Mobile Termination, Network Externalities, and Consumer Expectations∗ short title: Mobile Termination and Consumer Expectations

We re-examine the literature on mobile termination in the presence of network externalities. Externalities arise when firms discriminate between onand off-net calls or when subscription demand is elastic. This literature predicts that profit decreases and consumer surplus increases when termination charges increase. This is puzzling since in reality regulators are pushing termination rates down while being opposed to do so by network operators. This puzzle is resolved when consumers’ expectations are assumed passive but required to be fulfilled in equilibrium (as defined by Katz and Shapiro, AER 1985), instead of being responsive to nonequilibrium prices, as assumed until now. ∗Corresponding author: Ángel L. López, Departament d’Economia Aplicada, UAB, 08193 Bellaterra, Spain. AngelLuis.Lopez@uab.cat. We thank the editor and two anonymous referees, Lúıs Cabral, Giulio Federico, Doh-Shin Jeon, Bruno Jullien, and Patrick Rey, the seminar audiences at IAE, University of the Basque Country, University of Groningen, University of Vienna, TSE, ZEW Mannheim, UB, EUI, UAB, University of Alicante, IE Business School, Bank of Canada, University of Navarra, University of Valencia and Universidade de Évora, and conference participants at EEA 2011 (Oslo) for helpful comments. Hurkens gratefully acknowledges financial support from the Spanish Ministry of Economy and Competitiveness, through grant ECO2012-37065 and through the Severo Ochoa Programme for Centres of Excellence in R&D (SEV-2011-0075). López gratefully acknowledges the financial support of the Spanish Ministry of Economy and Competitiveness under ECO2008-05155 and ECO2011-29533, and from the Juan de la Cierva Program. This paper re-examines the effects of interconnection agreements, and in particular of termination charges, on competition and welfare in the mobile telephony market. Interconnection requires mobile operators to provide a wholesale service (called ‘call termination’), whereby each network completes a call made to one of its subscribers by a caller from a different network (typically termed as ‘off-net’ call). In most countries, call termination is provided in exchange for a fee or termination charge to be paid by the originating operator to the terminating operator. Naturally, the termination charge affects the operators’ cost of off-net calls and therefore has an impact on retail prices, competition and efficiency. Moreover, the termination charge affects the revenues accruing from providing termination services. This has then an impact on the competition for market share, which again affects retail prices and welfare. There is a striking discrepancy between what real world practitioners (regulators and firms) believe the impact of termination charges on competition to be, and the insights provided by a vast theoretical reflection on the topic of termination charges. We believe a general re-examination of this archival wisdom is called for. We will examine the role of consumer expectations in this literature and show that a modification in modelling them is sufficient to change the theoretical results and bring them in line with real world practice. Regulators around the world, and especially in the European Union, are concerned about inflated termination charges and have intervened in the markets of termination. For example, the European Commission recommended national regulators to diminish termination rates to reflect costs by the end of 2012 (EC 2009a). Mobile operators during the last decade have repeatedly opposed the cuts in termination rates imposed by the national regulatory authorities (NRAs), a clear indication that they expect a reduction