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

Mandatory network unbundling is perhaps one of the foremost topics in regulatory economics today. The concept has crucial importance in the deregulation of many previously regulated industries including telecommunications, gas, electricity and railroads. Moreover, the topic has emerged as one of the more prominent issues associated with the implementation of the 1996 Telecommunication Act in the United States. Upon initial examination, establishing the correct costing standards and/or 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, we show that this result is closely related to the specific conditions of the Hotelling framework. 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 under Bertrand price competition fra-mework. 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.