countryandneedsterminationservicesbytheothercarrier.Thatis,themonopolistsprovidecomplementaryinputstoeachotherandthereisnodirectcompetitionoverservicesubscriptions.Ifthetwocarrierssetsettlementratesnon-cooperatively,theequilibriumratesarealwaysabovethemarginalcostofprovidingtheterminationservice.Duetoastandarddouble-marginalizatione ect,consumersinbothcoun-triespayhighretailpricesforinternationaltelephoneservices.Anexplicitcollusionoversettlementratesmayactuallyreducetheratestowardmarginalcostsofpro-vidingaccess,whichinturndecreaseconsumerpricesinbothcountries.Whenareciprocityofthesettlementratesisimposed,themarginal-costbasedsettlementratecanbereachedifthetwocountriesaresymmetric.

Inmanycountries,competitionhasbeenrecentlyintroducedinthelongdistancetelephonemarkets.Carrierscompetenotonlyinretailpricesforinternationalcallsbutalsointerminationservicesforforeigncarriers.Whencompetingcarriersnego-tiatesettlementrateswithamonopolisticcarrierintheothercountry,thewelfaregainfromcompetitioncanbeo setbyin atedsettlementrates.In1987,theU.S.FederalCommunicationsCommissions(FCC)initiatedasetofregulatorypolicies,calledInternationalSettlementsPolicy(ISP),toguidesettlementnegotiations.TheISPconsistsofthreemajorcomponents.1)Uniformity:AllU.S.carriersmustpaythesamesettlementratefortheoutboundtra conthesameroute.Thisruleisdesignedtomakecompetingcarriersbehaveasasingleentitywhennegotiatingoverthesettlementrates.2)Reciprocity:AllU.S.carriersmustreceivethesamerateforterminatinginboundtra cfromaforeignmonopolisticcarrierastheratepaidforoutboundtra c.3)ProportionalReturnRule(PRR):Tra cfromaforeigncarrierisallocatedamongtheU.S.carriersinexactproportiontotheirsharesofoutboundtra cfromtheU.S.tothatcountry.Thatis,PRRallocatesincomingtra cbycarriers’retailmarketshares.

Inarecentpaper,Ju(2004)studiestheimpactofISPonthedeterminationofretailpricesandsettlementrates.HeillustratesthatPRRexertsadownwardpressureonretailpricesbecausedomesticcarriersarecompetingfortheinitiationofout owtra candthesettlementofin owthroughonestrategicvariable.UnderISP,whennegotiatingthesettlementratewithaforeignmonopolyprovider,domesticcompetingcarrierswouldindeedhavetheincentivetopayahighsettlementrateinordertoalleviatetheretailcompetition,asthelossattheretailsegmentcanbecompensatedbyforeignsettlementpayments.Fromasocialperspective,settlementrateabovemarginalcostrepresentsasocialcosttotheeconomy.Alowrateisdesirableforthecompetitivecountry,asitusuallyhasnetout ow.Thiscallsforthegovernmenttofurtherrestrictthecarriers’negotiationbyimposingaratecap.The