection to
maintain its dominant position. Moreover, in either case, competition in the retail market can be
undermined by collusion over access prices. We discuss the implications for some of the provisions
of the new U.S. Telecommunications Act, speciﬁcally mandatory interconnection and reciprocity of
tariffs, comparing these to the simple “bill and keep” rule.
Key words: Deregulation, interconnection, networks, telecommunications.
Stimulated by technological change and a pervasive deregulatory mood, network
industries such as electricity, rail and telecommunications are being transformed all
around the world. Previous national monopolies are being privatized and compe-
tition encouraged. A characteristic feature of network industries is that competing
suppliers need to interconnect, to utilize the facilities of one another to provide
services to their ﬁnal consumers. The determination of interconnection prices is an
issue of signiﬁcant economic importance. Since typically the industries are marked
by considerable asymmetry, with an established incumbent facing much smaller
entrants, the determination of interconnection fees is crucial for the economic
feasibility of entry and the viability of competition.
While interconnection is a feature of all network industries, it is a particu-
lar requirement in telecommunications. In many countries (e.g., Australia, United
Kingdom), interconnection fees between telecom providers are ﬁxed by an industry
speciﬁc regulatory authority. In the United States, the recent Telecommunications
Act provides for interconnection agreements to be negotiated between the parties,
subject to the approval of the State regulatory authority. A different course was
We gratefully acknowledge the research assistance of Richard Edlin, the helpful comments
of two anonymous referees and seminar participants at the Universities of Amsterdam, Auck-
land, Bielefeld, Canterbury, Freiburg, SUNY (Stony Brook) and Wissenschaftliches Institut für