> ![](media/image1.wmf){width="1.1416666666666666in" height="2.0in"}
>
> Federal Communications Commission
>
> Office of Plans and Policy
>
> 445 12^th^ Street, SW
>
> Washington, DC 20554

OPP Working Paper Series

> **Bill and Keep at the Central Office as the Efficient Interconnection
> Regime**
>
> **December 2000**
>
> Patrick DeGraba

**Bill and Keep at the Central Office**

**As the Efficient Interconnection Regime**

Patrick DeGraba[^1]

*Deputy Chief Economist*

*Federal Communications Commission*

Office of Plans and Policy

Federal Communications Commission

Washington, D.C. 20554

December 2000

OPP Working Paper No. 33

**Table of Contents**

Summary.............................................................................................
iv

**I. INTRODUCTION [1](#introduction)**

II\. OVERVIEW OF EXISTING INTERCONNECTION REGIMES AND THEIR PROBLEMS
[3](#overview-of-existing-interconnection-regimes-and-their-problems)

A. Existing Interconnection Regimes
[3](#existing-interconnection-regimes)

B. Problems Caused by Existing Interconnection Regimes
[6](#problems-caused-by-existing-interconnection-regimes)

III\. THE COBAK PROPOSAL [8](#the-cobak-proposal)

A. The COBAK Rules [9](#the-cobak-rules)

B. Illustrative Applications of the COBAK Rules
[12](#illustrative-applications-of-the-cobak-rules)

IV\. THEORETICAL AND POLICY JUSTIFICATIONS FOR COBAK
[13](#theoretical-and-policy-justifications-for-cobak)

A. The Appropriate Goals of an Interconnection Pricing Regime in
Competitive Markets
[14](#the-appropriate-goals-of-an-interconnection-pricing-regime-in-competitive-markets)

B. Revisiting the Assumptions Underlying the Current CPNP
Interconnection Regime
[15](#revisiting-the-assumptions-underlying-the-current-cpnp-interconnection-regime)

C. Implications of Revising the Assumptions Concerning Cost Causation
and Benefits
[17](#implications-of-revising-the-assumptions-concerning-cost-causation-and-benefits)

1\. Efficient Usage by Customers [17](#efficient-usage-by-customers)

2\. Efficient Pricing by Carriers [18](#efficient-pricing-by-carriers)

D. Rationale Underlying the COBAK Rules
[19](#rationale-underlying-the-cobak-rules)

1\. Rationale for Rule 1: Why the Costs of Local Access Should Be
Recovered from End User Customers.
[19](#rationale-for-rule-1-why-the-costs-of-local-access-should-be-recovered-from-end-user-customers.)

2\. Rationale for Rule 2: Why the Calling Party's Network Should Bear
the Cost of Transport.
[20](#rationale-for-rule-2-why-the-calling-partys-network-should-bear-the-cost-of-transport.)

V. EXISTING INTERCONNECTION PROBLEMS SOLVED BY COBAK
[22](#existing-interconnection-problems-solved-by-cobak)

A. Problems of Regulatory Arbitrage
[22](#problems-of-regulatory-arbitrage)

1\. Access Charge Arbitrage [23](#access-charge-arbitrage)

2\. ISP Reciprocal Compensation Problem
[24](#isp-reciprocal-compensation-problem)

3\. Inefficient Facilities Investment Resulting from Regulatory
Arbitrage
[24](#inefficient-facilities-investment-resulting-from-regulatory-arbitrage)

B. Monopoly Power over Terminating Access
[25](#monopoly-power-over-terminating-access)

C. The Problem of Estimating Interconnection Costs
[26](#the-problem-of-estimating-interconnection-costs)

D. Retail Rate Inefficiencies Caused by Interconnection Rates
[27](#retail-rate-inefficiencies-caused-by-interconnection-rates)

VI\. IMPLEMENTATION ISSUES FOR COBAK
[30](#implementation-issues-for-cobak)

A. Identifying Central Offices [30](#identifying-central-offices)

B. The Problem of Remotely Located Central Offices
[31](#the-problem-of-remotely-located-central-offices)

C. Distinguishing Between Carriers and End-User Customers
[32](#distinguishing-between-carriers-and-end-user-customers)

D. Accounting for "Unwanted" Calls [33](#accounting-for-unwanted-calls)

E. Determining Transport Rates [34](#determining-transport-rates)

F. Regulation of End User Charges [34](#regulation-of-end-user-charges)

1\. The Need for Regulation of LEC End-User Charges
[35](#the-need-for-regulation-of-lec-end-user-charges)

2\. Discriminatory End-User Rates 36

VII\. CONCLUSION [37](#conclusion)

Bill and Keep at the Central Office

As the Efficient Interconnection Regime

Executive Summary

This paper proposes a unified approach to interconnection pricing called
Central Office Bill and Keep ("COBAK"), which applies to all types of
carriers that interconnect with, and to all types of traffic that pass
over, the local circuit-switched network. COBAK is a *default*
interconnection regime, which means it would apply only when two
networks cannot agree on terms for interconnection.

The COBAK proposal consists of two rules for local calls involving two
networks. First, a called party's carrier cannot charge an
interconnecting carrier to *terminate* a call. (Thus, each carrier
recovers the cost of the loop and local switch from its own end-user
customers). Second, the calling party's network is responsible for the
cost of transporting a call between the calling party's central office
and the called party's central office. These rules are easily extended
to calls involving both local exchange and interexchange carriers.

COBAK will solve or ameliorate many of the significant problems that
plague the existing interconnection regimes. First, COBAK eliminates
various regulatory arbitrage opportunities that beset the current
interconnection regime, including the current preferential treatment of
Internet Protocol ("IP") telephony compared with traditional,
long-distance service, and the "ISP reciprocal compensation" problem.
Second, by eliminating termination charges, COBAK significantly reduces
the "terminating access monopoly" problem, which gives even the smallest
carrier monopoly power over calls that terminate with its customers.
Third, by eliminating inefficiently structured interconnection charges,
which carriers tend to flow through to end-user prices, COBAK is likely
to result in more efficient end-user prices and more efficient network
usage. Finally, COBAK reduces the need for regulatory intervention, both
initially and as competition develops in telecommunications markets.

The paper also addresses various implementation issues raised by COBAK.
Among other things, the paper discusses the issue of identifying central
offices under COBAK and possible incentives created by COBAK to locate
central offices inefficiently. The paper also discusses certain cost
recovery issues arising from the fact that, under COBAK, carriers will
recover the cost of termination from their end users. The paper proposes
various alternative solutions to these problems.

# Introduction

1.  The Telecommunications Act of 1996 ("1996 Act")[^2] envisions
    competitive, deregulated telecommunications markets, in which
    services are provided by multiple complementary and competing
    interconnected networks. Unfortunately, the existing patchwork of
    interconnection regimes, which are based on such historical,
    regulatory distinctions as local vs. long-distance, interstate vs.
    intrastate, and basic vs. enhanced,[^3] was not designed for
    competitive and deregulated telecommunications markets, and may not
    facilitate the efficient development of competition in
    telecommunications markets. Moreover, the existing interconnection
    regimes may not be sustainable in increasingly competitive
    telecommunications markets.

2.  For example, the explosive growth of the Internet is creating
    regulatory arbitrage opportunities[^4] that are undermining existing
    interconnection regimes. Specifically, Internet telephony and
    Internet Protocol ("IP") telephony, which generally are not subject
    to interstate access charges, are increasingly becoming substitutes
    for traditional long-distance service that is subject to these
    charges. Thus, the continued growth of these services as their
    quality improves is likely to threaten the existing access charge
    regime.[^5] In addition, the rapid increase in dial-up Internet
    usage is creating unbalanced traffic flows between local exchange
    carriers ("LECs"), which, under the reciprocal compensation scheme
    set forth in the 1996 Act,[^6] is resulting in substantial revenue
    transfers from incumbent LECs ("ILECs") to competitive LECs
    ("CLECs") that serve Internet Service Providers ("ISPs"). This
    problem is referred to generally as the "ISP reciprocal compensation
    problem." [^7]

3.  This paper proposes a unified approach to interconnection pricing
    called Central Office Bill and Keep ("COBAK"), which would apply to
    interconnection arrangements between all types of carriers that
    interconnect with the local circuit-switched network -- including
    agreements between two local exchange carriers and those between a
    local exchange carrier and an interexchange carrier (also referred
    to as "IXC" or "long-distance carrier"). COBAK also would apply to
    all types of traffic that pass over the local circuit-switched
    network -- including local and long-distance calls, wireless to
    wireline calls, and dial-up connections to the Internet. As
    proposed, COBAK is a *default* interconnection regime, which means
    it would only apply when two networks cannot agree on the terms for
    interconnection.

4.  As discussed in greater detail below, the COBAK proposal is premised
    in large part on three observations. First, both parties to a call
    -- *i.e*., the calling party and the called party -- generally
    benefit from a call, and therefore should share the cost of the
    call.[^8] By requiring interconnecting networks to recover most, if
    not all, of the cost of the call from their own customers, COBAK
    provides an efficient means by which the parties to a call can share
    the total cost of a call. The second observation is that competition
    operates more effectively when carriers recover their costs from
    their own end users, who can choose among competing carriers, rather
    than from interconnecting networks for whom the terminating carrier
    is a *de facto* monopolist. COBAK takes advantage of the forces of
    competition, where they exist, by requiring a carrier to recover all
    of its local access costs[^9] from its end users. Finally, COBAK
    recognizes that opportunities for regulatory arbitrage arise when
    regulation results in different charges being assessed for the same
    facility depending on the specific services provided by that
    facility. COBAK eliminates these arbitrage opportunities by
    recovering the cost of certain telephone facilities (such as the
    local loop and local switching) directly from subscribers, and
    thereby eliminating the need to recover these costs from different
    services that are provided over these facilities.

5.  The COBAK proposal consists of two rules for local calls involving
    two networks. First, the *called party's network* cannot charge the
    calling party's network for terminating the call.[^10] Second, the
    *calling party's network* is responsible for the cost of
    transporting calls between the calling party's central office and
    the called party's central office.[^11] As discussed below, these
    rules are easily extended to apply to calls requiring more than two
    networks, such as a long-distance call involving an interexchange
    carrier.

6.  This paper is organized as follows. Section II provides a brief
    overview of existing interconnection regimes and their associated
    problems. Section III explains the COBAK proposal and provides
    examples of how it would apply. Section IV discusses the theoretical
    and policy justifications for the COBAK proposal. Section V
    discusses how COBAK eliminates or ameliorates the most important
    problems plaguing the current interconnection regime. Finally,
    Section VI raises certain implementation issues. The paper does not
    address any of the legal issues raised by the COBAK proposal or
    possible transition strategies, however.

#  {#section .unnumbered}

# Overview of Existing Interconnection Regimes and Their Problems

7.  In order to understand the COBAK proposal and its potential
    benefits, it is necessary to understand the existing patchwork
    system of interconnection arrangements and the problems associated
    with this system. Accordingly, this section first provides a broad
    overview of existing interconnection regimes. It then describes some
    of the problems associated with the existing system.

## Existing Interconnection Regimes

8.  For much of this century, local telephony was viewed as a natural
    monopoly.[^12] Local telephone companies were given monopoly
    franchises and protected from competitive entry, but in return were
    subjected to rate regulation and certain universal service
    obligations.[^13] Because of their monopoly position, however, local
    telephone companies had incentives to resist interconnecting with
    certain other networks.[^14] More specifically, local telephone
    companies generally had no incentive to interconnect with competing
    local telephone companies, and, when forced to interconnect,
    generally sought to impose high interconnection costs on other
    networks.[^15] As a result, regulators, both at the state or federal
    level, traditionally have intervened and regulated interconnection
    arrangements between local telephone companies and other
    interconnecting parties.

9.  In addition, regulators at both the federal and state levels have
    frequently used interconnection regulation to achieve various social
    goals. For example, in order to keep local rates low, both federal
    and state regulators have permitted local telephone companies to
    charge long-distance companies above-cost access charges for
    originating and terminating long-distance calls.[^16] Similarly, in
    order to encourage the development of enhanced services, the
    Commission in 1983 exempted enhanced service providers from these
    access charge requirements.[^17]

10. What has resulted over time is a complex and frequently arbitrary
    patchwork of interconnection regulations that treats different
    classes of interconnecting parties and different types of services
    quite disparately even though there may be little difference in the
    costs that they generate.[^18] The interconnection regime that
    applies in a particular situation depends on such factors as:
    whether the interconnecting party is another local carrier, an
    interexchange carrier, or a subscriber; whether the service is
    classified as local or long-distance, interstate or intrastate, or
    basic or enhanced; and whether a call is completed using an enhanced
    service provider.

11. Broadly speaking, however, interconnection rules can be divided into
    two basic types: one set of rules that applies to "local" calls, and
    a second set of rules that applies to "long-distance" calls. Both
    sets of rules are, of course, subject to a number of exceptions.

12. Thus, for example, when a customer of one LEC makes a local call to
    a customer of another LEC, that local call is subject to reciprocal
    compensation.[^19] Under the Commission's current reciprocal
    compensation rules for incumbent LECs, the calling party's network
    generally must pay the called party's network to terminate the call
    (*i.e.*, to deliver the call from the central office serving the
    called party to the called party's premises).[^20] In addition, if
    the calling party's network uses the transport facilities of the
    called party's network to deliver the call to the called party's
    local central office, it must also pay the called party's network
    for transport. The Commission's current rules also permit states to
    impose bill-and-keep arrangements if "traffic is relatively
    balanced."[^21]

13. If the call is a long-distance call, however, then the calling
    party's interexchange carrier must pay both the originating local
    carrier and terminating local carrier either intrastate or
    interstate access charges, depending on whether the call crosses
    state lines. Finally, if the call is a long-distance call, but the
    customer uses a computer connected to an ISP to make an Internet
    telephony call, no originating access charges would be owed.[^22]

14. An alternative way to analyze interconnection regimes is to
    distinguish between "calling-party's-network pays" (CPNP) regimes
    and "bill-and-keep" regimes. In CPNP regimes, which cover the
    majority of interconnection arrangements for basic voice traffic,
    the calling party's network (the local exchange carrier in the case
    of a local call or the interexchange carrier in the case of a toll
    call) pays the called party's local network to terminate a call (and
    possibly also to transport the call). Thus, in the case of a local
    call, the calling party's LEC is required to pay transport and
    termination for traffic that terminates on the called party's
    network. Similarly, in the case of a long-distance call, the calling
    party's interexchange carrier must pay terminating access charges,
    either interstate or intrastate, to the called party's LEC to
    terminate the call (as well as originating access charges to the
    calling party's LEC to originate the call).

15. The second type of arrangement involves no inter-carrier
    compensation and is generally referred to as a "bill-and-keep"
    arrangement.[^23] Under such arrangements, the calling party's
    carrier does not have to pay the called party's carrier to terminate
    a call; rather, the called party's carrier must recover the cost of
    termination from its end-user customer.[^24] As previously
    indicated, such arrangements traditionally existed between adjacent
    local exchange carriers, such as between a Bell Operating Company
    ("BOC") and a neighboring rural ILEC. In addition, the 1996 Act
    states that the pricing rules applicable to interconnection
    agreements between incumbent LECs and other LECs do not "preclude"
    bill-and-keep arrangements.[^25]

## Problems Caused by Existing Interconnection Regimes 

16. The current collection of interconnection regimes is not only
    complex -- it also suffers from a number of fundamental problems.
    These problems distort usage of the network and deployment of
    facilities, impede the development of competition and the relaxation
    of regulation, and threaten the continued viability of the existing
    system.

17. First and foremost, the current interconnection regimes create
    significant opportunities to game the system through regulatory
    arbitrage. One such opportunity arises from the fact that IXCs must
    pay interstate and intrastate access charges to the LEC that
    originates a long-distance call, while an ISP that provides Internet
    or Internet Protocol ("IP") telephony does not.[^26] Consequently,
    an end user can avoid access charges by utilizing IP telephony to
    place long-distance calls.[^27] Although this has not proven a
    serious problem to date, improvements in the quality of IP telephony
    could lead to significant substitution of IP telephony for
    traditional circuit-based long-distance service, with a consequent
    erosion in access revenues. A second source of regulatory arbitrage
    arises from the fact that the interconnection charges, which the
    calling party's network has to pay to the called party's network,
    generally are above cost and inefficiently structured.[^28] Thus,
    for example, various CLECs have targeted ISPs, which generally have
    only incoming traffic, as customers, in order to become net
    recipients of local traffic. ILECs claim that this has cost them
    billions of dollars in reciprocal compensation payments.[^29] Both
    sources of regulatory arbitrage can distort the incentives of
    carriers to invest and deploy facilities efficiently and to offer
    services to customers.[^30]

18. A second problem is that current interconnection regimes typically
    confer on all local carriers market power over terminating access.
    This market power arises from the fact that interconnecting
    originating networks, including both local and interexchange
    carriers, have no alternative carrier that can terminate a call. In
    effect, each terminating carrier, no matter how small, has a
    monopoly over termination to its own customers. Moreover, under
    existing rules, neither the calling party nor the called party will
    have to pay the excessive termination charges, and, therefore, there
    will be no incentive for the called party to switch carriers. More
    specifically, the called party, by definition, will not incur the
    excessive termination charges, and, because of geographic
    rate-averaging requirements,[^31] the calling party will have little
    or no incentive to complain to the called party or ask him to switch
    carriers. This presents regulators with the unattractive choice of
    allowing non-incumbent carriers to exercise their market power,[^32]
    permitting IXCs to refuse to deliver calls to terminating carriers
    that charge excessive rates, or regulating the terminating access
    rates of all carriers, including those that would not possess market
    power under alternative interconnection regimes.[^33]

19. Third, the existing system of inter-carrier interconnection charges
    is likely to result in inefficient end-user charges. To the extent
    that interconnection charges tend to be traffic sensitive (*i.e.*,
    set on a per-minute or per-call basis), they create pressure on
    carriers to adopt traffic-sensitive retail prices. If the underlying
    network costs are not traffic sensitive, however, then these
    traffic-sensitive retail rates will reduce usage of the network to
    inefficient levels.[^34] In addition, such interconnection charges
    may result in customers paying higher prices for calls that cross
    networks than for calls that remain on one network. Such pricing
    would be inconsistent with the goal of providing interconnection
    between networks that is seamless and transparent to customers.

20. Finally, as will become clear below, a fundamental flaw with a
    majority of the existing interconnection regimes is that they are
    CPNP regimes, which impose all of the costs of a call on the calling
    party. Many of the problems affecting current interconnection
    regimes can be solved by moving to an interconnection regime that
    appropriately divides the cost of a call between the calling party
    and the called party. The next section proposes such a regime.

# THE COBAK PROPOSAL

21. This section presents an approach to interconnection pricing called
    "Central Office Bill and Keep" or "COBAK." COBAK is a default
    interconnection regime, which would apply only when two networks
    cannot agree on the terms for interconnection. In contrast to the
    existing patchwork of interconnection regimes, COBAK is a unified
    approach to interconnection pricing, which would apply to all types
    of carriers that interconnect with, and to all types of traffic that
    passes over, the local, circuit-switched network. Thus, COBAK
    applies to both local and toll traffic (including interstate and
    intrastate toll), and it applies to interconnection agreements
    between, for example, competing local carriers, adjacent local
    carriers, wireless and wireline carriers, and local and
    long-distance carriers.

22. This section first sets forth the COBAK proposal. It then
    illustrates how the COBAK rules would apply to a number of different
    interconnection scenarios.

## The COBAK Rules

23. For purposes of this discussion, consider a telecommunications
    network as consisting of two parts: (1) *local access facilities*,
    consisting of the loop serving the customers' premises and the
    central office switches that serve the customers' loops, and (2)
    *transport facilities*, consisting of both inter-office trunks and
    tandem switches.[^35] Further, for purposes of this discussion,
    define *termination* as the delivery of a call, by the called
    party's network, over the local access facilities to the called
    party, and *transport* as the routing and delivery of a call from
    the calling party's central office to the called party's central
    office.[^36]

24. With these definitions, COBAK can be described in terms of two
    basic, default rules. The first rule specifies how the cost of local
    access facilities should be recovered, while the second specifies
    which network is responsible for the cost of transport. For
    simplicity, let us begin by considering calls that traverse just two
    networks, such as a local call that originates on one local network
    and terminates on another local network in the same local calling
    area.

    *Rule 1: No carrier may recover any costs of its customers' local
    access facilities from an interconnecting carrier.* This rule means
    that the called party's network cannot charge the calling party's
    network to recover any costs associated with either the called
    party's loop or the switch that serves that loop. Thus, each carrier
    must recover the cost of local access facilities from its own
    end-user customers.

    *Rule 2: For calls traversing two networks, the calling party's
    network is responsible for the cost of transporting the call to the
    called party's central office.* Because the calling party's network
    is responsible for transporting a call to the called party's central
    office, the calling party's network must either provide its own
    transport facilities or pay another carrier, including possibly the
    called party's carrier, to transport the call to the central office
    serving the called party.

25. The following examples illustrate these rules. First, suppose that
    there are two networks, and each builds its own transport facilities
    to connect its network to the other network's central offices. In
    this case, the calling party's network would deliver a call from the
    calling party to the central office of the called party, where the
    called party's network would then terminate the call. Since both
    networks in this example possess their own transport facilities, the
    networks would exchange traffic at the central offices of the called
    party on a bill-and-keep basis -- hence the name "Central Office
    Bill and Keep." Now suppose that a calling party's carrier
    physically interconnected at some point on the called party's
    network other than at the called party's central office, such as at
    a tandem switch. In this case, the calling party's network would
    have to pay the called party's network for the use of the tandem
    switch and for transport links to the central office. It would not,
    however, pay a termination charge to contribute to the cost of the
    central office switch or the loop. Finally, it should be noted that
    a carrier could satisfy Rule 2 by leasing transport facilities or
    purchasing transport services from a third party. This last option
    is becoming more likely as the market for transport becomes
    increasingly competitive.

26. For calls traversing three networks, such as a long-distance call
    carried by an interexchange carrier, the first rule remains the
    same, while the second rule only requires slight modification. Under
    COBAK, the calling party is responsible for all of the costs of
    transport to the central office serving the called party. The
    calling party satisfies this responsibility by contracting with both
    a local network that will originate the call and an interexchange
    network that will transport the call from the calling party's local
    network to the called party's central office. More specifically,
    under COBAK, the calling party's *local carrier* is responsible for
    carrying the call from the calling party to the point of presence
    ("POP") of the calling party's interexchange carrier. The calling
    party's *interexchange carrier* is then responsible for carrying the
    call to the central office serving the called party. As with a local
    call, the called party's network is responsible for the cost of
    terminating a call over the local access facilities.

27. Thus, COBAK eliminates *all* originating access charges. It also
    eliminates any terminating access charges intended to recover the
    cost of the loop or the terminating central office. COBAK does not,
    however, eliminate access charges for terminating transport if the
    IXC uses the terminating LEC's transport facilities.

28. Notice that, in an interexchange call, the calling party's local
    network is responsible for delivering the call to the interexchange
    carrier's POP, just as it is responsible, in the case of a
    two-network call, for delivering the call to the central office of
    the called party. Thus, Rule 2 may be modified as follows:

    *Rule 2A: For interexchange calls, the calling party's local network
    is responsible for delivering the call to the point of presence of
    the calling party's interexchange carrier; the calling party's
    interexchange carrier is then responsible for delivering the call to
    the called party's central office.*

29. It is worth reiterating that COBAK is a default interconnection
    regime which would apply only if two interconnecting carriers are
    unable to reach a negotiated agreement on the terms of
    interconnection. It does not constrain in any way the kind of
    agreement carriers are allowed to negotiate.

30. This does not mean that the COBAK rules will not influence
    negotiated outcomes. In fact, the default rules, to a large extent,
    will determine the outcome of the negotiation. For example, COBAK's
    Rule 2 often creates incentives for interconnecting networks to
    establish a meet point between their two networks and to exchange
    traffic within a specific geographic area on a bill-and-keep basis
    at that point. In particular, to the extent that two carriers have
    relatively balanced traffic exchanges, they are likely to find it in
    their mutual interest to agree to such a meet-point arrangement, as
    this arrangement is likely to be less expensive than each carrier's
    building it own separate transport facilities to each central office
    of the other network.[^37] Similarly, several networks could agree
    to establish a common network access point ("NAP") or point of
    interconnection (similar to NAPs in the Internet) and all exchange
    traffic on a bill-and-keep (or other agreed upon) basis at such a
    point.[^38]

31. It is also worth pointing out that COBAK represents an approach to
    *interconnection pricing* between carriers; it does *not* specify
    how retail rates should be set. To the extent that local switch
    costs that formerly were recovered through access charges must now
    be recovered from end users, COBAK does not specify how those costs
    should be recovered. COBAK thus would not preclude regulators from
    simply shifting the per-minute, local-switching access charges from
    the IXC to the LEC's customer.[^39]

32. Finally, COBAK does not preclude alternative retail relationships
    between a carrier and an end user. For example, it would not be
    inconsistent with COBAK for an interexchange carrier to offer an
    "800 service" in which the called party pays the interexchange
    carrier for the cost of transporting the call. Nor would COBAK
    preclude a "calling-party-pays" service, where the called party's
    carrier bills calling parties (who may not be subscribers) for the
    cost of terminating a call.[^40] In fact, a carrier seeking to offer
    a "calling-party-pays" service could even negotiate with the calling
    party's network to have the latter network act as the collection
    agent. COBAK would only preclude the terminating carrier's demand
    that the originating carrier pay the cost of terminating a call as a
    condition for interconnection.

##  Illustrative Applications of the COBAK Rules

33. The following examples illustrate how COBAK would apply to a number
    of different interconnection scenarios.

34. *Example 1 -- A Local Call Between Two Networks Interconnecting at
    the Central Office:* Suppose there are two local networks in a city,
    A and B, each of which owns one local switch. In addition, assume
    that A owns a transport trunk connecting its switch to B's switch.
    In this case, for calls originating on A's network, A will use its
    own transport facilities to deliver calls to B's central office, and
    it will not have to pay B to terminate these calls. Thus, for these
    calls, interconnection occurs on a bill-and-keep basis at B's
    central office.

35. Suppose now that one of B's customers originates a call to a
    customer on A's network. B is responsible for the cost of
    transporting the call to A's central office. To satisfy this
    responsibility, B could either build its own transport trunk, use
    A's transport facilities, in which case it would pay A for this
    transport, or purchase transport from a third party.

36. *Example 2 -- A Local Call Between Two Networks with Interconnection
    at a Tandem Switch:* Again, assume that there are two local
    networks, but this time further assume that A has several central
    offices connected to a tandem switch, while B has just one central
    office switch. Finally, assume that B interconnects with A at the
    tandem switch. In this case, if a customer of B calls a customer of
    A, B would have to pay A for the cost of tandem switching and
    transport from the tandem to the called party's central office, but
    B would not have to pay termination costs. Thus, A could not charge
    B for any part of the cost of the local switch or the called party's
    loop.

37. Suppose now that a customer of A calls a customer of B. In this
    case, A could carry the call to B's central office, in which case it
    would owe B nothing. Or, A could choose to use B's interconnection
    trunks. In this case, A would have to pay B for transport from the
    tandem switch to B's central office, but A would not have to pay B
    for termination.

38. *Example 3 -- A Long-Distance Call Involving an Interexchange
    Carrier:* Suppose that a customer wants to make a long-distance
    call. The calling party's local carrier is responsible for
    delivering the call to the point of presence, or POP, of the calling
    party's interexchange carrier and can only recover this cost from
    the end user and not the IXC. The calling party's IXC is then
    responsible for delivering the call to the central office serving
    the called party. It recovers this cost from its customer, the
    calling party. Finally, the terminating local carrier serving the
    called party is responsible for delivering the call from the central
    office to the called party, and it recovers the termination costs
    from its end user, the called party. As discussed above, the only
    access charges the IXC might have to pay are for transport to the
    local central office of the called party.

39. *Example 4 -- A Long-Distance Call Involving a LEC with No Direct
    Connection to the IXC:* Suppose a rural LEC connects indirectly to
    the POP of an IXC by "transiting" the network of a larger adjacent
    LEC. For an interexchange call made by the rural LEC's customer, the
    rural LEC is responsible for delivering the call to the IXC's POP.
    This means, in this case, that the rural LEC will have to pay a
    transport charge to the larger adjacent LEC to have the latter
    transport the call to the IXC's POP.

40. Suppose now that the rural carrier's customer is a recipient of a
    long-distance call. In this case, COBAK dictates that the IXC is
    responsible for transporting the call to the rural LEC's central
    office, which serves the called party. This means that the IXC will
    have to pay transport charges to cover the cost of transport from
    its POP to the rural LEC's central office. This transport charge,
    which normally is billed by the larger LEC that is actually
    connected to the IXC, would then be split between the rural LEC and
    the larger adjacent LEC.

41. It may be helpful to compare COBAK to existing interconnection
    regimes. With respect to local calls, COBAK resembles the existing
    reciprocal compensation rules in making the calling party's network
    responsible for the cost of transporting the call to the central
    office of the called party. COBAK differs from the existing
    reciprocal compensation scheme in that the called party's carrier
    cannot recover from the calling party's network any of the cost of
    terminating the call over the called party's local access
    facilities.

42. For interstate and intrastate long-distance calls, COBAK represents
    a more significant departure from the existing access charge regime.
    As previously mentioned, the IXC, under COBAK, will pay no
    originating access charges at all to the calling party's local
    carrier, and it will pay no local switching or carrier-common-line
    charge to the called party's local carrier. At most, it will only
    pay the called party's local carrier for transport from the POP to
    the central office, should it choose to use the transport facilities
    of the called party's local carrier.

43. It is worth emphasizing that this paper is not proposing that COBAK
    be made the default for interconnection negotiations among Internet
    backbones. Internet backbones have been able to negotiate
    interconnection agreements among themselves without any regulatory
    intervention so far, and there appears to be no good reason to
    modify the existing system where it appears to be working well
    without the assistance of regulators.

# Theoretical and Policy Justifications for COBAK 

44. The previous section laid out the COBAK proposal and provided
    examples of how it would apply to various interconnection scenarios.
    This section describes the theoretical and policy rationales
    underlying the COBAK proposal. More specifically, the section first
    discusses the appropriate goals of an interconnection pricing regime
    in competitive markets. It next discusses the critical assumptions
    underlying the prevailing CPNP interconnection regimes -- that the
    calling party is the sole cost-causer and sole beneficiary of a call
    -- and explains why those assumptions are unrealistic and need to be
    reconsidered as competition is introduced into telecommunications
    markets. The section then explains the implications for
    interconnection pricing of adopting the more realistic assumption
    that both parties to a call "cause" the call and benefit from the
    call. Finally, the section lays out the theoretical and policy
    justifications for the two COBAK rules. In this regard, the section
    also explains how COBAK's default rules should encourage parties to
    negotiate efficient interconnection agreements without the need for
    regulatory intervention.

## The Appropriate Goals of an Interconnection Pricing Regime in Competitive Markets

45. There is general, though not universal, agreement that some
    regulation of interconnection is required at least between incumbent
    local exchange carriers and entering competitors. As suggested
    above, this is because small, new networks need interconnection with
    large networks in order to attract customers and compete with the
    incumbent. Without such interconnection, small networks would
    provide connection to only a few other customers, which would
    severely limit the value of their network. Large, incumbent
    networks, on the other hand, have a strong incentive to refuse to
    interconnect at all or to interconnect only on terms or conditions
    that would competitively disadvantage their new competitors, as a
    means of forestalling competition.[^41]

46. While suggesting the need for some form of interconnection
    regulation, these observations do not explain which form of
    interconnection regulation is most desirable from society's
    perspective. Moreover, regulators historically have used
    interconnection policy to achieve a variety of objectives, and have
    not always clearly articulated those objectives.[^42] Finally, at
    least under certain interconnection regimes, the regulatory
    objectives appear to conflict. For example, building implicit
    subsidies into interconnection rates might encourage universal
    service, yet it is inconsistent with the goal of encouraging the
    efficient use of the network by customers, the efficient deployment
    of facilities by carriers, and the efficient development of
    competition. Similarly, as discussed below, an interconnection
    regime that leads to efficient use of the network may be
    inconsistent with reduced regulation over time.[^43]

47. With the introduction of competition into telecommunications
    markets, and particularly local telecommunications markets, however,
    regulators need to limit the objectives they seek to accomplish with
    interconnection policy in order not to distort the development of
    competition.[^44] In particular, regulators need to focus on
    designing an *efficient* interconnection regime. This means, first,
    that the interconnection regime should encourage consumers to make
    efficient use of telecommunications networks, and, second, that it
    should encourage networks to make efficient investment in, and
    deployment of, network infrastructure.

48. In addition, efficiency means that the interconnection regime should
    minimize regulatory costs. Such regulatory costs include not only
    the administrative costs of regulation, but also costs associated
    with market distortions resulting from regulatory mistakes or
    imperfect information on the part of the regulator, which might, for
    example, lead to a miscalculation of interconnection costs. These
    considerations suggest that a default interconnection rule should be
    simple and easy for the regulator to implement.

## Revisiting the Assumptions Underlying the Current CPNP Interconnection Regime

49. Economic analyses of interconnection pricing have generally assumed
    that the calling party is the sole cost-causer and the sole
    beneficiary of a call. While these assumptions may have been a
    useful means of simplifying the analysis of various interconnection
    pricing problems, they have long been recognized as
    unrealistic,[^45] and, with the growth of competition in
    telecommunications, they need to be reconsidered.

50. As competition was introduced into the long-distance market,
    economists began considering the price that an incumbent local
    telephone company, controlling a bottleneck facility, should charge
    a competing long-distance company for access to its network.[^46] A
    particular focus of these studies was how to set the price of access
    along with the prices of other retail services offered by an
    incumbent carrier, so as to achieve efficient usage of the network
    while simultaneously taking account of network externalities and
    recovering the large, fixed costs exhibited by local telephone
    networks. To make their analyses tractable, these models tended to
    assume that the calling party was the sole cost-causer and sole
    beneficiary of the call.[^47]

51. With the introduction of competition in local markets, the
    assumption that the calling party is the only cost-causer creates
    additional, and potentially more serious, inefficiencies. In
    particular, models employing this assumption generally do not
    consider many of the problems facing today's interconnection
    regimes, such as the ISP reciprocal compensation problem, the
    arbitrage problem caused by IP telephony, and the terminating access
    problem caused by competitive LECs not subject to rate regulation.

52. Given these new problems, it seems necessary to reconsider the
    assumptions made by these earlier studies that the calling party is
    the sole cost-causer and sole beneficiary of a call. As discussed
    below, it is critical to recognize that both the calling party and
    called party jointly cause the call and that both benefit. Adopting
    these more realistic assumptions, moreover, leads to alternative
    interconnection pricing regimes that solve many of the problems
    facing the existing regime.

53. With respect to cost causation, it is only a slight
    over-simplification to say that the cost a network incurs from
    completing a phone call is the cost of having a circuit used during
    the call. This "congestion" cost is the same for a network whether
    the call is originated by its end-user customer or received by its
    end-user customer. [^48] Thus, with respect to resources used in a
    call, both the calling party's and called party's networks should be
    essentially indifferent whether its customer originated a particular
    call or its customer received the call. Finally, since both parties
    must agree to continue to carry on a conversation, it makes more
    sense to view both the calling party and called party as jointly
    causing the costs of a call.[^49]

54. Similarly, with respect to benefits, it appears to make more sense
    to assume that, with respect to the vast majority of calls, both
    parties will receive some benefit. For example, a customer who, upon
    listening to his answering machine, calls someone who had left a
    message suggests that both parties to the call clearly expect to
    receive a benefit. Similarly, businesses that take 800 service, such
    as mail order catalogues, and other businesses that depend on
    in-coming calls, such as pizza delivery services, are further
    examples of situations where the called party clearly receives some
    benefits from a call. Finally, while it is true that people receive
    some unwanted calls (for example from telemarketers), it appears
    that these calls represent a small fraction of telephone traffic and
    thus hardly present the basis upon which to build an entire
    interconnection regime. This is particularly true given that the
    called party can simply hang up on unwanted calls.

55. Thus, in contrast to earlier economic analyses of interconnection
    pricing, it appears more appropriate to assume that both parties
    jointly cause the call, and that both share in the benefits of a
    call. We now consider some of the implications of changing the
    traditional assumptions. In order to simplify the discussion, we
    will further assume that the two networks have equal costs and that,
    on average, the called party and the calling party share equally in
    the benefit of a call.[^50]

## Implications of Revising the Assumptions Concerning Cost Causation and Benefits

56. One clear implication of the traditional assumption that the calling
    party is the sole cost-causer and sole beneficiary of a call is that
    the calling party should bear the full incremental cost of the call.
    This assumption provides the theoretical basis for CPNP regimes. If,
    instead, we assume that both parties to a call benefit from the call
    and that both jointly cause it, then this suggests that a CPNP
    regime in which the calling party bears the entire incremental cost
    of the call will not be efficient. This point is briefly developed
    below.

### Efficient Usage by Customers

57. It is well established in economics that, for private goods[^51]
    that are individually consumed by specific customers, the price
    should be set equal to marginal or incremental cost in order to
    encourage efficient consumption decisions.[^52] Setting the price
    equal to incremental cost ensures that the consumer will purchase
    all units where the benefit he receives equals or exceeds the cost
    of the resources used to produce the good or service.

58. Where a good or service is jointly consumed by more than one
    consumer, such as a phone call, the analysis becomes slightly more
    complicated.[^53] In the case of a phone call, for example,
    efficiency requires both that: (1) the sum of the benefits that both
    parties to the call receive equals or exceeds the cost of the
    resources used to produce the call; and (2) the benefit that each
    party to the call receives equals or exceeds the price that each
    party paid for the call.

59. If one assumes that the parties to a call benefit equally from the
    call, then, in order to achieve efficient consumption decisions,
    each party should pay one-half the incremental cost of the
    call.[^54] If the incremental cost is split equally, then the
    benefits each party receives will equal or exceed the price he pays,
    while the total benefits both parties collectively receive will
    equal or exceed the costs of the resources used to provide the call.

### Efficient Pricing by Carriers

60. The above analysis suggests that customers would make efficient
    consumption decisions if they faced retail prices that evenly
    divided the cost of a call between the parties. The next question
    thus becomes: what kind of interconnection pricing regime will give
    carriers the incentive to set such prices.

61. If there is no inter-carrier compensation, then carriers must
    recover the cost of termination from their own customers. If there
    is sufficient competition for end-user customers, then carriers will
    only be able to charge prices that, on average, just recover these
    costs. If, on the other hand, there is insufficient competition,
    then the regulator will have to regulate the prices charged by
    dominant carriers (*i.e.,* those with individual market power), to
    ensure the efficient level and structure of end-user charges. The
    regulator should not have to regulate the rates charged by
    non-dominant carriers, however.[^55] As competition develops, the
    regulator should be able to relax regulation of all end-user rates.

62. Thus, to the extent that both parties to a call benefit equally from
    the call, this suggests that the parties should share equally in the
    cost of the call.[^56] Moreover, requiring carriers to recover
    network costs from their own customers has the added benefit of
    maximizing the influence of competition on prices.

## Rationale Underlying the COBAK Rules

63. This section applies the analysis of the previous section in
    explaining the economic and policy rationale behind each of the
    COBAK rules. The section first shows how the above analysis directly
    supports the first rule of COBAK -- that carriers recover local
    access costs from their end-user customers. The section then
    explains why the second default rule of COBAK -- that carriers are
    responsible for the cost of transporting calls to the called party's
    local central office -- deviates somewhat from the above analysis.
    Finally, the section explains how the COBAK default rules should
    lead to efficient and successful negotiations between carriers in
    the majority of circumstances.

### Rationale for Rule 1: Why the Costs of Local Access Should Be Recovered from End User Customers.

64. The main rationale for Rule 1 of COBAK follows directly from the
    above analysis. Specifically, if both parties benefit equally from a
    call, then they should share equally in the cost of the facilities
    necessary to provide the call. COBAK's first rule will divide the
    cost of local access between the calling party and the called party
    by requiring that each party pay for his own loop and local
    switching costs.

65. Of course, not every call will equally benefit the calling party and
    called party, and, accordingly, no simple, uniform interconnection
    rule can ensure that the cost of every call will be allocated
    proportionately to the benefits received by each party to the
    particular call. Nevertheless, if on average both parties to a call
    benefit equally, then a system in which the parties share the cost
    of the call will provide a more efficient cost recovery basis on
    average than a system in which the calling party bears the entire
    cost of the call.[^57]

66. There are other reasons that justify COBAK's first rule as well. As
    discussed below,[^58] COBAK should: (1) significantly reduce the
    terminating monopoly access problem; (2) allow carriers greater
    flexibility to achieve efficient end-user rate structures (rather
    than rely on per-minute charges to recover inter-carrier charges);
    and (3) reduce the incentive of carriers to discriminate against
    off-net calls.

### Rationale for Rule 2: Why the Calling Party's Network Should Bear the Cost of Transport.

67. The above analysis suggests that, if the parties to a call benefit
    equally from a call, they should share equally in its costs,
    including the cost of transport. COBAK's second rule does not
    require such equal sharing, however. Rather, it requires that the
    calling party's network bear the entire cost of transport. COBAK's
    second rule diverges from this theoretical prescription of
    equal-cost sharing for the reasons explained below.

68. Wherever networks interconnect, each network has an incentive to
    shift the cost of transporting calls to the other network. Thus, for
    example, assuming the absence of transport charges, a network would
    prefer to interconnect at a single point (*e.g.,* a tandem switch),
    rather than at multiple central offices, and have the called party's
    network carry the call to the called party. Similarly, where two
    networks are interconnected at multiple points, the originating
    network has an incentive to drop the call off as soon as possible on
    the terminating network, and thus shift as much of the transport
    cost as possible onto the latter network. One of the main issues
    that any rule allocating transport costs must address, therefore, is
    how to minimize free-riding on other carriers' transport networks.

69. There are several potential rules that address this free-rider
    problem. One such rule would be to require the two networks to split
    equally the incremental cost of transport. This solution clearly
    would be consistent with the above analysis favoring the equal
    sharing of costs.[^59] Unfortunately, it raises several problems.
    First, and most important, this rule would prove extremely
    complicated for a regulator to implement. For example, if one
    network wanted to interconnect at a single point, while the second
    carrier wanted to interconnect at multiple points, it is not clear
    how an arbitrator would decide this issue. Furthermore, even if two
    networks agreed where to interconnect, it is not clear what the
    incremental cost of transport would be. The following example
    illustrates this problem. Suppose that network A has several
    switches connected to a tandem switch, while network B has a single
    switch. Suppose further that A and B agree to interconnect mid-way
    between A's tandem and B's switch. In this scenario, the incremental
    cost of transport is not simply the cost of the transport trunk
    connecting A's tandem and B's switch. Rather, network A would likely
    have to increase the capacity of its interoffice trunks and possibly
    the capacity of its tandem and end-office switches as a result of
    interconnection; and network B might have to increase the capacity
    of its single switch. In other words, the incremental transport
    costs attributable to interconnection are not limited to the cost of
    the physical trunks linking the two networks, but may also include
    certain incremental costs of expanding other portions of the network
    to handle changing traffic patterns. These incremental
    interconnection costs, however, are likely to be difficult to
    estimate and subject to considerable debate.

70. In addition, it is not at all clear how one would split transport
    costs where a call involved three or more networks. While it is
    possible to imagine a generalization of the "split-the-cost" rule
    for transport costs where three or more networks are involved, such
    a rule would likely be complicated and difficult to implement.
    Moreover, because of its likely complexity, parties might be less
    willing to accept such a rule.

71. COBAK's second rule -- requiring the calling party's carrier to be
    responsible for the cost of transporting the call to the called
    party's local central office -- offers several significant
    advantages over the "split-the-cost" approach. First, the rule can
    be easily implemented if the parties cannot agree. Specifically, the
    calling party's network can always satisfy Rule 2 by constructing
    transport facilities to the called party's central office or by
    leasing transport facilities from another carrier. In addition, as
    discussed below,[^60] it appears reasonable, at least during the
    introduction of competition into local markets, to require incumbent
    local carriers to lease transport facilities to interconnecting
    carriers at regulated rates.

72. Second, unlike the split-the-cost approach, COBAK does not require
    carriers to agree on the specific routes for an interconnecting
    transport network. Rather, each network will be free to design its
    transport network so as to best serve the needs of its customers.
    For example, in the case of a new entrant interconnecting with an
    incumbent carrier, the new entrant can decide whether to have
    dedicated transport trunks to each of the incumbent's central
    offices or to interconnect at the incumbent's tandem switch and
    purchase tandem-switched transport. In addition, each carrier can
    decide the capacity of its dedicated interconnection trunks, which
    will determine the quality of service provided.

73. The final, and most important, advantage of COBAK's second rule is
    that it should encourage parties to negotiate between themselves and
    avoid resorting to the regulator. Specifically, where the two
    networks both originate and terminate traffic, it generally will be
    in their mutual interest to negotiate a meet-point interconnection
    arrangement, since it is generally cheaper to build a single
    transport trunk than for each individually to construct a separate
    transport trunk. In other words, because COBAK's second rule does
    not specify the efficient solution as the default, it increases the
    incentive of the parties to negotiate the efficient solution.

74. It should be noted that, where one of the networks exclusively (or
    primarily) receives traffic, COBAK may not result in a negotiated
    bill-and-keep arrangement. In that case, because the one-way network
    will not be delivering traffic, it will not need to build its own
    transport facilities under the default rule, and therefore will have
    no incentive to share the cost of a meet-point arrangement. It is
    not clear how significant a problem this will prove in practice,
    however. First, most networks do originate some traffic, and to the
    extent they do, they will have an incentive to negotiate some
    cost-sharing arrangement. Second, although COBAK does not solve this
    problem, it still represents an improvement over the existing
    reciprocal compensation regime, where one-way networks not only do
    not have to share the cost of transport, but also are paid to
    terminate incoming traffic. At least, COBAK eliminates the
    uneconomic incentive created by existing termination charges.
    Finally, as discussed below, additional remedies can limit the
    extent to which "receive-only" networks can impose transport costs
    on other networks.[^61]

# EXISTING INTERCONNECTION PROBLEMS SOLVED BY COBAK 

75. The previous section outlined the theoretical and policy
    justifications for the COBAK proposal. This section discusses a
    number of serious problems affecting existing interconnection
    regimes that COBAK either eliminates or ameliorates.

## Problems of Regulatory Arbitrage

76. Perhaps the most important problems facing existing interconnection
    regimes are the several opportunities for regulatory arbitrage that
    they create. The two most important arbitrage opportunities, in
    dollar terms, are discussed below.[^62]

### Access Charge Arbitrage

77. One source of arbitrage arises from the disparate treatment of
    interexchange and local telephone calls. Under current regulations,
    the calling party's LEC collects originating access charges from its
    customer's pre-subscribed IXC when that customer makes a
    long-distance call. Because the IXC passes on such charges in higher
    per-minute long-distance charges, the calling party, in making a
    long-distance call, effectively (if indirectly) pays his LEC for the
    local facilities used on a per-minute basis. In contrast to the
    access regime, customers in most parts of the country can purchase
    unlimited local calling on a flat-rated basis (*i.e.,* there is no
    per-minute charge for originating local calls).

78. These rules create an arbitrage opportunity for providers of IP
    telephony services that is likely to become significant as the
    quality of IP telephony improves.[^63] In particular, through the
    enhanced services exemption, the IP telephony provider generally
    does not have to pay originating access charges to the calling
    party's LEC. Thus, if a customer can reach its ISP by dialing a
    local call, it can then use an IP telephony provider to make
    long-distance calls and avoid originating (and possibly terminating)
    access charges. This arbitrage opportunity arises because, for
    long-distance calls, the calling party pays local access on a
    per-minute basis, while, for local calls, the calling party
    typically pays for the same access on a flat-rated basis.

79. Moreover, this opportunity for regulatory arbitrage is exacerbated
    if the ISP is a customer of another local exchange carrier. In that
    case, when the calling party makes a long-distance call using IP
    telephony, not only does the calling party's LEC *not* receive
    originating access charges; it also must pay a termination charge to
    the ISP's LEC.

80. COBAK eliminates this disparate treatment of local versus
    long-distance calls by requiring the calling party's LEC, in both
    cases, to recover its local access and transport costs from its
    end-user customer. Moreover, under COBAK, neither the IXC nor the
    ISP's LEC can charge the calling party's LEC for termination. Thus,
    COBAK eliminates any non-economic, regulation-induced incentive to
    choose an IP telephony provider over a traditional IXC, because
    customers face the same cost recovery mechanism for local access.
    Under COBAK, therefore, any differences in the cost of a
    long-distance call provided by a traditional IXC, compared with that
    provided by an IP telephony provider, should be based on the
    relative efficiencies of the carrier's networks and operations,
    which (along with the quality of service provided) is precisely the
    criterion on which a customer should choose a carrier.

### ISP Reciprocal Compensation Problem

81. A second source of regulatory arbitrage arises from the fact that,
    under the Commission's existing rules, the calling party's LEC
    generally must pay termination charges for local traffic terminating
    on another LEC's network,[^64] and that these termination charges
    generally are above-cost or inefficiently structured. Because of
    this, certain CLECs have targeted as customers ISPs and other
    entities that primarily receive calls in order to generate
    unbalanced traffic flows and thus collect termination revenues from
    incumbent LECs. This problem is frequently referred to as the "ISP
    reciprocal compensation problem." Exacerbating this problem is the
    fact that, given the prevalence of flat-rated local service,
    incumbent LECs generally are unable to recover their termination
    costs from their customers who cause them.

82. Another problem, closely related to the ISP reciprocal compensation
    problem, is the problem of "one way" networks. Under the existing
    reciprocal compensation regime, a business that primarily receives
    calls has an incentive to claim to be a network. More specifically,
    instead of purchasing business lines from a LEC, such a business has
    an incentive to install a switch and claim to be a network in order
    collect termination charges for all the calls it receives. The
    difference between the two problems is that the ISP reciprocal
    compensation problem concerns the incentives of carriers to seek
    customers that primarily receive traffic, whereas this problem
    concerns the incentive of an entity to claim to be a carrier, rather
    than a customer, in order to avoid having to pay for a business
    line.

83. By eliminating termination charges, COBAK significantly reduces the
    ISP reciprocal compensation problem and the one-way-network problem,
    while at the same time freeing regulators from having to determine
    the economically efficient level and structure of termination
    charges. Thus, under COBAK, carriers will not be able to earn large
    profits by targeting customers that receive more minutes of traffic
    than they originate. It should be noted, however, that COBAK will
    not completely eliminate the incentive of a business that primarily
    receives calls to claim to be a network. Specifically, because COBAK
    requires the calling party's network to deliver the call to the
    local central office (or switch) of the called party, a business
    that primarily receives calls may still claim to be a network so
    that the calling parties' LECs will have to transport calls without
    charge to the business's switch. Under that scenario, the business
    may be able to avoid having to pay a retail end-user rate for a
    business line.

### Inefficient Facilities Investment Resulting from Regulatory Arbitrage

84. The arbitrage opportunities discussed above not only cause
    significant rent transfers between carriers, they can also create
    incentives to invest inefficiently. In particular, carriers may have
    an incentive to invest, or not to invest, in a particular technology
    because of the favorable regulatory treatment the technology
    receives, rather than because it minimizes the cost of providing
    service.

85. For example, the existence of a per-minute termination charge may
    deter certain competitive carriers from cooperating with incumbent
    carriers in adopting compatible packet-based technology that more
    efficiently handles data traffic. A network that receives more
    traffic than it delivers may be unwilling to adopt compatible
    technology, because doing so may reduce its revenues from reciprocal
    compensation. More specifically, time is the incorrect way to
    measure usage, or congestion, on packet-based networks, and
    terminating packet-based networks may not even be able to measure
    and bill the time a particular customer has been online. Because the
    use of per-minute termination charges appears to be incompatible
    with the use of packet-switched technology, carriers that terminate
    more traffic than they originate may well refuse to cooperate with
    other carriers in jointly adopting compatible packet-based
    technologies if this means that they will lose reciprocal
    compensation revenues.

86. The one-way-network problem generates similar incentives to invest
    inefficiently. Specifically, under the reciprocal compensation
    regimes adopted by the vast majority of states, networks that
    primarily receive calls are entitled to charge for termination,
    while business customers that primarily receive calls must simply
    pay a carrier for business lines. As previously noted, this
    dichotomy creates an incentive for a business that primarily
    receives calls to purchase a switch, self-provide dial tone, and
    claim to be a network in order to be able to charge termination fees
    for all the calls it receives.

87. COBAK reduces these incentive problems in at least two ways. First,
    COBAK is technology neutral; it applies the same rules regardless of
    the technology a carrier uses. This reduces the likelihood that a
    carrier will choose a less efficient technology solely because it
    receives more favorable regulatory treatment. Thus, COBAK gives
    carriers the incentive to use the technology that provides services
    at the least cost. Second, by eliminating per-minute termination
    charges, COBAK eliminates any incentives for carriers to invest
    inefficiently. In particular, COBAK reduces incentives arising from
    the ISP reciprocal compensation problem and the one-way-network
    problem.

88. It should be acknowledged that COBAK does not solve all the
    incentive problems, however. Specifically, there remains a small
    incentive under COBAK for an entity to claim to be a network rather
    than simply subscribe as a customer. If an entity can qualify as a
    network, it can avoid paying business line rates (and, as a carrier,
    be entitled to have calls transported to the business's switch).
    Nevertheless, such incentives exist today under the current
    interconnection regime, and this incentive is less than if the
    entity could also claim per-minute termination charges. Thus, COBAK
    does not introduce any new distortions.

## Monopoly Power over Terminating Access 

89. The current requirement that carriers pay the called party's network
    to terminate calls confers monopoly power on the called party's
    network with respect to terminating access. This market power arises
    from the fact that the calling party's carrier, whether a local
    carrier or an IXC, has no alternative carrier that can terminate a
    call to a particular called party. Thus, the calling party's carrier
    must pay the terminating network whatever price it demands in order
    to reach the called party. In effect, each terminating carrier, no
    matter how small, has a monopoly over termination to its own
    customers. Recently in fact, IXCs have begun to complain that
    certain CLECs have exploited their monopoly power in termination by
    setting access charges that far exceed those charged by major
    incumbent LECs.[^65]

90. This problem presents regulators with the unattractive choice of
    allowing non-incumbent carriers to exercise their terminating market
    power, which could raise retail prices and reduce network usage, or
    regulating the terminating access rates of all carriers, even those
    that would not possess market power under alternative
    interconnection regimes.[^66] COBAK eliminates this problem by
    requiring a carrier to recover its termination costs from its own
    end-user customers. To the extent that a carrier faces competition
    from other carriers for end users, it will not have monopoly power
    over termination, since any attempt to charge above-cost rates is
    likely to cause it to lose customers to competing carriers. In the
    case where there is no competition for end users, the incumbent
    LEC's local rates would be regulated, as they traditionally have,
    and the issue of how to recover local access costs would simply be
    folded into the rest of the local rate regulation process. Thus,
    COBAK eliminates the need for regulators to set prices for
    termination.

## The Problem of Estimating Interconnection Costs

91. An additional problem with the existing CPNP regime is that it
    requires regulators to set both the level and structure of
    interconnection rates. This is a difficult task for a regulator,
    made even more difficult by the fact that incumbent LECs possess the
    relevant information but have incentives not fully to disclose the
    information. More specifically, as previously discussed, incumbent
    LECs have an incentive, at least in the case of access charges, to
    report as high a cost (whether historical or forward-looking) as
    possible for their regulated services. For example, where the
    termination rate is based on the cost of switching, incumbent LECs
    may have an incentive to overstate both their direct costs of
    switching and the overheads that are to be allocated to switching.
    Setting reciprocal compensation rates (*i.e.,* rates for two-way
    access) raises related, but slightly different, issues.

92. It is also extremely difficult for regulators to set an efficient
    rate *structure*. Economists have long recognized that the efficient
    way to recover the cost of "congestible" or "traffic-sensitive"
    shared facilities, such as switches and transport trunks, is to
    adopt peak-load pricing.[^67] Unfortunately, because of the
    practical difficulties of developing peak-load prices,[^68]
    regulators, including the Commission, have tended to adopt
    per-minute pricing that attempts to recover the average cost of the
    congestible facility.[^69] This means, however, that prices will be
    too high during off-peak periods and too low during peak periods. In
    addition, carriers have an incentive to overstate their termination
    costs to regulators in order to obtain a higher termination rate in
    the case of one-way access or in situations where the regulator sets
    individual termination rates for each carrier based on that
    carrier's costs.

93. COBAK eliminates both the need for regulators to set termination
    rates and the incentive of a carrier to overstate its termination
    costs. Specifically, by requiring carriers to recover the cost of
    local access from their end users, COBAK allows the workings of the
    competitive market to discipline the way that LECs recover local
    access costs. Once competition develops, if a carrier sets prices
    that more than recover the costs of serving a customer, a competing
    carrier is likely to lure the customer away by charging a lower
    price that better reflects the true cost of serving the customer.
    Similarly, if a carrier adopts an inefficient rate structure, it
    likewise risks losing customers to carriers that have adopted an
    efficient rate structure.

## Retail Rate Inefficiencies Caused by Interconnection Rates

94. The existing interconnection regimes, particularly CPNP regimes,
    create certain inefficiencies that will tend to result in
    inefficient retail rates. Such inefficient retail rates can result
    in inefficient usage of the network and can distort customer choices
    among competing local carriers.

95. One source of inefficiency is that existing termination charges
    create an "artificial" per-minute cost structure for carriers that
    will tend to result in inefficient per-minute retail prices. In
    unregulated, competitive markets, such as the markets for CMRS
    services and Internet access services, retail pricing is moving away
    from per-minute charges and towards flat charges or two-part tariffs
    that guarantee a certain number of free minutes. This suggests that
    few costs are incurred on a per-minute basis, and that flat-rated
    pricing will lead to more efficient usage of the network. The
    existing reciprocal compensation scheme, which requires the calling
    party's network to pay usage sensitive termination charges to the
    called party's network, imposes an "artificial" per-minute cost
    structure on carriers which, if retail rates are unregulated, will
    likely be passed through to customers in the form of per-minute
    retail rates. Such usage sensitive rates thus would likely reduce
    usage of the network below efficient levels.[^70]

96. COBAK solves this problem by eliminating per-minute termination
    charges, which in turn eliminates the artificial per-minute marginal
    cost of calling. In other words, COBAK eliminates any artificial
    usage-based costs that result from regulation. To the extent that
    retail rates are unregulated (for at least some carriers), this
    should lead to more efficient retail rates.

97. A second inefficiency caused by inter-carrier termination charges is
    that they create an artificial cost difference between on-net and
    off-net calls. Specifically, termination charges will cause carriers
    to have a higher effective cost for completing off-net calls than
    they have for completing on-net calls.[^71] This cost differential
    will lead to several types of inefficient behavior.

98. If retail rates are *not* regulated, then this cost difference will
    tend to cause carriers to charge a higher price for off-net calls
    than for on-net calls. This in turn will create an incentive for
    customers to choose their network based, at least in part, on the
    customers that currently subscribe to the particular network, rather
    than on the basis of which network most efficiently meets his/her
    needs. This network externality not only will cause some customers
    to choose a network that they otherwise might not, but it could also
    increase the tendency of telecommunications markets to tip into
    monopoly, as larger networks will have a relative advantage in
    attracting new customers.[^72]

99. If, on the other hand, retail rates *are* regulated, inter-carrier
    termination fees will cause a different type of inefficiency. In
    particular, if regulations require that termination costs be
    recovered from all customers equally, then CPNP termination will
    force a carrier's customers that do not make off-net calls to
    contribute to the cost of the facilities of other networks and to
    subsidize the carrier's customers that do make off-net calls. [^73]

100. Again, COBAK substantially solves this problem, regardless of
     whether retail rates are regulated. By eliminating inter-carrier
     termination charges, COBAK eliminates any *artificial* cost
     differential between off-net and on-net calls.[^74] This, in turn,
     will reduce the incentive of non-rate-regulated LECs to charge
     different prices for off-net and on-net calls.[^75] In the case of
     rate regulated carriers, on the other hand, COBAK will reduce the
     ability of one network to impose its network costs on another
     network's customers.

101. A final possible inefficiency of the existing interconnection
     regime is that the inter-carrier interconnection charges may be
     used to facilitate oligopolistic collusion. More specifically,
     competing local networks may agree on above-cost interconnection
     charges in order to justify higher end-user prices.[^76] Again,
     COBAK solves this problem by eliminating per-minute termination
     charges. Thus, under COBAK, carriers have no ability to collude by
     agreeing on above-cost interconnection charges.

# IMPLEMENTATION ISSUES FOR COBAK 

102. Like any other interconnection regime, COBAK raises a number of
     implementation issues which would have to be resolved before COBAK
     could be adopted. Several of the more important issues are
     discussed below.

## Identifying Central Offices

103. COBAK's second rule makes the calling party's carrier responsible
     for the cost of transporting the call to the called party's central
     office. This raises two separate implementation issues concerning
     the location of central offices. First, to the extent that there is
     any uncertainty concerning which facilities qualify as a central
     office, this rule will give networks an incentive to claim that
     their central offices are as close to the end-user customer as
     possible. Second, and relatedly, this rule may cause networks to
     locate their central offices inefficiently. These issues are
     discussed in this and the next sections.

104. To illustrate the first issue, consider a traditional wireline
     carrier that employs digital-loop-carrier ("DLC") technology.[^77]
     The DLC electronics typically are installed in a remote terminal
     ("RT") located somewhere between the central office and the
     customers' premises. All else being equal, such a carrier would
     rather have the RT declared a central office than the switch to
     which it is connected. Although this issue is not likely to prove a
     significant problem for existing network technologies, it could
     prove a problem as new technologies are developed and deployed.

105. It thus appears reasonable to adopt rules defining those points in
     a given network that qualify as central offices for purposes of
     COBAK. One approach would be to define the central office or local
     switch in terms of certain observable attributes. For example, one
     could define the central office as the node at which loops: (1) are
     aggregated, and (2) gain access to the transport network. The
     definition, of course, raises the question of what is meant by the
     phrase "gain access to the transport network."

106. A second approach would be to define a central office as a node
     that interconnects and exchanges traffic with other equivalent
     nodes. Under this definition, remote terminals would not be
     considered central offices because they do not exchange traffic
     with other remote terminals. Rather, remote terminals aggregate
     traffic for the purpose of carrying that traffic to the central
     office, which provides local switching. Alternatively (or
     additionally), one might define a central office as a node at which
     other networks can interconnect.

107. An alternative approach would be to specify that, in order qualify
     as a central office, a node must connect a minimum number of
     customers (*e.g.,* 50,000). A similar approach would be to declare
     that any node within a specified distance of the called party (say,
     15 miles) could be treated as the central office for purposes of
     COBAK.

108. Despite the abstract difficulties in defining the local central
     office, this does not appear to present an insurmountable problem
     in practice. First, as previously mentioned, there appears to be
     general agreement as to what constitutes a central office for
     today's wireline technology.[^78] Second, it appears likely that
     networks will generally negotiate one or more meet points for
     exchanging traffic on a bill-and-keep basis, particularly where
     each network both originates and terminates traffic. They will find
     it in their mutual interest to so agree because they each can then
     avoid individually having to bear the cost of transport facilities
     to multiple end offices.

## The Problem of Remotely Located Central Offices 

109. Another implementation issue involving central offices is who
     should bear the cost of transport where the called party's network
     locates its central office switch in a remote location, such as
     outside the local calling areas.[^79] Thus, for example, if both
     parties to a call live within the same local calling area, but the
     switch serving the called party is located in another state, should
     the calling party's network be forced to bear the cost of
     transporting the call to the called party's switch?[^80] Note, in
     this regard, that this problem is likely to be significantly
     greater where the called party's network only receives traffic.

110. One way to deal with this problem, at least for incumbent LECs
     subject to retail rate regulation, would be through adjustments in
     retail end-user rates (competitive LECs clearly could implement
     this solution on their own). Thus, a regulator might allow the
     incumbent LEC to impose toll charges whenever its customers called
     customers served by remotely located central offices. To the extent
     that calling parties then complain to customers of the network with
     the distant central office, those customers might consider changing
     carriers so that friends and neighbors could call them without
     incurring toll charges. This potential loss of customers might thus
     induce the network with the remote central office to negotiate
     points of interconnection within a local calling area and to bear
     the cost of such "remote transport" itself. On the other hand, this
     solution may not be effective if the calling parties do not
     complain to the called party, or if the called party does not care
     about the toll charges others may pay.

111. A second approach would be to require the network with a remotely
     located switch to provide points of interconnection within a local
     calling area. Under this approach, each such point of
     interconnection would be treated as the called party's central
     office when the network with the remote switch receives calls from
     another network. This is similar to the practice of wireless
     carriers of establishing points of interconnection in local calling
     areas in order to avoid having calls to their network classified as
     a toll call.

112. Two final points are worth noting. First, as previously mentioned,
     this problem of remotely located central offices is likely to be
     particularly acute for networks that primarily or exclusively
     terminate traffic. Because, under COBAK, such "receive-only"
     networks are not responsible for the cost of transporting traffic
     they receive from other networks, they have no incentive to locate
     their central offices in a manner that minimizes the total cost of
     building transport facilities. The two approaches suggested above
     should mitigate these problems, however. For example, a paging
     company may have difficulty attracting customers if parties seeking
     to page those customers must incur a toll charge. Second, although
     COBAK does not completely eliminate incentives of carriers to
     locate central offices inefficiently, it certainly does not
     exacerbate the problem as compared with the existing CPNP
     interconnection regime. This is due to the fact that the calling
     party's network is responsible for the entire cost of transport
     under the current CPNP regime, just as it would be under COBAK.

## Distinguishing Between Carriers and End-User Customers

113. A third implementation issue is whether COBAK, or any other
     interconnection regime, creates incentives for end-user customers
     to claim to be an interconnecting network. This "sham network"
     problem clearly exists under the current interconnection regime.
     Specifically, a business today, particularly if it primarily or
     exclusively receives calls, may have an incentive to claim to be a
     network instead of an end-user customer in order to: (1) receive
     reciprocal compensation payments; and (2) avoid paying business
     line rates to be connected to the incumbent's network.[^81] Thus,
     for example, although the Commission, in the *Local Competition
     Order*, concluded that paging companies were local exchange
     carriers entitled to reciprocal compensation under section
     251(b)(5),[^82] ILECs have argued that they should not be required
     to transport calls, or to pay reciprocal compensation, to paging
     companies.[^83]

114. COBAK significantly reduces this "sham network" problem.
     Specifically, by eliminating termination charges, COBAK eliminates
     the possibility that the interconnection regime could become a
     "money pump" for the business claiming to be a network.

115. COBAK does not entirely eliminate the incentive for a business that
     only receives calls to claim to be a network, however. In
     particular, if such a business can qualify as an interconnecting
     network, then the originating network will be responsible for the
     cost of transport to that business's switch, and the business can
     avoid having to pay a subscription fee (*i.e.,* purchase business
     service from the interconnecting carrier). For this reason, it
     seems reasonable to require some showing that the business claiming
     to be a network exhibits characteristics of a network, such as
     ownership of a switch.

116. Whether COBAK's inability to solve completely this "sham network"
     problem will pose a significant problem in practice is unclear. It
     may be that the costs of qualifying as a network, such as
     purchasing a switch or interconnecting with the incumbent's
     signaling system, may be sufficiently high as to render this
     problem a mere curiosity. What is clear, however, is that COBAK
     reduces the problem significantly, compared to the incentives that
     exist under the current CPNP regimes.

## Accounting for "Unwanted" Calls

117. Much of the analysis of this paper assumes that the called party
     benefits from received calls and therefore should share in the cost
     of such calls. To the extent that implementation of COBAK results
     in the assessment of per-call or per-minute charges on the called
     party, the issue arises as to how to protect called parties from
     being charged for unwanted calls, such as calls from a telemarketer
     received during dinner. Note that this would not be a problem if
     the called party's carrier decided to recover local access costs
     through flat charges rather than per-minute or per-call charges.
     If, as suggested above, competition will tend to generate
     flat-rated end-user charges, rather than per-minute or per-call
     charges, this problem accordingly will not arise.

118. Even if there are per-minute end-user rates, unwanted calls do not
     appear to pose a significant problem, provided that the called
     party actually answers the phone and participates in the call. In
     this case, if the called party does not want to talk to the calling
     party, he can simply hang up, thus avoiding continuing termination
     charges. This should significantly limit the amount of per-minute
     charges for which the called party may be liable. Alternatively,
     carriers could agree (or could be required) not to charge their
     customers for the first minute of a received call. This incoming
     "free minute" would give called parties the opportunity to identify
     the calling party and decide whether they wish to continue the
     call.[^84] Finally, parties, using caller-ID or similar devices,
     could screen their calls to avoid incurring unwanted termination
     charges.

119. This issue could prove a bit more problematic for calls where the
     called party does not actually answer the phone. For example, if
     the calling party left a message on an answering machine or
     delivered an unsolicited fax, then the called party might be
     charged for termination without affirmatively accepting the
     charges. In addition, it is possible that parties may receive large
     unsolicited e-mails that, when downloaded, could tie up a telephone
     circuit for several minutes. Although it is not clear how
     significant a problem this may become, the last example suggests
     that it may become necessary, or advisable, to develop the
     technical capability to stop the transmission of large data files
     beyond the local central office, until the called party
     affirmatively approves the download.[^85]

## Determining Transport Rates

120. While COBAK makes the calling party's carrier responsible for the
     cost of transporting the call to the called party's local central
     office, it does not specify how the calling party's carrier should
     arrange for the transport of the call. Thus, while some carriers
     may construct their own transport network, others may lease
     transport facilities from other parties, including the incumbent
     LEC. The issue then arises whether regulators need to constrain in
     some way the lease rates charged for such transport facilities.

121. If there are a sufficient number of alternative providers of
     transport facilities, regulation should be unnecessary, for
     competition will drive the price or transport toward economic cost.
     If, however, the only provider of transport facilities is the
     incumbent LEC, then there is cause for concern, because the
     incumbent LEC may have an incentive to charge high prices for
     transport in order to deter entry. In such a case, it will be
     necessary to regulate the price that incumbent LECs charge for
     transport facilities, at least until competition renders such
     regulation unnecessary.[^86] This regulation should be less
     extensive than what is currently required under the existing
     interconnection regime (which also regulates the rates charged for
     terminating switching), and moreover, should be able to be lifted
     as competition develops in the transport market.

## Regulation of End User Charges

122. That COBAK eliminates most existing inter-carrier charges, and
     instead requires carriers to recover those costs from their end
     users, raises the general issue of whether it is necessary or
     appropriate to regulate the way in which carriers recover those
     costs from their end users. In particular, it raises the following
     two questions: First, under what conditions is it necessary to
     regulate the level or structure of end-user rates? Second, should
     LECs be allowed to charge end users different fees depending on
     whether the call terminates on or off the originating LEC's
     network? These issues are discussed briefly below.

### The Need for Regulation of LEC End-User Charges

123. As previously explained, if COBAK were adopted, it would eliminate
     much of the revenues LECs currently receive from inter-carrier
     charges. Specifically, it would eliminate all originating access
     charges (both interstate and intrastate) and any terminating access
     charges that currently recover the cost of the loop and local
     switch. In addition, it would eliminate any revenues that LECs with
     unbalanced traffic receive from reciprocal compensation. Instead,
     under COBAK, LECs would recover the costs of these network
     facilities from their end users. The question then becomes: is it
     necessary to regulate the charges the LECs impose on their end
     users, or alternatively, for which carriers is it necessary to
     regulate such charges?

124. The answer to this question is clear, and already has been adopted.
     And it is the same answer that the Commission adopted when it
     opened the long-distance market to competition. Specifically,
     regulation of end-user rates is necessary and appropriate where a
     LEC is a dominant carrier (*i.e.,* possesses individual market
     power), but is unnecessary if a LEC is non-dominant (*i.e.,* does
     not possess individual market power).[^87] Thus, it appears
     appropriate to extend rate regulation of incumbent LECs, where the
     LEC already is regulated, to the recovery of these costs, while it
     appears unnecessary to regulate the rates of carriers whose
     end-user rates are not currently subject to regulation. Moreover,
     as competition develops and erodes the market power of incumbent
     LECs, it should be possible to eliminate all regulation of end-user
     rates.

125. It is important to recognize that shifting the recovery of these
     costs from carriers to end users should not, on average, increase
     the total costs faced by end users. This is so because carriers
     that currently pay inter-carrier charges, like long-distance
     carriers, pass these costs on to end-user customers in the form of
     higher rates. Thus, although a customer may see an increase in the
     bill he receives from his LEC, he should see a corresponding
     decrease in other charges, such as lower charges from his
     long-distance carrier. Of course, to the extent that the existing
     interconnection regime (and the current geographic averaging
     requirement for long-distance carriers) involves implicit
     subsidies, a shift to COBAK may result in some shift in costs among
     specific groups of consumers, such as raising slightly the costs of
     customers in high cost areas. Any undue additional burden, however,
     should be able to be addressed through targeted universal service
     or other support.

126. Finally, although this paper does not attempt to address the legal
     issues associated with the COBAK proposal, it is worth noting that
     COBAK could be implemented relatively easily. For example, the
     Commission, which has jurisdiction over interstate access charges,
     could simply adopt rules requiring that access charges currently
     assessed on IXCs instead be charged to the end user. Similarly, the
     state commissions could simply transfer the current intrastate
     access charges from IXCs to end users. Of course, it seems
     reasonable that both sets of regulators should reassess the rate
     structure of existing access charges before shifting them to end
     users.

     **2. Discriminatory End-User Rates**

127. Regardless of the prevailing interconnection regime, a LEC may want
     to impose different end-user charges for different types of
     traffic. For example, while a LEC may offer unlimited calling
     within a specified geographic area for a flat monthly fee, it may
     wish to charge an additional fee when a customer calls a party
     outside that specified local calling area. Similarly, a LEC may
     want to charge a higher fee when a customer calls someone on
     another carrier's network. Finally, in order to encourage its
     customers to use its own interexchange affiliate or Internet
     service provider, a LEC might want to charge a customer an
     additional fee if the customer subscribed to a competing
     interexchange carrier or Internet service provider.

128. As a general matter, the issue of whether to permit discriminatory
     end-user charges is more of a competition or antitrust concern,
     rather than an interconnection concern *per se.* In other words,
     the real issue is whether specific instances of price
     discrimination constitute anti-competitive behavior, or whether
     they simply reflect an efficient method for recovering costs.[^88]

129. If the relevant telecommunications market is sufficiently
     competitive that there is no dominant carrier, then permitting
     differential charges is not likely to cause a problem. Thus, for
     example, a LEC that attempted to charge its customers a usage fee,
     when connecting to a specific ISP, that was not cost-justified
     would likely find this strategy to be unprofitable. Specifically,
     if the market were sufficiently competitive, competing firms would
     offer equivalent interconnection at a lower charge and steal the
     first LEC's customers. Thus, if there is sufficient competition, it
     is unlikely that a single carrier could cause a competitive harm or
     hurt consumers by charging an above-cost fee.

130. Permitting a dominant firm to price discriminate in this manner
     could have anti-competitive consequences, however. For example, if
     a dominant LEC offered a complementary service, such as Internet
     service, for free, while charging customers that use a competing
     Internet service provider, this could competitively disadvantage
     competing Internet service providers. It is worth reiterating,
     however, that this is not an interconnection concern. This issue of
     the competitive effects of discriminatory end-user pricing arises
     regardless of the interconnection regime.

131. Although this issue of how to prevent the anti-competitive use of
     price discrimination is beyond the scope of this paper, it is worth
     noting that there are a number of different ways to address this
     problem. One simple approach would be to provide interconnecting
     carriers the option to avoid such discriminatory pricing.
     Specifically, if, for purposes of receiving calls, an
     interconnecting network agrees to bear all of the cost of transport
     between the central office of the calling party and that of the
     called party, then the calling party's network would not be able
     charge its customers an additional charge for calling customers of
     the interconnecting network.

132. Finally, it is worth reiterating that this problem of
     anti-competitive price discrimination can arise regardless of the
     particular interconnection pricing regime. Nevertheless, as
     competition is introduced among networks, this problem surely will
     become more significant, and regulators need to be alert to this
     possible problem.

# CONCLUSION

133. The existing patchwork of interconnection regimes has evolved over
     time in response to regulatory and service distinctions and
     multiple, evolving policy goals. Unfortunately, existing
     interconnection regimes face increasing problems as
     telecommunications markets become competitive, and as the Internet
     continues to experience explosive growth. These problems include
     various opportunities for regulatory arbitrage, the terminating
     monopoly access problem, and inefficient retail rate structures
     caused by inefficient interconnection prices. These growing
     problems call into question the continued viability of the existing
     system and highlight the need to develop a rational and uniform
     system of interconnection pricing that is technologically neutral
     and that will allow the lifting of regulation as competition
     develops.

134. This paper proposes a unified approach to interconnection pricing,
     which would apply to all types of carriers that interconnect with,
     and to all types of traffic that pass over, the local
     circuit-switched network. The proposed approach should eliminate or
     significantly ameliorate the most significant of the problems
     afflicting current interconnection regimes. It should also
     encourage efficient use of networks by customers and efficient
     investment and deployment by carriers. Finally, it should reduce
     the need for regulatory intervention, both now, and as competition
     develops in all telecommunications markets.

Recent Working Papers Series

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Broadcast Television in a Multichannel Marketplace, by Florence Setzer
and Jonathan Levy;

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[^1]: ^^ An earlier version of this paper was presented at the 28^th^
    annual Telecommunications Policy Research Conference in Alexandria,
    VA on September 25, 2000. I wish to thank Jay Atkinson, Christopher
    Barnekov, Robert Cannon, Ben Childers, Dale Hatfield, Michael Kende,
    Johanna Mikes, Robert Pepper, Michael Riordan, William Rogerson,
    Gregory Rosston, William Sharkey, Howard Shelanski, Douglas Sicker,
    and Donald Stockdale for helpful comments. The views expressed in
    this paper are those of the author and do not necessarily represent
    the views of the Federal Communications Commission, any
    Commissioners, or other staff.

    This document is available on the FCC's World Wide Web site at
    <http://www.fcc.gov/>.

[^2]: Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat.
    56*, codified at* 47 U.S.C. §§ 151 *et seq*.

[^3]: *See* David Sieradzki, *Will Online Calls Kill Access Charges?*,
    L[egal Times,]{.smallcaps} May 8, 2000, at 35.

[^4]: The phrase "regulatory arbitrage" refers to profit-seeking
    behavior that seeks to take advantage of cost or revenue disparities
    that are due solely to regulation. It should be noted that this
    definition differs somewhat from the traditional definition of
    "arbitrage" as "an operation involving simultaneous purchase and
    sale of and asset . . . in two or more markets between which there
    are price differences or discrepancies[." The MIT Dictionary of
    Modern Economics]{.smallcaps} 17 (David W. Pearce, ed. 1992).

[^5]: *See, e.g.*, Peter Huber, *Old Regulations Stifle the New
    Economy*, [Wall St. J.,]{.smallcaps} June [5, 2000]{.smallcaps} at
    [A32;]{.smallcaps} Mike Senkowski & Jeff Linder, *Is it a Zebra or a
    Striped Horse? Internet Telephony Challenges Traditional Regulatory
    Distinctions*, [Legal Times,]{.smallcaps} May 8, 2000, at 33-34;
    David Sieradzki, *supra* note 2. *See also Federal-State Joint Board
    on Universal Service*, CC Docket No. 96-45, Report to Congress, 13
    FCC Rcd 11501 (1998) (*Stevens Report*) (discussing various types of
    Internet telephony and whether they should be subject to access
    charges).

[^6]: *See* 47 U.S.C. §§ 251(b)(5), 252(d)(2).

[^7]: *See, e.g.,* David Sieradzki, *supra* note 2.

[^8]: *See, e.g*., Patrick DeGraba, Efficient Interconnection Regimes
    for Competing Networks (October 2000) (on file with the Office of
    Plans and Policy, Federal Communications Commission).

[^9]: As discussed below, *local access costs* include the cost of the
    loop and the cost of the local switch nearest to the customer. *See*
    section III.A *infra.*

[^10]: In this sense, COBAK differs from most current interconnection
    regimes, under which the calling party's network must pay the called
    party's network for terminating the call. *See generally
    Implementation of the Local Competition Provisions in the
    Telecommunications Act of 1996*, CC Docket No. 96-98, First Report
    and Order, 11 FCC Rcd 15499, 16024-25 (1996) (*Local Competition
    First Report and Order*), aff'd in part and vacated in part sub nom.
    *Competitive Telecommunications Ass'n v. FCC,* 117 F.3d 1068 (8^th^
    Cir. 1997) and *Iowa Utils. Bd. v. FCC*, 120 F.3d 753 (8^th^ Cir.
    1997), aff'd in part and remanded, *AT&T v. Iowa Utils. Bd.*, 525
    U.S. 366 (1999).

[^11]: As discussed in greater detail below, the calling party's network
    may accomplish this by: constructing its own transport links,
    purchasing transport facilities or services from the called party's
    network, or purchasing or leasing such facilities or services from a
    third network. In the early stages of moving from monopoly to
    competition -- when incumbent local carriers still possess monopoly
    power over local network facilities -- it will most likely be
    necessary to require the incumbent to provide transport facilities
    to interconnecting networks at regulated rates. Nevertheless, even
    if the incumbent network provides the facilities, the cost of
    transporting the call remains on the calling party's network, which
    either leases the incumbent's facilities or purchases transport
    services from the incumbent. *See* sections III.A, III.B *infra*.

[^12]: *See, e.g.,* [Peter W. Huber, Michael K. Kellogg & John Thorne,
    Federal Telecommunications Law]{.smallcaps} 2 (2d ed. 1999)
    (hereinafter "[Peter W. Huber, et al]{.smallcaps}.") ("The high cost
    of fixed plant, the steadily declining average cost of service, and
    the need for all customers to interconnect with one another made it
    seem both sensible and inevitable to have a single, monopoly
    provider."); [Jean-Jacques Laffont & Jean Tirole, Competition in
    Telecommunications 3 (2000) ("]{.smallcaps}The absence of
    competition was motivated by the existence of large fixed costs in
    several parts of the network, whose duplication was neither
    privately profitable nor socially desirable; the telecommunications
    industry was deemed to be a 'natural monopoly.'"). *See also* *AT&T
    v. Iowa Utils. Bd.*, 525 U.S. 366, 370 (1999) ("Until the 1990s,
    local phone service was thought to be a natural monopoly.").

[^13]: *See generally* [Peter W. Huber, et al.,]{.smallcaps} *supra*
    note 11 at 212-26 (summarizing early history of telephone
    regulation); [Gerald W. Brock, Telecommunication Policy for the
    information Age]{.smallcaps} 63-70 (1994) (same).

[^14]: *See, e.g.,* David F. Weiman & Richard C. Levin, *Preying for
    Monopoly? The Case of Southern Bell Telephone Company, 1894-1912*,
    102 [J. Pol. Econ.]{.smallcaps} 103 (1994) (describing predatory
    strategies of AT&T, including its refusal to interconnect with
    independent telephone companies); [Peter W. Huber, et
    al.]{.smallcaps}, *supra* note 11 at 213 (same).

[^15]: *See* section IV.A *infra.*

[^16]: *See, e.g.*, *Federal-State Joint Board on Universal Service*, CC
    Docket No. 96-45, Report and Order, 12 FCC Rcd 8776, 8784-85, at
    paras. 10-12 (1997) (*Universal Service Report and Order*)
    (discussing implicit subsidies, including those in access charges);
    [Peter W. Huber et al]{.smallcaps}., *supra* note 11 at 552 (same).

[^17]: *See MTS and WATS Market Structure*, CC Docket No. 78-72,
    Memorandum Opinion and Order, 97 FCC 2d 682, 711-12 (1983) (*MTS and
    WATS Order*).

[^18]: This system of interconnection regulation is further complicated
    by the fact that telecommunications users, telecommunications
    carriers and other service providers can interconnect with an
    incumbent LEC's network in a variety of ways. For example, a party
    can interconnect with an incumbent LEC's network at the line side or
    trunk side of a switch, and it can interconnect at an end-office
    switch or a tandem switch. *See, e.g.,* *Local Competition First
    Report and Order*, 11 FCC Rcd at 15608-09, paras. 209-12. Similarly,
    a party seeking to interconnect with an incumbent LEC can construct
    its own transport links to connect to the incumbent's network, or it
    can purchase them from the incumbent or from third parties. *See,
    e.g.*, *Implementation of the Local Competition Provisions of the
    Telecommunications Act of 1996*, CC Docket No. 96-98, Third Report
    and Order and Fourth Further Notice of Proposed Rulemaking, 15 FCC
    Rcd 3696 (1999) (*Local Competition Third Report and Order*).

[^19]: *See* 47 U.S.C. §§ 251(b)(5), 252(d)(2). *See also* *Local
    Competition First Report and Order*, 11 FCC Rcd at 16008-58, paras.
    1027-1118.

[^20]: *See id.* at 16024-25, paras. 1057-58.

[^21]: *Id.* at 16055, para. 1112. It is interesting to note that
    traditionally contiguous, but non-overlapping incumbent local
    exchange networks have frequently exchanged traffic on a
    bill-and-keep basis.

[^22]: *See MTS and WATS Order*, 97 FCC 2d 682; *see generally* [Peter
    W. Huber, et al]{.smallcaps}., *supra* note 11 at 127-29. Whether
    terminating access charges would be owed depends on how the provider
    of the Internet telephony service decides to terminate the call. It
    appears that today many such providers find it easier simply to pay
    terminating access charges when delivering the call.

[^23]: *See, e.g.,* *Local Competition First Report and Order*, 11 FCC
    Rcd at 16045-58, paras. 1096-1118 (discussing bill-and-keep
    interconnection arrangements); *Interconnection Between Local
    Exchange Carriers and Commercial Mobile Radio Service Providers*, CC
    Docket No. 95-185, Notice of Proposed Rulemaking, 11 FCC Rcd 5020
    (1996) (*LEC-CMRS Interconnection NPRM*) (same).

[^24]: The treatment of transport costs may vary depending upon the
    specific bill-and-keep proposal. *See* section IV.D *infra.*

[^25]: 47 U.S.C. § 252(d)(2)(B).

[^26]: The phrases "Internet telephony" and "Internet Protocol
    telephony" ("IP telephony") refer to similar, but distinct concepts.
    IP telephony involves the provision of a telephony service or
    application using Internet Protocol. IP telephony may be provided
    over the public Internet or over a private IP network. In contrast,
    Internet telephony is a subset of IP telephony that is distinguished
    by the fact that it is provided over the public Internet and uses
    the domain-name system for routing. *See, e.g., Stevens Report,* 13
    FCC Rcd at 11541-51, paras. 83-104 (discussing Internet and IP
    telephony); [Harry Newton, Newton's Telecom Dictionary]{.smallcaps}
    378 (14^th^ ed. 1998) (same). For simplicity, the text will refer
    generally to the broader concept of IP telephony.

    IP telephony can also be categorized by the equipment used to
    provide the service. For example, IP telephony may be provided using
    two personal computers ("computer-to-computer" IP telephony); the
    service may be provided between a computer and a standard telephone
    using a single IP gateway ("computer-to-phone" IP telephony); or it
    may be provided using two standard telephones that connect through
    two IP gateways ("phone-to-phone" IP telephony). *See, e.g., Stevens
    Report,* 13 FCC Rcd at 11543-44, paras. 87-89.

[^27]: Depending on how an IP telephone call is provided, the call may
    be subject to access charges, reciprocal compensation, or no
    charges. As an example, suppose that two parties make a
    computer-to-computer IP telephone call. In this case, no access
    charges would apply, but reciprocal compensation charges might
    apply. In particular, if the calling party's ISP is a customer of a
    different LEC than the calling party himself, then the calling
    party's LEC is likely to be required to pay reciprocal compensation
    to the ISP's LEC. In this case, not only does the calling party's
    LEC not receive access charges, but it must also pay reciprocal
    compensation. If, on the other hand, the calling party and the
    calling party's ISP were both customers of the same LEC, then no
    inter-carrier charges would apply.

[^28]: Termination charges typically are structured as per-minute
    charges. Yet it is clear that most switching costs are based on
    required peak capacity rather than minutes of use. *See, e.g.,
    Access Charge Reform*, CC Docket No. 96-262, Fifth Report and Order
    and Further Notice of Proposed Rulemaking, 14 FCC Rcd 14221,
    14328-30, paras. 211-16 (1999) (*Pricing Flexibility Order and
    NPRM*) (noting that switching costs vary with peak demand and not
    the total number of switched minutes).

[^29]: *See, e.g.,* Letter from W. Scott Randolph, Verizon
    Communications, to Magalie R. Salas, Secretary, FCC (Nov. 1, 2000),
    filed in Docket No. 99-68.

[^30]: Most dial-up Internet service still passes through the circuit
    switches of the traditional telephone network. It would be more
    efficient, however, to strip such calls off the circuit-switched
    network before they reach the calling party's switch, route them
    over a packet-switched network, and then bypass the called party's
    circuit switch when terminating the call. Doing so would eliminate
    the need to tie up a circuit during an Internet session, which is
    clearly inefficient as packets are transferred during only a small
    fraction of the period a customer is online. CLECs serving ISPs
    would, most likely, oppose such an arrangement, however, since it
    would prevent them from collecting termination charges on a
    per-minute basis.

[^31]: Note that, because of geographic rate-averaging requirements,
    IXCs cannot pass these high termination charges directly through to
    calling parties who place calls to these high-priced networks. Thus,
    end-user customers on networks with high termination charges are
    unlikely even to hear complaints from the parties that call them.

[^32]: ILECs generally are not able to exercise terminating market power
    because their interconnection rates are regulated.

[^33]: *See, e.g., Pricing Flexibility Order and NPRM*, 14 FCC Rcd at
    14312-20, paras. 180-90 (discussing problem of CLEC access charges).
    *See also* [Jean-Jacques Laffont & Jean Tirole,]{.smallcaps} *supra*
    note 11 at [186 (]{.smallcaps}discussing "common fallacy" that small
    players do not have market power and should therefore face no
    constraint on their termination charges). In fact, carriers with
    smaller market shares may have a greater incentive to charge
    excessive terminating access charges because those charges are
    unlikely to be flowed through to interconnecting carriers' end-user
    prices. *See id*.

[^34]: More specifically, because carriers will view traffic-sensitive
    interconnection charges as raising their marginal costs, they will
    tend to raise their traffic-sensitive retail prices, even though the
    underlying cost structure of the networks may be
    non-traffic-sensitive.

[^35]: A loop provides connection between the customer and the central
    office that switches a call onto the transport network. The term
    "loop," as used here, can refer either to the traditional wireline
    facility that connects a customer's premise to a switch, or a
    wireless connection, whether fixed or mobile, between a customer and
    the switch of the wireless network. The central office can be viewed
    as a place in the network where loops are aggregated and calls are
    switched onto the transport network. *See* section VI.A *infra*.

[^36]: *Cf.* *Local Competition First Report and Order*, 11 FCC Rcd at
    16015, paras. 1039-40 (defining *termination* as "the switching of
    traffic that is subject to section 251(b)(5) at the terminating
    carrier's end office switch (or equivalent facility) and delivery of
    that traffic from that switch to the called party's premises," and
    *transport* as "the transmission of terminating traffic that is
    subject to section 251(b)(5) from the interconnection point between
    the two carriers to the terminating carrier's end office switch that
    directly serves the called party (or equivalent facility provided by
    a non-incumbent carrier).").

[^37]: Even if traffic is not balanced, interconnecting networks are
    still likely to have an incentive to share the cost of building
    shared transport links. Specifically, provided that both networks
    originate some traffic and that it is cheaper to build a single
    shared transport facility than two separate transport facilities,
    then the parties will have an incentive to agree to a shared
    facility whose cost would be split in some way between the two
    carriers.

[^38]: In fact, it has been proposed that the Commission establish such
    points of interconnection and require networks to interconnect on a
    bill-and-keep basis at such points. Douglas A. Galbi, *Transforming
    the Structure of Network Interconnection and Transport,* 8 [J. Comm.
    L. & Pol]{.smallcaps}. 203 (2000). While there are clearly some
    advantages of such an arrangement, such as eliminating the need to
    determine what qualifies as a central office, it creates
    administrative problems of its own, including determining where such
    points would be located, who would run such interconnection points,
    and how the quality level of interconnection would be determined and
    maintained.

[^39]: This issue is discussed in greater detail in section VI.F
    *infra*.

[^40]: Such "calling-party-pays" services are commonly offered by
    wireless carriers in other countries. In addition, the Commission
    addressed this issue in *Calling Party Pays Service Offering in the
    Commercial Mobile Radio Services*, WT Docket No. 97-207, Declaratory
    Ruling and Notice of Proposed Rulemaking, 14 FCC Rcd 10861 (1999).
    Of course, such calling-party-pays arrangements create a terminating
    access problem. *See, e.g.,* Office of Telecommunications, Price
    Control Review (Oct. 2000) at paras. 2.32-2.35 (discussing need to
    regulate price of calls made by wireline customers to wireless
    customers).

[^41]: *See, e.g., Local Competition First Report and Order*, 11 FCC Rcd
    at 15508, para. 10 ("Because an incumbent currently serves virtually
    all subscribers in its local serving area, an incumbent LEC has
    little economic incentive to assist new entrants in their efforts to
    secure a greater share of the market. An incumbent LEC also has the
    ability to act on its incentive to discourage entry and robust
    competition by not interconnecting its network with the new
    entrant's network or by insisting on supracompetitive prices or
    other unreasonable conditions. . . " (footnote omitted)); *see also*
    Robert D. Willig, *The Theory of Network Access Pricing,* *in*
    [Issues in Public Utility Regulation]{.smallcaps} 109, 146 (H.
    Trebing, ed. 1979); Mark Armstrong, Chris Doyle & John Vickers, *The
    Access Pricing Problem: A Synthesis,* 44 [J. Ind. Econ.]{.smallcaps}
    130 (1996); Michael L. Katz & Carl Shapiro, *Network Externalities,
    Competition, and Compatibility,* 75 [Amer. Econ. Rev]{.smallcaps}.
    424 (1985).

[^42]: *See, e.g.,* [Jean-Jacques Laffont & Jean Tirole]{.smallcaps},
    *supra* note 11 at 98 (noting that interconnection regulation
    generally "must reflect multiple objectives.").

[^43]: *See* paras. 89-90 *infra.*

[^44]: To the extent that regulators seek to achieve other goals as
    well, they should address these separately from interconnection
    policy. In addition, with the introduction of competition,
    regulators need to take care that their efforts to achieve these
    other goals do not distort the efficient development of competition.

[^45]: *See, e.g.,* Robert D. Willig, *supra* note 40 at 124-28
    (discussing the fact that the called party generally benefits from a
    call); Lyn Squire, *Some Aspects of Optimal Pricing for
    Telecommunications*, 4 [Bell J. Econ]{.smallcaps}. 515 (1973)
    (same).

[^46]: Early studies included: Roland Artle & Christian Averous, *The
    Telephone System as a Public Good: Static and Dynamic Aspects*, 4
    [Bell J. Econ]{.smallcaps}. 89 (1973); Lyn Squire, *supra* note 44;
    Jeffrey Rohlfs, *A Theory of Interdependent Demand for a
    Communications Service*, 5 [Bell J. Econ]{.smallcaps}. 16 (1974);
    Robert D. Willig, *supra* note 40. For more recent studies, *see,
    e.g.,* Jean-Jacques Laffont & Jean Tirole, *Access Pricing and
    Competition*, 38 [Eur. Econ. Rev]{.smallcaps}. 1673 (1994); Mark
    Armstrong, Chris Doyle & John Vickers, *The Access Pricing Problem*,
    44 J. Ind. Econ. 131 (1996); Jean-Jacques Laffont, Patrick Rey &
    Jean Tirole, *Network Competition: I. Overview and Nondiscriminatory
    Pricing,* 29 [Rand J. Econ]{.smallcaps}. 1 (1998); Jean-Jacques
    Laffont, Patrick Rey & Jean Tirole, *Network Competition: II Price
    Discrimination*, 29 Rand J. Econ. 38 (1998). *See generally*
    [Jean-Jacques Laffont & Jean Tirole]{.smallcaps}, *supra* note 11 at
    102-04.

[^47]: Although these earlier studies assumed (at least implicitly) that
    the calling party was the sole beneficiary of the call, the authors
    of the studies, as previously indicated, clearly recognized that, in
    reality, both parties tended to benefit from calls. *See, e.g.,* Lyn
    Squire, *supra* note 44; Robert D. Willig, *supra* note 40 at
    124-28. The reason that these authors were willing to make this
    simplifying assumption appeared to be that they believed that the
    parties to the call could internalize the cost of the call. *Id.* at
    128.

[^48]: Of course, there also may be certain call set-up costs associated
    with initiating a call. These costs do not undermine the basic
    point, however, that both parties are responsible for continuing a
    call.

[^49]: A related argument is that, if the calling party had not
    initiated the call, then the call would not have been made. Thus, it
    has been argued that the calling party is the cost-causer and
    therefore should be charged *all* the costs of the call. This
    reasoning is wrong for at least two reasons. First, even if we grant
    that the call would not have occurred if the calling party did not
    initiate it, it is equally true that the call cannot continue
    without the consent of the called party. Thus any costs incurred by
    networks for the duration of the call are a result of a joint
    decision of the calling party and the called party to continue the
    call. Therefore, the calling and the called party are jointly
    responsible for all costs incurred during the duration of the call.

    Second, as a general matter, it is not true that, if the calling
    party did not make the call, then the call would not be made. As a
    simple counter example, suppose a customer on network A calls a
    customer on network B. When the called party does not answer the
    phone, the calling party leaves a message on the answering machine.
    If the customer on network B subsequently retrieves the message and
    calls back, whom should we say is the initiator or causer of the
    call? If the customer on B's network would not have called the
    customer on A's network but for the voice mail, then we might
    conclude that the customer on A's network is the initiator or causer
    of the call, but the customer on B's network is the one who dialed
    the successfully completed call.

[^50]: Relaxing this assumption and recognizing that different networks
    may have different costs does not change the basic results of this
    analysis nor does it undermine the two COBAK rules. *See* note 53
    *infra.*

[^51]: *See, e.g.,* James M. Buchanan, "An Economic Theory of Clubs," 32
    *Economica* 1 (1965) (discussing the differences between private and
    public goods).

[^52]: *See, e.g.,* I [Alfred E. Kahn, The Economics of Regulation:
    Principles and Institutions]{.smallcaps} 65-70 (1970).

[^53]: *See* James M. Buchanan, *supra* note 50.

[^54]: There are two possible complications to this analysis that should
    be noted. Neither complication should change the basic conclusion,
    however.

    First, one needs to consider the implications if the two parties to
    a call do not benefit equally from the call (in the sense of having
    identical demand functions). Ramsey analysis suggests that, in that
    case, one should allocate the cost of each specific call based on
    the relative elasticities of demand of both parties to the call.
    Frank Ramsey, *A Contribution to the Theory of Taxation*, 37 [Econ.
    J.]{.smallcaps} 47 (1927); *see also* [Kenneth E. Train, Optimal
    Regulation: The Economic Theory of Natural Monopoly]{.smallcaps}
    115-45 (1991). Unfortunately, it is clearly impossible in practice
    to estimate individuals' demands for specific calls, particularly
    for recipients of calls. Given this, it appears necessary to develop
    some general assumptions concerning demand. As the above analysis
    suggests, it appears more realistic to assume that both parties
    benefit equally than it is to assume that the calling party is the
    sole beneficiary of the call. *See also* para. 65 *infra.*

    Second, one needs to consider the implications of two networks
    having different costs. In general a network with higher costs
    should offer greater services. For example, a mobile wireless
    network may have higher termination costs than a wireline network,
    but it offers its customers the advantage of mobility. Similarly, a
    broadband network may have higher costs, but again it may offer its
    customers the advantage of additional services. To the extent that
    differences in cost are due to differences in the features of a
    network, it appears reasonable to require the party choosing the
    more expensive network to pay for the additional costs of that
    network.

[^55]: *See, e.g., Policy and Rules Concerning Rates for Competitive
    Common Carrier Services and Facilities Authorizations Therefor*, CC
    Docket No. 79-252, First Report and Order, 85 FCC 2d 1, 31-35 (1980)
    (*Competitive Carrier First Report and Order*) (discussing reasons
    it is unnecessary to regulate the rates of non-dominant carriers).

[^56]: As previously noted, there is a slight exception to the general
    rule that the parties should equally split the cost of the call.
    Specifically, if one network has higher costs than another because
    it offers more features, such as mobility, it appears reasonable to
    require the customer subscribing to, and benefiting from, the more
    expensive network to pay the higher costs.

[^57]: *See* Patrick DeGraba, *supra* note 7.

[^58]: *See* section V *infra.*

[^59]: A more regulatory approach would be for a regulator to simply
    announce a default location at which carriers must exchange traffic
    destined for a specific geographic area on a bill-and-keep basis.
    Again, such a location would have to be used only as a default for
    carriers that are unable to reach agreement on interconnection
    points. *See* Douglas A. Galbi, *supra* note 37. One major problem
    with this approach is that there is no reason to suppose that the
    regulator will have the information necessary to select efficient
    meet point locations.

[^60]: *See* section VI.E *infra*.

[^61]: *See* section VI.B *infra.*

[^62]: There are other sources of regulatory arbitrage as well. For
    example, large end users may employ Private Branch Exchange ("PBX")
    on their premises. In some cases, such PBX customers may also employ
    leased lines to connect multiple PBX's at distant locations (such as
    at different regional offices). These leased lines permit employees
    to call other employees at remote offices without incurring access
    charges. In some private networks, however, employees can also place
    "off-net" calls that traverse the leased line and then "hop off"
    onto the local exchange network. Because these off-net calls are
    treated like any other call from the PBX, access charges do not
    apply. This problem of the "leaky PBX" caused a sufficient erosion
    in access charges that the Commission imposed a \$25 per month
    charge for each leased trunk that could "leak" traffic into the
    public switched network. *See* 47 C.F.R. § 69.115. *See generally*
    *MTS and WATS Market Structure*, CC Doc. No. 78-72, First
    Reconsideration Order, 97 FCC2d 682 (1983), Second Reconsideration
    Order, 97 FCC2d 834 (1984). This charge was designed to compensate
    the LEC, at least partially, for the loss of regular access charges
    that would have applied if the call were handled as a regular
    long-distance call. COBAK should reduce this problem just as it
    reduces the problem of IP telephony arbitrage discussed in the text.

[^63]: It appears that the current inferior quality of IP telephony,
    compared with circuit-switched long-distance service, combined with
    reductions in per-minute access charges, has limited somewhat the
    shift to IP telephony in this country. Expected quality improvements
    in IP telephony are likely to accelerate the erosion of access
    revenues, however.

[^64]: *See* *Local Competition First Report and Order*, 11 FCC Rcd at
    16008-58, paras. 1027-1118.

[^65]: *See, e.g., Pricing Flexibility Order and NPRM*, 14 FCC Rcd at
    14316-17, para. 186 (discussing AT&T's petition for declaratory
    ruling that complained of excessive CLEC access charges).

[^66]: *Id.* at 14312-20, paras. 180-89*.* *See also* [Jean-Jacques
    Laffont & Jean Tirole,]{.smallcaps} *supra* note 11 at [186
    (]{.smallcaps}discussing "common fallacy" that small players do not
    have market power and should therefore face no constraint on their
    termination charges). In fact, carriers with smaller market shares
    may have a greater incentive to charge excessive terminating access
    charges because those charges are unlikely to be flowed through to
    interconnecting carriers' end-user prices. *See id*.

[^67]: *See, e.g., Local Competition First Report and Order*, 11 FCC Rcd
    at 15878, para. 755 ("\[A\]s a matter of economic theory, . . . if
    usage-sensitive rates are used, then somewhat higher rates should
    apply to peak period traffic, with lower rates for non-peak usage.
    The peak load price would be designed to recover at least the cost
    of the increment of network capacity added to carry peak period
    traffic."). *See also* I [Alfred E. Kahn]{.smallcaps}, *supra* note
    51 at 89-103.

[^68]: In the *Local Competition Proceeding*, the Commission described
    some of the practical difficulties associated with peak-load
    pricing, including the fact that different geographic areas (such as
    downtown business areas compared with suburban residential areas)
    could experience peak volumes at different times, that such peak
    periods could shift over time (*e.g.,* due to increasing Internet
    usage), and that peak load pricing could cause peak period traffic
    to shift to off-peak periods. *See Local Competition First Report
    and Order*, 11 FCC Rcd at 15878, para. 756. *See also LEC-CMRS
    Interconnection NPRM*, 11 FCC Rcd at 5041-42, paras. 44-45
    (discussing practical difficulties in setting peak-load
    interconnection rates).

[^69]: *See, e.g., Local Competition First Report and Order.*, 11 FCC
    Rcd at 15878-79, paras. 756-57 (declining to require states to
    impose peak-load reciprocal compensation rates).

[^70]: The ISP market illustrates the importance of rate structure on
    usage. When AOL changed from usage sensitive rates to a flat charge
    for unlimited usage in late 1996 the number of customers and the
    usage per customer rose dramatically and other competitors soon
    followed. *See, e.g.,* Kevin Coughlin, *AOL Logs on to Profits --
    Added Gear Revives Online Giant,* [The Star Ledger]{.smallcaps} (May
    18, 1997); Phil Waga, *AOL Smooths Out Problems, Readies New
    Features,* [Gannet News Service]{.smallcaps} (June 5, 1997). In
    addition, many believe that the main reason that Internet usage and
    penetration is lower in Europe than in the United States is because
    local service is priced on a traffic-sensitive basis in Europe,
    while it tends to be priced on a flat-rated basis in the United
    States. As a result, European regulators are considering how to
    offer flat-rated Internet access services. *See, e.g.,* Office of
    Telecommunications, Determination of a Dispute between BT and MCI
    Worldcom Concerning the Provision of a Flat Rate Internet Access
    Call Origination Product (FRIACO) (rel. May 26, 2000) (U.K.
    regulator requires incumbent LEC to offer flat-rated option to
    competitive ISPs); *Regulators Tell DT To Offer ISP's Flat-Rate
    Connections,* [Telecommunications Rep]{.smallcaps}., Nov. 20, 2000
    at 23 (German regulator requires incumbent LEC to offer flat-rated
    option to competitive ISPs). Similarly, the introduction by CMRS
    providers in the United States of pricing plans that include
    "buckets" of minutes appear to have contributed significantly to the
    growth in wireless usage.

[^71]: More precisely, assuming that the LEC has the same average
    transport costs for on-net and off-net calls, the carrier can
    recover the transport cost of an on-net call from both parties to
    the call, whereas, in the case of an off-net call, it must recover
    the entire transport costs from the calling party.

[^72]: *See,* Patrick DeGraba, *supra* note 7.

[^73]: To illustrate this, suppose that there are two networks -- an
    incumbent LEC network and a CLEC network. Suppose further that the
    CLEC's only customer is an ISP that only receive calls from the
    ILEC's network. In this case, if the termination charge for the
    CLEC's network equals the per-minute cost of its switch, then the
    CLEC network would recover the entire cost of the switch through
    termination charges. Thus, customers of the ILEC's network will pay
    for the entire cost of the CLEC's switch.

[^74]: COBAK will not completely eliminate the cost differential between
    on-net and off-net calls, however. In the case of an on-net call,
    the carrier can split the cost of transport between the calling and
    called parties. In the case of an off-net call, however, the calling
    party's carrier, which bears the entire cost of transport, can only
    recover that cost from its own end-user customer. Thus, if the COBAK
    default is employed, the calling party's carrier is likely to view
    an off-net call as somewhat more expensive than an on-net call. If,
    as appears likely, however, carriers negotiate a meet-point
    arrangement in which they split the transport costs, this should
    reduce any cost differential.

[^75]: Of course a carrier may still choose to offer different rates for
    off-net and on-net calls as a marketing device. In a competitive
    market, however, such pricing would tend to survive only if it were
    efficient. The important point is that such rates are not induced by
    the regulatory regime.

[^76]: [Jean-Jacques Laffont & Jean Tirole]{.smallcaps}, *supra* note 11
    at 190-95.

[^77]: In a digital-loop-carrier system, "analog signals are carried
    from the customer's premises to a remote terminal (RT), at which
    they are converted to digital information, multiplexed with other
    signals, and transported, generally through fiber facilities, to the
    LEC central office." *Deployment of Wireline Services Offering
    Advanced Telecommunications Capability and Implementation of the
    Local Competition Provisions of the Telecommunications Act of 1996,*
    CC Docket Nos. 98-147, 96-98, Third Report and Order in CC Docket
    No. 98-147 and Fourth Report and Order in CC Docket No. 96-98, 14
    FCC Rcd 20912, 20945-46, para. 69 n.152 (1999) (*Line Sharing
    Order*).

[^78]: Similarly, most would agree that the mobile telephone switching
    office ("MTSO") should qualify as the central office for a wireless
    network.

[^79]: This issue is a specific manifestation of the more general
    problem of whether COBAK, or any alternative interconnection regime,
    creates incentives for networks to deploy the efficient number of
    switches and to locate them efficiently. For example, one might also
    ask whether a particular regime creates appropriate incentives for
    carriers to choose the efficient number of central office and tandem
    switches to include in its network. While the more general question
    is beyond the scope of this paper, it appears that COBAK is likely
    to create fewer incentives to engage in inefficient investment than
    the current CPNP regime, for it eliminates inter-carrier termination
    payments.

[^80]: A similar problem arises in wireless networks, where a single
    MTSO may serve a very large geographic area. In that case, the
    question becomes whether wireline networks should be responsible for
    building transport facilities to the wireless network's MTSO.

[^81]: In addition, an entity may claim to be a network in order to
    qualify to lease unbundled network elements from an incumbent LEC.
    *See* 47 U.S.C. § 251(c)(3) (requiring an incumbent LEC to offer
    nondiscriminatory access to network elements on an unbundled basis
    to "any requesting telecommunications carrier").

[^82]: *Local Competition First Report and Order*, 11 FCC Rcd at 15997,
    para. 1008.

[^83]: *See, e.g., TSR Wireless, LLC v. U S West Communications*, File
    Nos. E-98-13 *et al*., Memorandum Opinion and Order, 15 FCC Rcd
    11166 (2000).

[^84]: It should be noted that many wireless companies offer this
    service today.

[^85]: In fact, certain ISPs currently do just this when they merely
    notify customers that an e-mail has been received, but do not
    download the e-mail until the customer affirmatively opens the
    e-mail message.

[^86]: In the *Local Competition Proceeding*, the Commission identified
    transport facilities as a network element that must be provided to
    requesting carriers on an unbundled basis. *See Local Competition
    First Report and Order*, 11 FCC Rcd at 15714-22, paras. 428-51;
    *Local Competition Third Report and Order*, 15 FCC Rcd at 3840-66,
    paras. 319-80. The Commission has also indicated, however, that it
    will relax or eliminate regulation of transport rates as competition
    develops. *See Pricing Flexibility Order and NPRM*, 14 FCC Rcd
    14221.

[^87]: *See Competitive Carrier First Report and Order*, 85 FCC 2d 1.

[^88]: It should be noted that numerous examples of price discrimination
    can be found in competitive markets. For example, airlines typically
    charge significantly different prices for identical seats on the
    same or a similar flight, with the variation in price depending on
    such factors as how far in advance the customer books the flight,
    whether the passenger is staying over on a Saturday night, and
    whether the passenger is a member of the airline's frequent flyer
    club.