The current phone system relies on a reliable but largely inefficient method for connecting calls known as circuit switching. This technique, which has been used for over 100 years, means that when a call is made between two people, a connection is maintained in both directions between callers for the duration of the call. This dual directional characteristic gives the system the name circuit.

For example, you make a 30-minute call, the circuit will be continuously open and thus used between the two phones. Up until about 1960, this meant that every call had to have an actual dedicated wire connecting the two phones. This led to expensive long distance calls because you were paying for pieces of copper wire to be connected all the way from your phone to the destination phone, and for that connection to remain constant throughout the call.

Today, your analog call is converted after leaving your house to a digital signal, where your call can be combined with many others on a single fiber optic cable. While this system is certainly an improvement over the past copper wire system, it is still quite inefficient. This inefficiency is due in part to the fact that the telephone line cannot distinguish between useful talking and unneeded silences. For example, in a typical conversation while one person is talking and the other person is listening. Thus the current analog system uses roughly half its space sending useless messages like this silence. But there is also more information, even down to pauses in speech, which under a more efficient system can be effectively cut out rather than wasting the circuit space.

This idea of only transmitting the noisy bits of a telephone call and saving a great deal on circuit space is the basis of Packet-Switching, the alternative method to circuit switching, which the VoIP phone system uses.

Packet-Switching is the same method that you use when you view a website. For example, as you read http://www.abc.com, your computer is not maintaining a constant connection to the site, but rather making connections to send and receive information on an "as needed basis" (such as when you click on a link).
Just as this system allows the transfer of information over the Internet to work so quickly, it also works similarly in the VoIP system.

While circuit switching maintains a constant and open connection, Packet-Switching opens connections just long enough to send bits of data called packets from one computer to another. This allows the network to send your call (in packets) along the least congested and cheapest lines available, while also keeping your computer or IP phone free to send and receive messages and calls with other computers.

This way of sending information (not to mention data compression) makes the amount of information that must be transmitted for every call at least 3 to 4 times lesser for VoIP, as compared to the exact same call in a conventional telephone system. This is the main reason why VoIP is so much cheaper than conventional calling plans.