Academic journal article Business and Economics Research Journal

Horizontal Product Differentiation and the Irrelevancy of Input Prices for Make-or-Buy Decisions

Academic journal article Business and Economics Research Journal

Horizontal Product Differentiation and the Irrelevancy of Input Prices for Make-or-Buy Decisions

Article excerpt

Abstract: Mandatory network unbundling is one of the most important topics in regulatory economics today. The concept has crucial importance in the deregulation of many previously regulated industries including electricity, telecommunications, gas and railroads. Upon initial examination, determining the correct input prices would seem important for sending the correct price signals to the entrants for their efficient make-or-buy decisions. However, Sappington uses a standard Hotelling location model to show that input prices are irrelevant for an entrant's make or buy decision. In this study, it is shown that this result is closely related to the degree of product differentiation when firms are engaged in price competition. Specifically, it is shown that input prices are irrelevant when firms produce homogeneous products, but are relevant for make-or-buy decisions when the entrant and incumbent produce differentiated products. These results suggest that, in general, it is important for regulators to set correct prices in order to not distort the entrants' efficient make-or-buy decisions.

Keywords: Input Prices, Mandatory Unbundling, Make-or-Buy Decisions, Deregulation, Horizontal Product Differentiation

JEL Classification: L13, L49, L51, L97

(ProQuest: ... denotes formulae omitted.)

1. Introduction

To introduce competition into the telecommunications industry, the 1996 Telecommunications Act requires incumbent providers to unbundle their networks and lease individual network elements to any requesting telecommunications carrier.1 This concept is known as a mandatory unbundling policy and is prevalent in many network industries throughout the world. As a direct result of these unbundling policies, optimal access pricing for unbundled network elements has become a prominent issue in regulatory economics.2 Moreover, mandatory unbundling and the price of unbundled network elements, known as access charges, have emerged as more prominent issues associated with the implementation of the 1996 Act. In general, the issue of access charges has attracted significant interest from researchers even before the implementation of the Act. As a result, a voluminous access pricing literature has emerged with the focus on optimal access charges.

Without question, one of the most important results in the optimal access charge literature is known as the Baumol-Willig efficient component pricing rule (ECPR). Willig (1979) and Baumol (1983) advocate the ECPR.3 Their analyses depend on contestable markets which can be treated as part of a perfect competition framework. Based on the ECPR, the optimal access price of a bottleneck input should be equal to the direct incremental cost of access plus the opportunity cost borne by the integrated access provider in supplying access. The opportunity cost is the decrease in the incumbent's profit caused by the provision of the bottleneck input to a rival. Therefore, the access charge can be higher than the direct incremental cost by a substantial margin.

Spencer and Brander (1983) focus on departures from marginal cost pricing induced by imperfect competition in industries that require publicly-produced inputs. As they assumed the public enterprise has a vertically-integrated structure, their analysis is conducted with and without the non-negative profit constraint imposed on the public enterprise. They show that in order to induce the socially desirable output under imperfect competition, the first best access charge requires an input price set below the marginal cost of the input. However, when the profit constraint is introduced, the second-best input price exceeds the marginal cost of the input.

Laffont and Tirole (1994) investigate optimal access prices in a competitive fringe model using a principal-agent framework. The authors show that the first-best access pricing should be marginal cost pricing. However, when marginal cost pricing results in an earnings shortfall for the incumbent provider, competitors should contribute to the fixed cost of the network. …

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