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

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.