This paper assesses the private and social incentives for disjoint networks to interconnect under various ownership structures. Terms of interconnection are derived for a noncooperative equilibrium. We find that networks mutually profit from interconnection when it creates new services that did not exist beforehand, but also when it creates services that compete directly with existing ones. Given the opportunity to move first, an integrated network will choose not to foreclose its non-integrated rivals. Generally we find that when two or more networks contribute components to a service, double marginalization reduces industry profit and consumer surplus. For this reason, divestiture often harms consumers as well as lowering network profits. Competitive supply of gateway services reduces profit and surplus, but individual networks profit by selling off these facilities to a third party. In contrast, an integrated network will not voluntarily divest its end-to-end service. Compulsory divestiture may inflict serious harm, not only on owners of the integrated network, but on consumers as well.

* We thank Neil Gandal, Nancy Gallini, Gerard Gaudet, Rob Masson, Frank Mathewson, Roy Radner, Mike Riordan, Mike Waldman, Roger Ware, Larry White, and participants at the 20th Telecommunications Policy Research Conference and at seminars at Cornell, NYU, Queen's University, Universite de Quebec at Montreal and University of Toronto for their comments and suggestions. The views of the authors do not reflect the position of GTE Corporation or any of its subsidiaries.

Address beginning December 1, 1992: University-wide Energy Research Group, University of California, 2539 Channing Way, Berkeley, CA 94720.

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