Peering is an ISP connecting to another ISP to exchange traffic. It is the provider interconnections to and among the backbones.
Suppose that you have a cable modem through Comcast, and want to get to a web site hosted in a Digex colocation rack. Comcast buys transit (hypothetically) from Level 3 and has a DS3 from Comcast's network to Level 3's network. Digex is a subsidiary of Worldcom using their backbone over gigabit Ethernet.
Level 3 and Worldcom (hypothetically for a moment) only connect at public exchanges, and it happens that they both have OC3 lines into PAIX in Vienna, VA. A "public exchange" is a well-known place where a bunch of providers bring high speed lines in and drop a router, and then it's just a matter of configuring routing/BGP4 policies and maybe a VLAN in a switch, and they can "virtually" connect to other ISPs, perhaps at full rate/best-efort, or perhaps at a particular traffic-shaped speed. This is called "public peering." This is a cheaper way for many ISPs to connect to many other ISPs versus each of them running a separate leased line to every ISP they want to connect to, and it is good for exterior routing that ISPs be as well connected as possible.
But suppose that Level 3 and Worldcom find they have a lot of traffic between them, eating up a serious (say >10%) chunk of each's link to the public exchange, then instead they might run a leased line between each other, creating what's called a "private peeing." The business arrangements surrounding public peering are often secretive and case-by-case, but the short of it is that if both directions on the link are carrying nearly the same amount of traffic (so each is sending about the same amount to the other), it's usually done for free because each benefits equally from the deal, but if the traffic is lop-sided, somebody's paying the other for the traffic. The cost at this level can be steep, which is why a lot of tier 2 and tier 3 ISPs, who typically don't qualify for the settlement-free (no cost) peering, don't connect to many other except at the public exchange points. This cost is also why tier 1 ISPs are so much better than others - the definition of a tier 1 is to have settlement-free private peerings with all the other tier 1s, and thus be really well connected from a peering perspective (hint: tier 2 ISPs' marketing departments desparately want you to believe they're tier 1, while tier 1 ISPs don't often mention it).
Why does all this matter? Packet loss. If any of the links that need to be traversed to get from your ISP to the destination's ISP are congested, packets will get dropped, and your performance will suffer. Unfortunately, the protocol brain damage of HTTP and the web makes this effect much more noticeable to end users - that is, even very low levels of packet loss look bad to users. So good peering is very important to perceived network performance.
The tier 1 ISPs are the ones who matter most, frankly, and they're not stupid. They get lines to the public exchange points that aren't super fat, and therefore those lines are overloaded. So if your ISP doesn't shell out the $$ to get a private peering arrangement with a tier 1, then their users are likely to see some loss to customers of those tier 1s. The tier 1s have the majority of the country's (maybe world's, but internationally things are a bit different) customers behind them, especially business customers. So tier 2 ISPs have two choices: either spend lots of $$ on peering which they have to pass on to you, or don't get good peering and not deliver as good a service. Most tier 2s mostly do the latter but get a few private peerings too, and most tier 3s are simply buying transit from a tier 2.
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