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Why would the operators of websites like,, and route phone calls to their services through rural American towns like Riceville, Iowa? To take advantage of complicated telecommunications regulations and make a bundle of money from American consumers of long-distance telephone calls.

The Federal Communications Commission regulates the fees that local telephone carriers can charge long-distance carriers for calls originating from the long-distance carrier's network. The local carriers initiate the process of setting those rates by filing schedules of rates with the FCC. The FCC, in turn, evaluates the proposed rates to ensure that local carriers receive a "reasonable" rate of return based on projected costs and projected volume of calls routed through the local carriers' networks.

The operators of sex chat lines, conference bridges, and other high call volume operations make millions of dollars in profits through a form of regulatory arbitrage. Website operators advertised the services over the Internet as free or as limited to the cost of the long distance call and contracted with local wire-line phone carriers to provide the services and split the revenues created by the increased call traffic. The federally mandated rates that the local carriers could charge were based on historically low levels of cost and call volume, so the rates were set by FCC regulators at relatively high levels per minute of access. When the call volume increased dramatically, the local carriers extracted huge payments from the long-distance carriers. The local carriers then split the payments with the Internet-based application providers through private contractual arrangements.

For example, when a long-distance customer of Verizon placed a "free" call to an Internet-based service like Male Box (an "all male, all gay" chat line), the call was routed through the switching equipment of a carrier like Farmers Telephone of Riceville, Iowa. Farmers Telephone then charged Verizon to connect the call on a per-minute basis at inflated rates set by FCC regulators. Farmers Telephone then split the profits with the operator of Male Box.

COSTS The profits generated by this regulatory arbitrage came from the pockets of all long-distance customers. FCC regulations prevent long-distance phone carriers from passing access charges back to the customers who place the calls, forcing the long-distance carriers to distribute the charges among all of their customers. Thus, in the example above, all Verizon long-distance customers would have paid artificially higher rates to pay for the calls to the Internet-based services.

This type of call traffic stimulation is socially wasteful for two reasons. First, it induces the owners of calling services to locate their equipment in the local carrier's service area solely in order to collect high access charges even if it would be more efficient for those services to be located elsewhere. Second, it artificially inflates all long-distance users' rates by distributing the regulated cost of the calls to all long-distance customers instead of to the callers who actually made the calls.

Beyond artificially driving up demand for long-distance calls, the regulatory regime of intercarrier access charges imposes significant costs on consumers in the form of forgone benefits caused by the higher price of long-distance service. Consumer demand for long-distance service is very responsive to price changes. Thus, access charge regulations that inflate the price of long-distance service cause consumers to consume less long-distance service, generating significant reductions in consumer welfare. My Mercatus Center colleague Jerry Ellig estimated that, as of 2002, the cost of each $.01 interstate access charge reduced consumer welfare by $300 million.

SOLUTION The FCC could solve the problem of call traffic stimulation and help reduce the burden on consumers of the regulatory regime of interstate access charges through an approach that avoids additional regulation and allows market forces to work.

To solve the problem, the FCC could forbear, in situations where call traffic stimulation occurs, from enforcing regulations that prevent long-distance carriers from passing access charges on to the customers who made the calls. If the long-distance carrier passes the charge back to the customer placing the call, it creates an incentive for the caller to take into account the total cost of the call. Faced with a significant surcharge, customers of chat lines and conference services would likely switch to service providers that do not generate these surcharges. This would remove the profit incentive for service providers to team up with local carriers that impose high access charges, effectively eliminating the incentive for call traffic stimulation.


This solution would end the practice of call traffic stimulation almost immediately. It would create a market incentive for the long-distance customer to avoid services that incur unreasonable access charges. It would also provide an incentive for the Internet-based service providers to fund their services through means other than access charges.

The rules that prevent itemized pass-through of access charges are intended to subsidize rural customers at the expense of urban customers by forcing the long-distance carrier to average charges across all customers. Ideally, the subsidization of rural telephone customers would be funded through direct payments from general tax revenues, as those payments would be more transparent, allowing for a more informed political debate on the costs and tradeoffs of the policy. In addition, a direct funding mechanism would have much less distortionary effects on people's behavior. However, this approach would require Congress to overhaul completely the way that the federal government subsidizes rural phone customers and is unlikely to be politically viable at this time.

Regardless of the way in which rural phone customers are subsidized, the practice of call traffic stimulation does not reduce their rates. Rather, it merely transfers wealth to the local carriers, third party service providers, and possibly the users of the services. Regulations that have the effect of subsidizing another customer's use of chat lines, conference services, and other services that are traditionally used to stimulate call traffic demand do not contribute to the policy's goals.

Another way the FCC could solve the problem of call traffic stimulation would be to forbear from enforcing regulations that force long-distance carriers to interconnect at mandated rates when the long-distance carrier has evidence that the local carrier is improperly stimulating increased demand. If the FCC did not enforce the mandatory interconnection rules in this circumstance, the long-distance carrier could simply refuse to connect its customers with the local carrier that is engaging in the practice.

Critics of this market-oriented approach might argue that the long-distance carrier could improperly cut off calls to customers of local carriers in order to avoid paying access charges. However, market competition would limit this option. For example, Verizon would be constrained from improperly cutting off calls because it would risk losing customers to another long-distance carrier, like AT&T, that allows access to customers of the local carriers in question. Since access charges would still be regulated, forbearance by the FCC would not give long-distance carriers the opportunity to cut off calls simply as a ploy to negotiate lower access charges across the board.

The local carriers themselves would have an immediate incentive to stop the practice of call traffic stimulation since they could lose customers to competing local carriers who offer access to other customers on other networks. Even if a local carrier in a rural area like Farmers Telephone faces little competition from wireless, satellite, Voice over Internet Protocol, and other wire-line providers, it would still have an incentive to stop the practice of call traffic stimulation because the alternative would be to lose all long-distance revenue.

If the FCC were to choose either of these approaches to address the problem of call traffic stimulation, market forces would end this wasteful practice. No longer would clever operators of Internet-based services be able to team up with the owners of local telephone carriers to fleece American consumers by taking advantage of a flawed system of regulation.


Mercatus Center

Christopher Hixon is associate director of the Regulatory Studies Program at the Mercatus Center at George Mason University.
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Title Annotation:BRIEFLY NOTED
Author:Hixon, Christopher
Date:Mar 22, 2008
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