Review of Industrial Organization 22: 27–46, 2003. © 2003 Kluwer Academic Publishers. Printed in the Netherlands. 27 Asymmetric Network Interconnection ⋆ MICHAEL CARTER and JULIAN WRIGHT ⋆⋆ University of Canterbury and University of Auckland Abstract. We develop a model of competition between interconnected networks, that allows for carriers to differ in size. Under two-part pricing, we show that because of asymmetry the larger network will always prefer a reciprocal interconnection charge be set at cost. For sufficiently large asymmetry the smaller network will have the same preference. Under the assumptions of our model a particularly simple regulation is optimal – if carriers cannot agree on the terms of interconnection, the larger carrier is entitled to select the access price which is then applied reciprocally. Key words: Interconnection, networks, reciprocity, telecommunications. JEL Classifications: D41, K21, L41, L43, L51. I. Introduction Many countries around the world are engaged in deregulation of network in- dustries. Previous national monopolies are being privatized, regulatory oversight reduced and competition encouraged. One of the biggest challenges is achiev- ing competition in local telecommunications markets. Local telecommunications networks have in the past been viewed as natural monopolies, exhibiting net- work externalities on the demand side and economies of scale on the cost side. Duplication of the local loop is now feasible with new technologies. However, carriers require access to each other’s networks in order to compete. This need for interconnection raises concerns regarding anticompetitive behavior since in- terconnection requires cooperation between competing networks. These potential difficulties have stimulated research into the means of achieving effective compet- ition in local telecommunications markets. A key question is whether the need for interconnection undermines retail competition in a deregulated environment and what regulations are needed in this new environment. Some guidance to these questions is provided by the burgeoning literature on interconnection. This literature shares a common framework. Once the terms for in- terconnection are agreed, the competing networks play a standard Bertrand pricing game, where the consumers choose networks according to the Hotelling model of ⋆ We thank Mark Armstrong for helpful comments and Aaron Schiff for research assistance. ⋆⋆ Author for correspondence: Department of Economics, University of Auckland, Private Bag 92019, Auckland, New Zealand. E-mail: jk.wright@auckland.ac.nz