Internet Telephony and the International

Accounting Rate System

Robin Mason
Centre for Communications Systems Research and Department of Applied
Economics, University of Cambridge, Austin Robinson Building, Sidgwick Avenue,
Cambridge CB3 9DE, U.K.. Tel.: +44 1223 335290; fax.: +44 1223 335299;
e-mail: robin.mason@econ.cam.ac.uk

Abstract
This paper attempts to provide an economic framework for assessing why and how
Internet telephony may aect the international accounting rate system in partic-
ular, and communication over circuit switched networks in general. It reviews the
regulatory treatment of Internet telephony, and compares the costs and prices of
making international calls over the Internet and the public switched telephone net-
work (PSTN). It argues that Internet telephony is unlikely to prove central to the
downfall of the international system; other technologies, such as resale, will play a
larger role. The paper also suggests a general framework in which to analyse com-
petition between networks (such as the Internet and the PSTN). This framework
indicates that dierences in the preferences of end users for congestion will drive
networks to specialise.

1 Introduction

One version of the future runs as follows. The Internet acts as the ultimate ar-
bitrage mechanism in telecommunications. Any over-pricing in circuit switched
networks is unsustainable, since trac can be carried just as well over packet
switched networks. Communication takes place using the transport medium of
lowest cost. The international accounting rate system, insofar as it maintains
price above cost, falls in the face of such competition. Another version of the
1 I would like to thank Graham Louth, for his help and patience with cost and
elasticity estimates, and Richard Gibbens for explaining technical issues. Neither
are responsible for any errors in the paper. The research for this paper was carried
out on a project funded by Alcatel Bell.

Preprint submitted to Elsevier Preprint 8th May 1998

future sees the Internet, already straining at the seams, becoming more and
more congested. No adequate (pricing) solution can be implemented, because
the costs of accounting and billing for packet switched trac are too large.
The Internet is consigned to be the playground of hobbyists and academics.
Telephony remains the province of circuit switched networks; the international
accounting rate system is untroubled, at least from this quarter.
Depending on the version of the future to which you subscribe, Internet tele-
phony is set to take o, growing by a factor of twenty over the next four
years; 2 or it is an application of limited potential, popular with some while
prices of calls over the public switched telephony network (PSTN) are very
high, but bound to be limited as those prices move closer (but not all the way)
to costs. 3 This paper will try to provide an economic framework for assess-
ing why and how Internet telephony may aect communication over circuit
switched networks, and in particular the international accounting rate system.
The paper will argue that Internet telephony is unlikely to be the `killer
app' that nishes o the international system. It is one arbitrage mechan-
ism amongst several (others are e.g. resale and call-back); and probably not
the most eective for bypassing the high settlement payments required on
licensed international circuits. In the short-run { the time left to the inter-
national system { it will play a limited role. Its prospects in the medium- to
long-term will be determined less by cost and price dierentials (which will be
modest), and more by factors such as the network benets of integrating cir-
cuit and packet switched networks, and the extra functionality than Internet
telephony oers.
The rest of the paper is structured as follows. The next section reviews the
international accounting rate system, and identies some of the challenges
that it currently faces. Section 3 discusses Internet telephony, surveying the
technology, the current regulatory treatment, and pricing structures in the
market; and estimating the costs of telephony over packet switched networks.
Section 4 develops a framework within which the challenges to the interna-
tional accounting rate system can be assessed. In particular, it describes how
price competition between the Internet and PSTN should be viewed. Section
5 concludes.

2 For example, Frost and Sullivan, quoted in [41], estimate global Internet telephony
software sales to grow from US$93 million in 1997 to US$1,889m in 2001.
3 For example, Joel Engel of Ameritech Corp. predicts that Internet voice will

continue to be a niche product (quoted in Interactive Week, June 24th 1996; see
http://www4.zdnet.com/intweek/print/960624/bandw/doc2.htm).

2
 Collection Volume of calls
rate A → B = 100 min
Country Country
A B
Volume of calls
B → A = 50 min
Collection rate = Collection rate =
15 units per min. 30 units per min.
Accounting
rate
• Accounting rate = 10 units per minute
• Settlement rate = 5 units per minute
Settlement
• A pays B (100-50) x 5 = 250 units
rate
• A earns (15x100) - (5x100) + (5x50) = 1,250 units
• B earns (30x50) - (5x50) + (5x100) = 1,750 units

Fig. 1. The International Accounting Rate System

2 The International Accounting Rate System

Until recently, the telephone network in a country, and the services delivered
over the network, were provided by a single rm { the public telecommu-
nication operator (PTO) { operating under monopoly rights. This market
structure (which no longer holds in many countries) is re ected in the ac-
counting rate system which is used for international telephony services. The
system, developed in the 1930s, determines the division of revenues from inter-
national calls between originating, transit and terminating countries. Consider
the simplest case of a call being made from country A to country B, with a
single PTO operating in each country. For the call to be completed, PTO B
must agree to carry the call over its network. PTO B is reimbursed for the
cost of this service by a payment from PTO A. The payment is determined
by the accounting rate; call the rate x. An agreement between the PTOs will
specify that PTO A will pay PTO B an amount B x per minute of trac for
calls originating in country A and terminating in country B; for calls in the
reverse direction, PTO B will pay PTO A Ax per minute of trac (where
A + B = 1). (In most cases, the fractions A and B are both set to 0.5
i.e. the accounting rate is shared equally between the PTOs.) The amount
actually paid to the terminating operator (PTO B, in this case) is known as
the settlement rate. PTO A covers the settlement payment by charging the
caller in country A a collection rate for the total service provided. For a de-
tailed description of the international accounting rate system, see [42]; gure
1 illustrates the various rates.
There are several points to note about the accounting rate system. First, the
accounting rate between two PTOs is determined by negotiation. It is not
necessarily related to the costs of termination in the two countries; indeed,
there are very good reasons for thinking that it will far exceed the cost (see,

3
for example, [7] and [46]). 4 Secondly, settlement occurs only periodically; and
so payments are made between countries only if there is an imbalance in trac
ows. In the example above, with an equal division of the accounting rate x
between PTOs A and B: if there are y minutes of trac originating in country
A and terminating in country B, and y minutes of trac passing from country
B to country A, then there will be no settlement payments made between
the two PTOs. If, however, z < y minutes of trac pass from country B to
country A, then PTO A will be required to make a (net) payment to PTO
B of 0:5x(y , z), while PTO B will pay nothing. The important point to
take from this example is that signicant trac imbalances combined with
high accounting rates can lead to large settlement payments being made by
a single country. Hence countries have little incentive to undertake an action,
such as lowering collection rates, which increases the trac imbalance. Thirdly,
the accounting rate system applies only to telephone services delivered over
international circuits operated by PTOs. Where international trac is e.g.
carried over a leased line, no accounting rate applies, even if the leased line is
connected to the (domestic) networks of the PTOs at either end.

2.1 Threats to the International System

There is a widespread consensus that the international accounting rate sys-

tem is under considerable strain; see, for example, [24] and [38]. There are
several dierent sources of pressure: regulators concerned at the high price to
consumers of international calls; PTOs faced with large trac imbalances and
the consequent settlement payments; and new technologies which manipulate
or bypass altogether the accounting rate system.
A measure of the social losses from the settlement payment is the deadweight
loss. When price is set above costs, consumers suer and rms gain; the lat-
ter does not outweigh the former, and total surplus (consumers' benet plus
rms' prots) is lower than if price were equal to cost. This is illustrated in
gure 2. The horizontal axis measures number of call minutes; the vertical axis
measures price and unit cost. Total demand is the downward sloping line (i.e.
call minutes are low when price is high, and vice versa). Unit cost is constant,
at US$0.08 per minute; price is set above cost, at US$0.55 per minute. (These
numbers will be explained below.) Consumer surplus is the area between the
price line and the demand curve; rms' prots are the rectangle dened price,
unit cost and call minutes; total surplus lost by the price markup is the triangle
DWL.
Without question, the collection rate of international calls far exceed the costs.
4 The reason is related to the double mark-up problem between vertically-related

monopolists. See [43].

4
 Price,
cost

p = 0.55 D

c = 0.08 W L
Demand

Call minutes

Fig. 2. The Deadweight Loss of Price-cost Markup

A major driver of this dierence is the settlement payments that must be
made by PTOs. A specic case will help to illustrate the amounts involved.
The retail price to a domestic user for an international call from the United
Kingdom to the United States was, on average, US$0.55 per minute in 1995. 5
The cost of such a call was US$0.0857 per minute. 6 The collection rate was
therefore almost a factor of seven greater than the (full incremental) cost of
the call. Put another way: depending on the price elasticity of demand for calls
between the U.K. and the U.S., 7 the deadweight loss in U.K. social surplus
5 This gure includes both the usage charge, or collection rate, of US$0.5208 per
minute, and the annual line rental charge, spread out over the average number
of call minutes by a U.K. household. Sources: British Telecom (see the Web site,
http://www.bt.com) and The Independent, 21st December 1995. All gures are in
1995 values.
6 This cost is a total long-run incremental gure. It is
based on estimates obtained from Analysys, FCC (see
http://www.fcc.gov/ccb/local competition/sec7.html), [24], and the In-
dependent. It is broadly in line with other estimates of the cost of international
calls; see e.g. [42] and [11], who put the incremental cost of international calls from
the U.S. between US$0.06 and US$0.09 per minute.
7 Empirical studies generally report high price elasticities for international calls.

See [4,2,1,22]; and [11] for a review. There are also theoretical reasons for assuming
a high price elasticity. In 1995, only two operators were licensed in the U.K. for
international telephony services: British Telecom (BT) and Mercury. The market

5
in 1995 due to the retail price exceeding cost is between US$750 million and
US$3bn per annum. 8 The settlement rate in 1995 between the U.K. and
the U.S. was US$0.185 per minute (i.e. half the accounting rate of US$0.37
per min.). 9 Reduction of the settlement payment to cost (while leaving BT's
price mark-up unchanged) would have increased U.K. social surplus in 1995
by between US$170 million and US$350m per annum (depending again on
the price elasticity of demand); the increase in consumer surplus would be
between US$170 million and US$210m per annum.
Growth in trac imbalances between countries, combined with a reluctance
to decrease accounting rates (despite drops in the costs of international calls),
has lead to wide variations in the net settlement payments made by countries.
The problem is particularly acute between wealthy and lower-income coun-
tries. Accounting rates between these sets of countries are high for three reas-
ons: 10 the cost of termination in developing countries is high, due to inecient
technologies; settlement payments generate revenue for developing countries
to invest in network improvement; and some developing countries have come
to rely on the international settlement system as a reliable source of valu-
able foreign currency. In addition, trac imbalances have increased where one
country unilaterally lowers its collection rates for international calls (e.g. by
allowing competition in its domestic market). For example, in 1975, outgoing
international trac from the United States exceeded incoming trac by 51
million minutes; by 1995, the dierence had grown to 8.6 billion minutes (see
[24], and gure 3, which shows call minutes in billions on the vertical axis,

share of BT for international calls was around 70%. Hence BT had considerable
price-setting power in this market. Standard microeconomic theory predicts that a
prot-maximising monopolist will raise price until he is operating on a price elastic
portion of the market demand curve; see [44]. In the case of BT, this tendency
was exacerbated by regulation which encouraged high international prices in order
to subsidise regulated and less protable areas of operation, such as domestic line
rental. The surplus gures quoted use elasticities of (slightly greater than) 1 and 2,
respectively.
8 The calculation assumes an iso-elastic inverse demand curve of the form P =

Q, , where P is the average price (line rental plus usage) per minute and Q is the
total number of minutes of use.  is a constant which is estimated by calibrating the
demand curve to 1995 gures: P1995 = US$0.55 per minute; Q1995 = 1.025 billion
minutes (see [16]).  is the reciprocal of the price elasticity of demand. The following
caveat must be applied to this result: the deadweight loss estimate assumes that,
if there are increasing returns to scale in the telephone network (as seems likely,
especially at the local level), then the market inverse demand curve meets the long-
run average cost curve to the right of the minimum ecient scale i.e. that demand
for international calls is suciently large.
9 For U.K. accounting rates, see the Oftel Web document at
http://www.oftel.gov.uk/feedback/interac1.htm.
10 See [12] for an analysis of the relationship between accounting rates and G.D.P..

6
 Fig. 3. Outgoing and Incoming International Trac for the U.S.
against year on the horizontal axis). As a result, the U.S. incurred a total
net settlement decit with the rest of the world in 1995 of US$5 billion {
US$876 million with Mexico alone (see [24]). In 1996, the FCC stated that
\U.S. industry and consumers can no longer be required to bear the burden of
above-cost accounting rate payments to foreign carriers" ([15], p. 9). In 1997,
the Commission unilaterally announced benchmark settlement rates, eective
from 1st January 1998, which are considerably lower than bilaterally agreed
levels (see [17]).
The nal source of pressure on the international accounting rate system is
the many alternative calling procedures that have emerged recently. These
procedures fall into two general groups { those that use the PSTN, and those
that do not. The rst, PSTN-based group of procedures do not bypass the
international accounting rate system; instead, they arbitrage dierences in
accounting or collection rates between countries. For example, the accounting
rate between the U.S. and Spain in 1995 (for international direct dial calls) was
US$0.80 per minute; between the U.K. and Spain, US$0.283 per minute; and
between the U.K. and the U.S., US$0.168 per minute. In this case, a carrier
transporting an international call originating in the U.S. and terminating in
Spain will incur a settlement charge of US$0.40 per minute (half the accounting
rate) if the call is routed directly; or US$0.225 per minute if the call is routed
via the U.K.. 11 This procedure is known as rele. Other procedures arbitrage
11The latter route takes advantage of the low accounting rate between the U.K. and
the U.S., and the TEUREM-negotiated rate between the two European countries,
the U.K. and Spain.

7
dierences in collection rates by allowing calls eectively originated in a high
collection rate country to be billed in a low collection rate country; call-back
is an example of this. See [34] for a review.
The second group of procedures routes trac over networks other than the
PSTN, and hence avoid accounting rate payments altogether. The next section
discusses two major examples of such procedures { telephony over the Internet,
and resale.

3 Internet Telephony

Why should PTOs fear Internet telephony? The standard response is because
it is cheap. There are three reasons for this belief. The rst is that Internet tele-
phony avoids regulatory charges which are imposed on the PSTN. Secondly,
current pricing practices make Internet telephony eectively free at the mar-
gin. Finally, the technology employed by the Internet is such that savings may
be gained in transmission costs. This section starts by reviewing what is meant
by `Internet telephony', and how it works. It then considers the regulation,
pricing and cost of Internet telephony.

3.1 A Classication of Internet Telephony

In this paper, `Internet telephony' will be dened as any communication which

is carried, for some portion of its journey, over a packet switched network
using the Internet Protocol (IP), which could have been carried over a circuit
switched network (e.g. the public switched telephony network, or PSTN). 12
Three classes of Internet telephony can be distinguished. 13 Class 1 is `phone-
to-`phone, using a packet switched network as the main transport medium. 14
For example, trac may originate and terminate on the PSTN, with the
middle portion being carried over the Internet. Class 2 is computer-to-`phone,
with a gateway eecting compatibility between the packet switched and circuit
switched networks. Finally, Class 3 is computer-to-computer telephony over a
packet switched network. (Class 0 is `phone-to-`phone over the PSTN.) The
classes are summarised in table 1. In order to assess the relative importance
12 More specic denitions are possible. For example, attention could be conned
to two-way voice communication. The value of using the broad denition is that it
allows a wider assessment of the impact of the Internet on the PSTN.
13 The following classication was developed by David Clark at M.I.T..
14 The term \phone" is a short-hand which includes xed link and mobile telephones

and faxes { essentially any communication device connected directly to the PSTN.

8
Table 1
Classes of Internet Telephony
Class Description
0 Phone-to-phone over PSTN
1 Phone-to-phone over PSTN/Internet/PSTN
2 Computer-to-phone over Internet/PSTN
3 Computer-to-computer over Internet
of the classes, consider the potential number of users. The number of Internet
hosts stood at 16 million at the beginning of 1997, and is forecast to grow to
250 million by 2001 (see [8]); the number of xed and mobile telephones and
faxes is currently around 800 million, and set to increase to over 1000 million
by 2001 ([24]). In terms of sheer numbers, therefore, currently class 1 Internet
telephony oers the greatest market opportunity; but classes 2 and 3 will grow
in importance. The evolution of Internet telephony is such that, technically,
class 3 is most developed (with the rst commercial client introduced by Vo-
calTec in 1995), followed by class 2 (rst oered commercially in 1996), and
nally class 1 (commercial oerings emerging in 1997).
Internet telephony converts the voice from analogue signals to a series of di-
gits, bundles the data into packets (perhaps compressing silences to save on
bandwidth), and transmits the packets over the Internet (or some other packet
switched network). For class 3 Internet telephony, with both computers linked
directly to the Internet, voice packets travel entirely over a packet switched
network. In classes 1 and 2, data travel over circuit and packet switched net-
works. In these cases, a gateway is required to eect compatibility between
the two networks.
The technical details of Internet telephony have important economic implica-
tions. 15 First, packet switching permits statistical sharing of communication
lines. In contrast, the circuit switched PSTN reserves a xed share of network
resources for each call, regardless of the amount of data being transmitted at
any point in time. Consequently, the transport cost per bit of information is
lower over packet switched networks. Secondly, IP implements dynamic rout-
ing, so that packets from the same call can arrive at their destination via many
dierent routes. In contrast, circuit switching sets up a single route for the
duration of a call. 16 Thirdly, with current technology, Internet packets are
accepted on a `best eort' basis; packets may be delayed or lost. In contrast,
15 See [24], chapter 4, for further discussion of the technology of Internet telephony.
16 The Transmission Control Protocol (TCP), which many Internet applications
overlay on IP, is connection-oriented. Most voice Internet telephony software cur-
rently uses, however, the User Datagram Protocol (UDP) rather than TCP; UDP
is connection-less.

9
the dedicated line set up by a circuit switched network permits delay and loss
guarantees. Finally, current Internet protocols are non-isochronous: packets
need not arrive at their destination in the same order as they were transmit-
ted from their source (this is a consequence of the connection-less nature of
the Internet Protocol). With circuit switching, data bits arrive in the correct
sequence. 17
In short, packet switched networks are best suited to `elastic' trac (a term
coined by Shenker), where features such as delay are less critical. In this case,
transmission costs may be lower due to multiplexing (see section 3.4 for further
discussion). Packet switched networks are less well-adapted to inelastic, real-
time trac, where delay and the sequence of arriving bits are important. 18

3.2 Regulatory Charges and Internet Telephony

Internet telephony avoids regulatory charges which are imposed on the PSTN;
in particular, it bypasses the international accounting rate system. 19 An Inter-
net service provider (ISP) in one country pays at most a national interconnect
payment plus the local call charge when delivering trac for termination in a
foreign country. The ISP is not liable to pay a settlement charge to the PTO
of the foreign country. Since the settlement payment accounts for 75% of the
price of international calls on some routes, this means that Internet telephony
has a considerable price advantage over PSTN-routed international telephony.
Internet telephony is not the only technology, however, that bypasses the in-
ternational accounting rate system. Resale also avoids settlement payments;
and in other respects, it is equivalent to Internet telephony. In resale, a car-
rier leases an international circuit for transporting trac, rather than owning
17 TCP over IP resequences packets to ensure an isochronous connection. UDP does

not resequence.
18 Protocols are emerging to deal with these technical limitations of Internet tele-

phony. For example, the Real Time Protocol (RTP) deals with the isochronology
issue. The Resource Reservation Protocol (RSVP) allows a host \to request spe-
cic qualities of service from the network for particular application data streams or
ows". See [24] and [5].
19 In addition, Internet telephony operators may not be liable to payments to PTOs

to cover universal service obligations or access decits. In the U.S., ISPs are deemed
to be `enhanced service providers', and consequently avoid the local access charge
which is imposed on long-distance telephony carriers. This charge amounts to ap-
proximately US$0.03 per minute, which is signicant compared to the low marginal
cost of long-distance telephony. In Europe, current interpretation of E.U. regulation
(the 1990 Services Directive) does not consider Internet telephony to be `voice tele-
phony', and so ISPs conveying voice over the Internet are not required to contribute
to universal service obligations; see [8].

10
its own facility. 20 Settlement payments are not due to services provided over
leased lines. In principle, this allows resellers to price below PTOs; for ex-
ample, the price of ISR (a form of resale { see below) between the U.K. and
the U.S. in 1995 was around US$0.24 per minute ([34]), compared to the Brit-
ish Telecom collection rate of US$0.55 per minute. 21 Resale trac which does
not break out onto the PSTN at either the origination or termination end (i.e.
a private network, such as a corporate intranet) is analogous to class 3 Internet
telephony. One-end resale, in which there is break-out at one end, is equivalent
to class 2 telephony. International simple resale (ISR) has break-out at both
ends, and is therefore very similar to class 1 Internet telephony.

There are two important dierences, however, between resale and Internet
telephony. First, resale oers a much closer substitute than Internet telephony
for existing PSTN services. Internet telephony requires the user to be satis-
ed with the performance characteristics (in terms of delay and loss of data)
of packet switched networks. Resale allows international trac to bypass the
accounting rate system while remaining on a circuit switched network. Resale
should therefore oer greater competitive pressure on the PSTN settlement
system. (See section 4 for further discussion of competition between networks.)
Secondly, resale is easier to regulate than Internet telephony. Currently, there
are extensive regulatory restrictions on both. Resale for voice trac is al-
lowed only by Australia, Canada, Sweden, the U.K. and the U.S. to specied
countries (see [34]). 22 A third of OECD countries have banned class 1 and 2
Internet telephony, reserving voice telephony for commercial purposes to the
domestic PTO. 17% of countries allow only qualied operation of commercial
Internet voice telephony. 23 But eective regulation of Internet telephony is
problematic, since it is dicult to distinguish voice from other forms of data.
And even if voice telephony from one source can be regulated, it is a simple
matter to re-route on the Internet. Finally, restriction of Internet telephony
may con ict with other policy objectives, such as encouraging growth of the
Internet. See [34], [8] and [45].

20 See [34] for a detailed discussion of resale, and other technologies.

21 Note that only 60% of the dierence between the ISR price and the B.T. collection
rate is due to bypass of the accounting rate.
22 For example, Oftel allows ISR for voice and data trac to and from the U.K.

and Australia, Canada, Finland, New Zealand, Sweden and the U.S.. ISR for data
trac is allowed to and from all countries in the European Economic Area. See [35].
23 Figures are taken from a presentation by Sam Paltridge, OECD, given

at the Spring `97 VON conference. Copies of slides can be obtained at

http://www.oecd.org/dsti/sti ict.html.

11
3.3 The Price of Internet Telephony

The current pricing structure of Internet services is such that most users face
a marginal usage price of zero (neglecting, for the moment, charges that may
arise e.g. from use of the PSTN to gain access to the Internet). The emer-
ging market consensus for dial-up access to the Internet is a at-rate pricing
structure { unlimited access (provided a connection to the ISP can be estab-
lished) for a xed monthly fee. 24 Leased-line access is charged according to
the capacity of the line.
This pricing structure to the end-user is supported by the peering arrange-
ments between ISPs and backbone providers (see [40]). Until recently, all ISPs
operated on a `bill-and-keep' system, where no settlement payments were
made. Each network carried others' trac without charge { the underlying
assumption being that ows were roughly symmetric (and that any other ar-
rangement would stunt the growth of the Internet). Large increases in trac
volumes combined with unequal development of networks have, however, put
this system under considerable stress. Network access contracts are beginning
to be established, whereby networks make payments to each other based on the
size and capacity of the connection (e.g. UUNet's decision to charge smaller
networks for connection.) At no point are charges made on the actual volume
of trac.
Overall, therefore, a class 3 (computer-to-computer) Internet telephone call
does not incur, in most cases, a marginal charge beyond the price of a local
call to the ISP (and in several countries, even this is either zero or time-
invariant). 25 But this will not be the case for class 1 and 2 calls { these incur
a variable charge from the gateway provider. The market for these services is
still too young for a pricing standard to have emerged. Early indications are,
however, that the usage (or marginal) price of an international Internet call
(of any class) is signicantly below the usage price of the same call made over
the PSTN. 26
This at-rate pricing structure for Internet usage almost certainly has been
one of the main drivers of congestion on the Internet. The underlying economic
problem is an old one, known as `the tragedy of the commons', a termed coined
24 This convention is more rmly established in the U.S.; in Europe, some ISPs
charge hourly rates after a certain number of hours of access.
25 But note that this portion of the price of Internet access can be signicant. In

e.g. Britain, France and Italy, charges from the PSTN account for more than 80%
of the cost of peak-rate Internet access; see [34].
26 For example, the Deutsche Telekom Internet telephony trial, which oers class

1 telephony, charges less than 20% of the regular (i.e. PSTN-based) price of an
international call between Germany and the U.S..

12
by [23] in his seminal article on the optimal use of grazing land. Users of any
common and freely-accessed resource have a tendency to over-exploit: each
will use the resource until the private (marginal) cost of doing so equals the
private (marginal) benet, ignoring the social consequences of their actions.
The potential for a tragedy on the Internet has long been recognised, and
many pricing schemes have been proposed to combat the problem of rising
congestion. A full survey is not possible, given the number of proposals; but
see, for example, [9,21,27,32] for theoretical papers; and [6] for a discussion of
New Zealand's experience of Internet charging, and [10] for a trial implement-
ation of proportionally fair pricing scheme of [28] . This set of papers attacks
two problems. First, what is the theoretically correct way of charging for use
of a congestible resource? Secondly, how would such a scheme be implemented,
given the costs of accounting and billing for packet-based trac (which may
be large)? The proposals dier considerably in their detail; but common to
all is the recognition that, at least in times of congestion, Internet users must
face a marginal usage price which is greater than zero.
The feasibility of telephony over the Internet will be determined by the levels
of congestion. In turn, congestion will depend on capacity and trac volumes.
Ultimately, both of these latter factors rely on pricing { to generate revenues
to invest in capacity, and to control use of network resources. For these reas-
ons, at-rate pricing for Internet telephony will be replaced by some form of
congestion pricing; in short, Internet telephony will be priced more like PSTN
telephony. How quickly this will happen will depend on the speed at which
the practical problems of Internet pricing are solved.

3.4 The Costs of Internet Telephony

A third potential source of advantage for Internet telephony is the intrinsic

cost of data transport over packet switched versus circuit switched networks.
There is an immediate diculty, however, in comparing the correct costs when
assessing telephony over the Internet and the PSTN. Short-run costs (i.e.
costs with current capacity xed) are relatively straightforward to calculate.
But economic theory says that the relevant measure is long-run incremental
costs (LRIC): the additional costs that are incurred by carrying an extra unit
of trac, over a period long enough that all costs are variable or avoidable.
The cost gure quoted for an international call over the PSTN in section 2.1
(US$0.0857 per minute) is calculated on such a basis. The gures for Internet
telephony in this section are not, since it is impossible to collect reliable estim-
ates from the thousands of dierent networks, many privately owned, which
comprise the Internet. The gures presented here are best interpreted as an
approximation of the short-run average cost (SRAC) of Internet telephony.

13
There are three main elements of Internet telephony costs: the cost of con-
necting to the Internet, the cost of providing additional network capacity, and
the (social) cost of congestion. Congestion costs are negligible while the load
on the network is less than capacity, but rise steeply as capacity is reached.
There are few estimates of congestion costs, although indications are that they
are large. For example, [21] calculate (in a calibrated simulation model) that
delay in the U.S. Internet cost US$2 billion in 1997. 27 In the absence of a
more reliable gure, congestion costs will not be considered further.
An estimate of the rst two cost categories can be obtained from current mar-
ket prices of Internet services, combined with cost gures published by the
FCC in the U.S.. A study of the cost structure of an Internet access pro-
vider (IAP) 28 estimates costs to an IAP of US$0.0206 (for class 3 telephony,
computer-to-computer) and US$ 0.0294 (for class 1 telephony). These costs
have three components: local line and switching to connect the IAP to users
(on one side) and an upstream Internet service provider (ISP, on the other
side); the charge made by the ISP; and IAP operations. 29 The local line costs
do not include elements connecting users to the central oce; and so these
must be added in. The FCC reports the (total element long-run incremental)
cost of this as between US$0.0165 and US$0.0296 per minute. 30 This implies
that the combined costs of connecting to the Internet plus the provision of net-
work capacity for a complete international Internet telephone call are between
US$ 0.0832 and US$ 0.0920 per minute.
Finally, it is worthwhile to check these estimates against others that have
been conducted. Few studies are made public. A notable exception is the
estimate of costs presented at the Fall VON 97 conference by Joe Rinde,

27 Their estimate is a short-run cost, since they keep the capacity of their simulated
network xed.
28 The study was conducted by students at M.I.T. as a response to the ACTA

petition to the FCC that Internet service providers be subject to the local access
charge in the U.S.. Their paper and modelling appendices can be obtained on the
Web at URL http://itel.mit.edu/docs/ACTA/TPP91.HTM.
29 The ISP charge is assumed to include the cost of e.g. backbone capacity. If this

assumption is not reasonable, then backbone costs must be added. The total cost
of sending a packet over the Internet backbone (using TCP/IP) has been estimated
by [33] as US$0.000017. The average cost of the NSFNET backbone in 1993 was
about US$1 million per month, while the average trac level was 60 billion packets
per month. This implies that the backbone cost of a voice conversation is US$0.005
per minute (the average packet is 1600 bits; the bandwidth of the PSTN is 64 kbits
per second, but silence compression can reduce this to 8 kbps).
30 See FCC, http://www.fcc.gov/ccb/local competition/sec7.html for the

denition and estimates of costs.

14
Table 2
Rinde's Estimates of the Capital Costs of Telephony
Component Cost
Circuit Switched
Switches 0.00034
Transport 0.01440
Total 0.01474
Packet Switched
Gateways 0.00876
Routers/ATM Switches 0.00006
Transport 0.00644
Total 0.01526
director of switched network architecture at MCI. 31 Rinde's estimates are as
yet provisional, and there is some discussion about both the assumptions that
he uses and the detailed mechanics of his calculations. He himself has revised
his gures once; the calculations presented here make further adjustments
to correct for arithmetic errors in the spreadsheet. Rinde sets up two model
networks, one circuit switched, the other packet switched, to estimate the
capital cost of a voice call over a 2,000 mile distance in the U.S.. Rinde's cost
estimates are presented in table 2. (Note that the calculations do not include
the access network { the costs are for the long-distance portion only.) The table
shows that the capital costs of a call are around US$ 0.015 per call minute.
This is lower than any of the gures presented above, which lay in the range
US$ 0.02{0.03. This reason for this may be that Rinde's costs do not include
operating and common costs of the network. The gures conrm the general
conclusion, however, that there is little, if any, cost advantage for Internet
telephony. Indeed, the version of his estimates presented in this section show
that circuit switched telephony is around 3% cheaper.
These estimates suggest a modest cost advantage { at most 3%, perhaps sig-
nicantly less { for telephony over the Internet. There are several reasons why
the cost advantage is not larger. First, the cost estimates for Internet tele-
phony are not true costs, but include some elements which are actually prices
(e.g. the ISP charge); this may bias the estimate upwards (depending on the
extent of price mark-up by ISPs). More importantly, the small dierence in
the costs of Internet and PSTN telephony is a re ection of the cost structure
31Copies of the spreadsheet containing Rinde's calculations are available from the
URL http://www.pulver.com/downloads/, or from the author of this paper on
request.

15
of a traditional telecommunication network. Around 60% of the total cost of
a telecoms network are line driven i.e. are independent of the levels of trac
carried by the network; up to 75% of total costs relate to the local loop (the
last ten miles to the user). 32 There is, therefore, a large common compon-
ent in the costs of a PSTN and Internet call, and hence a limit to the cost
advantage of Internet telephony.
One nal factor is central to the comparison of Internet and PSTN telephony.
The discussion of costs so far has failed to consider quality. The Internet
currently operates on a `best eort' basis { it oers no guarantees on delay
or loss of packets. This may be a satisfactory arrangement for elastic trac;
and so, from the user's perspective, packet and circuit switched networks oer
comparable service quality. Internet and PSTN telephony costs can therefore
be compared directly for this type of trac. For inelastic trac, however,
delay and loss guarantees must be provided. The cost of the RSVP and RTP
protocols that provide these guarantees for Internet telephony relate to the
additional network capacity that they demand. There are few indications of
the extra capacity that will be needed, since these protocols have yet to be
implemented on a signicant scale. (The estimates given above do not include
these costs.) The intrinsic cost advantage of packet switched networks for
inelastic trac is therefore uncertain.

3.5 Summary

This section has presented the empirical detail { operation, regulation, pricing
and cost { of Internet telephony. The discussion can be summarised by the
following points:
(1) Internet telephony is best-suited to elastic trac; circuit switched net-
works are preferable for inelastic trac.
(2) Internet telephony avoids many of the regulatory charges that are present
on the PSTN. There are, however, some attempts to regulate telephony
over the Internet.
(3) The current at-rate pricing structure for Internet usage will need to be
revised if congestion on the Internet is to be managed. Charging for Inter-
net telephony currently is at rate; PSTN pricing has non-zero marginal
prices.
32 These estimates, supplied by Graham Louth of Analysys, relate to British carriers
and residential connection. Industry sources suggest that the corresponding gures
for U.S. carriers are, on average, around 70% and up to 80%; but that there is more
variation between telcos in the U.S.. Commercial connection will have somewhat
lower costs; but the broad conclusion still holds.

16
(4) The cost structures of Internet and PSTN telephony are similar, since
they have large common costs (due to the local loop).
These points suggest an answer to the question: will Internet telephony be the
`killer app' that nishes o the international accounting rate system? That
answer is: no. Consider telephony over the Internet, and telephony over resold
capacity. The two have similar costs; they will soon have similar pricing (once
congestion pricing is introduced on the Internet). Both avoid international set-
tlement payments. Resale oers, however, the closer substitute for telephony
over the PSTN. All of these factors point to other arbitrage mechanisms (such
as resale) being more central to the downfall of the international system.
The remaining question, therefore, is whether Internet telephony is destined
to remain a niche product, in the medium- to long-term; or whether it will
meet some of the more spectacular growth forecasts. To answer this question,
the fundamental drivers of Internet telephony growth must be identied and
assessed. The discussion so far has concentrated on four { quality, regulation,
cost and price. Others may also be important; for example, the network bene-
ts of integrating voice and data trac onto a single network; or the additional
functionality of interfaces on packet based networks. A full analysis is beyond
the scope of this paper; but the next section will attempt to make a start
on the task. It ignores factors such as network benets and functionality, and
concentrates on the outcome of price competition between two networks (such
as the Internet and the PSTN). The question that it seeks to address is: will
competing networks oer similar services, or will they dierentiate? Put more
simply: what competitive pressure will the Internet exert on PSTN telephony
in the long-run?

4 Competition between Networks

A standard economic model of competition is that of pure price, or Bertrand.

In this model, two similar rms sell the same single good to consumers. Each
rm is prepared to serve the entire market demand, which it will do in the
event that it charges a lower price for the good than its rival. It is easy to
see that, in this situation, competition between the rms will drive the price
down to cost; 33 see e.g. [44].
This model omits, however, two aspects which are key to competition between
networks: `network externalities' and congestion. A user's valuation of a net-
33If the rms are identical, then price is driven down to their common cost; if the
rms dier in their costs, the price is set just below the cost level of the higher-cost
rm.

17
work has (at least) three components. First, there is the intrinsic benet gained
from using the networked good. 34 Secondly, there is the benet gained from
having others connected to the same network (there is far higher benet to
be gained from a telephone if you are not the only owner of a `phone). Fi-
nally, there are the dis-benets experienced when levels of network use are
large compared to the capacity of the network. (On circuit switched networks,
it may be dicult to obtain a dial-tone when congestion occurs; on packet
switched networks, delay and loss are more likely as congestion increases.)
Competition between the networks should not, therefore, be viewed as in-
volving a single, homogeneous good. Rather, the price of e.g. an international
call will be only one factor in determining the choice of network by users.
The basic Bertrand model must be extended to incorporate the other features
identied in the previous section which are important for competition between
networks. This section will concentrate on the eect of congestion for equilib-
rium between networks. (A more formal analysis can be found in [20]. Other
aspects have been analysed extensively elsewhere; for example, the eect of
positive network externalities has been analysed by, amongst others, [25,26],
and [13,14].

4.1 The Eect of Congestion

In the Bertrand model, the rm that oers the lowest price wins the entire
market. The underlying assumption is that the competing rms do not face
any constraints on production capacity. If there are capacity constraints, then
competition between the rms is limited and price can be maintained above
cost. See [29] for the original argument, [43] for a simplied exposition, and
[3] for an extension dealing with the case in which price adjustments can be
made more often than capacity changes.
The relevance of this point to telephony is clear. In 1994 (the last year for which
there are reliable trac statistics for the Internet), PSTN trac volume from
the U.K. to the U.S. was ten times the level of Internet trac. 35 At historical
34 For communication networks, this intrinsic benet is generally low (compared
to the other components) { there is little utility simply from having a telephone,
without having anyone to call. But for e.g. sports clubs, the intrinsic benet may be
large (pleasure can be gained from a round of golf, say, without having an opponent).
35 The NSFNET recorded total trac originating in the U.K. of 1.6x107 megabits.

(This is the trac recorded by the portion of the ANSNet backbone that received
direct NSFNET sponsorship. This accounts for at least 95% of trac; see Merit's
Web page http://www.merit.edu.) The F.C.C. states that U.K.-U.S. trac was
906 million minutes. The bandwidth of the PSTN is 64 kbps. With a feasible com-
pression ratio of 8:1, this gives a data volume of 3.8x108 Mb.

18
growth rates, Internet trac should have overtaken PSTN trac on this route
during 1997. 36 Any signicant switch of trac would, therefore, represent a
considerable increase in volume (and hence congestion) on the Internet. This
suggests that capacity constraints may be signicant in the short-run. For
example, Vint Cerf has stated
\I do not see these (Internet telephony products) as major threats and the
reason I don't yet, anyway, is that the Internet cannot carry a great deal of
trac yet." [34], p. 75.
There is, however, considerable excess capacity in international circuits { the
F.C.C. reports that 24% of total U.S. capacity was idle in 1996 (see [18]), while
the ITU estimates the capacity utilisation of submarine bre-optic cables to
be less than 20% and declining (see [34]). This means that the short-run may
be very short indeed.
In the medium- to long-run, of course, Internet capacity will expand and the
constraint may slacken. But even in this case, competition will not necessarily
drive network prots to zero. There are two reasons for this. First, the congest-
ibility of networks limits the degree of competition. To see this, consider two
networks charging the same (total) price and having the same capacity. The
logic of Bertrand competition states that, if the networks are earning positive
prots in this case, then each has a strict incentive to lower its price and gain
the entire market from its rival. The process of undercutting continues until
prots are driven to zero. With a network of xed capacity, however, a price
cut is not enough to attract all users from the rival rm. As users migrate
to the lower price network, the level of congestion of that network rises until
eventually, users no longer wish to join. Instead of gaining the entire market,
the undercutting network gains only a fraction. As a result, price is not driven
down all the way to cost; and networks earn positive prots in equilibrium,
even when charging the same price and having equal capacities.
A second factor contributes to the limit on competition between networks.
Users have a variety of preferences for the level of congestion on the net-
work. Those whose trac is inelastic (e.g. voice telephony) will attach a large,
negative value to congestion. Users with elastic trac (e.g. fax and e-mail)
will also value congestion negatively, but to a lesser extent. In the absence of
congestion eects, it is well-established that rms faced with heterogeneous
consumers will oer products of dierent qualities in order to decrease the ex-
tent of competition that they face; see [43] and [19]. A similar result appears
to hold with congestible networks: competition leads rms to choose dierent
prices and (perhaps) capacities in an attempt to dierentiate themselves from
36The Merit and F.C.C. data show annual growth rates in Internet and PSTN
trac on the U.K.-U.S. route of 317% (over the period 1988-1994) and 14.6%. (over
the period 1980-1995).

19
their rivals. See [31] for an early result, and [36] and [37] for more recent devel-
opments of the theory. 37 An important conclusion from this research is that
(in general) the higher quality (less congested) network charges a higher price,
has greater capacity, and earns larger prots than its lower quality rival; see
[37] and [30]. If two networks enter a market simultaneously, then each will
try to become the high quality provider. If one network is established in the
market, then it is likely that it will occupy the high quality niche; see [30].

4.2 Summary

The purpose of this section has been to argue that competition between the
Internet and the PSTN for telephony trac is more complicated than simply
\the network with the lower price wins". All-out price competition is con-
strained in the short-run by limited capacity. In the medium- and long-run
(where capacity is more exible), variation in user preferences may lead net-
works to dierentiate.
These factors suggest that the Internet will play some role (where permitted)
in competing with the PSTN for telephony trac. That role is unlikely to
be as a head-to-head competitor: network owners will earn greater prots
if they dierentiate their service oerings. Some networks will specialise in
transporting elastic trac; these networks will charge lower prices and/or have
smaller capacities. Other networks { such as the PSTN { will carry inelastic
trac, charging higher prices and providing greater capacity. It is important
to note that, even in this scenario (which is less extreme than the all-out war
between the Internet and PSTN predicted by some), there may be a signicant
switch of trac from the PSTN to the Internet. For example, fax trac, which
could account for as much as 30% by volume of international calls over the
PSTN ([41]), 38 is already switching to the Internet.

5 Conclusions

The international accounting rate system grew up in an era when telephony

was the preserve of national monopolies. Changes in regulation and compet-
ition, and advances in technology mean that the system is under increasing
37 There is some confusion in the literature, however, as to the exact conditions

under which congestible networks will dierentiate, and whether prices alone, or
both prices and capacities will be used to dierentiate. These questions are the
subject of on-going research; see [20].
38 The [16] reports that industry sources estimate that fax trac accounts for almost

half of the calls between the United States and Japan.

20
pressure. Internet telephony is just one factor contributing to this pressure.
Others are likely to prove more important to the downfall of the system. For
example, resale, like Internet telephony, allows bypass of settlement payments.
But it is a closer substitute than Internet telephony for existing telephony ser-
vices, and should therefore oer greater competitive pressure on the accounting
rate system. This does not mean that Internet telephony has a limited future.
Undoubtedly, Internet telephony will grow (although probably not as much as
its most ardent advocates forecast). International settlement payments, and
continued regulation of technologies such as resale, will cause directly some
trac to migrate from the PSTN to the Internet; fax (and other elastic trac)
is the leading case. But it is unlikely that Internet telephony, on its own, will
be responsible for the end of the behemoth of international settlements. The
capacity and quality issues which currently plague Internet telephony will be
solved in time. By then, however, other competitive pressures will have put
paid to the current distortionary system.

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24