Pricing inputs to induce efficient Make-or-Buy decisions

We investigate input pricing regimes that induce efficient Make-or-Buy decisions by entrants when there is constant returns in the production of the input(s) and simultaneous noncooperative price competition in downstream retail markets. Necessary and sufficient conditions for efficient Make-or-Buy decisions are derived. The necessary condition shows that input prices are relevant for Make-or-Buy decisions except under restrictive and often unverifiable assumptions on the demand structure, and that the least informationally-demanding way to ensure efficient Make-or-Buy decisions is to price inputs at marginal cost provided changes in the entrant’s cost have a “normal” effect on the entrant’s profit. The conditions also show that pricing the incumbent’s input at the entrant’s marginal cost always ensures efficient Make- or-Buy decisions. The extent to which input prices can depart from marginal cost while still inducing efficient Make-or-Buy decisions increases with the efficiency differential between the incumbent and entrant and with the demand displacement ratio.      

Local loop unbundling and antitrust policy

This paper examines economic effects of local loop unbundling. We confirm the common belief that the incumbent can deter entry effectively by denying local loop unbundling. However, contrary to the widely held perception, the incumbent may also benefit from local loop unbundling if it is obliged to accommodate entry, because denying the entrant’s request for local loop unbundling may compel the entrant to build its own facilities and this is just to abandon the incumbent’s chance to reap rental revenues. Furthermore, the model demonstrates that local loop unbundling itself does not weaken the entrant’s incentive of building facilities.     

Imperfect legal unbundling of monopolistic bottlenecks

We study an industry with a monopolistic bottleneck supplying an essential input to several downstream firms. Under legal unbundling the bottleneck must be operated by a legally independent upstream firm, which may be partly or fully owned by an incumbent active in downstream markets. Access prices are regulated but the upstream firm can perform non-tariff discrimination. Under perfect legal unbundling the upstream firm maximizes only own profits; with imperfections it is biased and to some extent accounts also for the incumbent’s downstream profits. We show that increasing the incumbent’s ownership share increases total output if the upstream firm’s bias is sufficiently small, while otherwise effects are ambiguous. Stronger regulation that reduces the bias without changing ownership shares generally increases total output. We also endogenize the bias and show that it can depend non-monotonically on the ownership share.     

On the social optimality of make-or-buy decisions

This article examines the impact of input prices on an entrant’s make-or-buy decision and on the subsequent social welfare level for three alternative models of downstream competition. For each particular model, it derives the range of input prices that induce the entrant to undertake: (a) the productively efficient make-or-buy decision; and (b) the socially optimal make-or-buy decision. The main conclusion of this article is that the entrant’s efficient make-or-buy decision is always socially optimal in the case of the Hotelling model, is socially optimal for the set of input prices that induce the entrant to undertake the efficient decision in the case of Cournot competition and is not necessarily socially optimal in the Bertrand vertical differentiation model. Last, this article examines the conditions under which the efficient and/or socially optimal make-or-buy decision undertaken by an entrant fulfills the regulatory two-fold goal of promoting service-based competition and encouraging facilities-based competition. Therefore, this article also provides the optimal access pricing policy that results in the best feasible outcome in terms of social welfare, productive efficiency, competition level and investment level for a given downstream competition model.     

Asymmetric Regulation of Access and Price Discrimination in Telecommunications*

Suppose that a strong and a weak operator compete in a telecommunications market. To terminate a call operators need access to the competitor’s network if the call is off-net. Operators set two-part tariffs and price-discriminate according to termination of a call. Suppose as a benchmark that access prices are regulated at costs. I show that the weak operator’s profit and consumer welfare increase if the regulator sets a higher price to access the weak operator’s network. However, total surplus decreases even locally. *I received helpful comments from Mark Armstrong, Toker Doganoglu, Tommaso Valletti, Julian Wright, and, in particular, two referees and the editor Michael Crew. I gratefully acknowledge financial support from the Deutsche Forschungsgemeinschaft (Heisenberg Fellowship).     

The employment contract when the firm can utilize a free resource

The output of a free resource, like Open Source programming or basic research, may influence the firm’s revenue by reducing costs or through market interaction. Under moral hazard, if the principal determines how much to utilize the free resource, he will utilize it more, profits are higher and the agent’s effort is lower than when the agent makes the decision. Contrary to the standard result, the incentive coefficient is increasing in the variance of the free resource’s output. Utilization of the free resource and the agent’s effort are always substitutes.     

Delegating Infrastructure Projects with Open Access

This paper provides a simple model that examines a firm's incentive to invest in a network infrastructure through coalition formation in an open-access environment with a deregulated retail market. A regulator faces a dilemma between inducing an incentive for efficient investment and reducing the distortion generated by imperfect competition. We show that, in such a case, the degree of the cost-reducing effect of the investment is crucial from a welfare point of view. In particular, when network investment through coalition formation creates a large (small) cost-reducing effect, the regulator can (should not) delegate an investment decision to firms with an appropriate level of access charge.     

Investment in quality upgrade and regulation of the internet

This paper studies the investment decision by a monopolistic internet service provider (ISP) in different regulatory environments. We consider that the ISP can technically provide separate quality upgrades to two vertically differentiated content providers (CPs). Our results show that if unregulated, the ISP could optimally provide asymmetric quality upgrades to both CPs, in favor of the high-quality CP. This subsequently increases the degree of content differentiation, softening competition between the CPs. Imposing a nondiscrimination regulation that forces the ISP to provide an equal quality upgrade to both CPs, however, reduce the ISP’s investment incentive and social welfare. Furthermore, the social planner provides preferential treatment to the high-quality CP if the degree of substitutability is sufficiently low. In contrast, it is socially optimal to prioritize the low-quality CP if the contents are sufficient substitutes, or provide exclusivity if vertical differentiation is high.

     

Are input prices irrelevant for make-or-buy decisions?

The 1996 Telecommunications Act requires incumbent providers to lease network inputs to rivals at cost-based prices in order to jump-start competition. Sappington (Sappington, D. (2005). American Economic Review, 95(5), 1631–1638) uses the Hotelling model to show that input prices are irrelevant for an entrant’s decision to make or buy an input required for downstream production. We show that this result depends upon the particular model of competition employed. Specifically, input prices are not necessarily irrelevant in the Bertrand vertical differentiation model and are not irrelevant in the Cournot model. It follows that departures from cost-based input prices may distort entrants’ make-or-buy decisions in settings of practical interest.      

Strategic sourcing for entry deterrence and tacit collusion

By sourcing key intermediate goods to a potential entrant, an incumbent firm can credibly and observably commit to an intense post-entry competition, thereby deterring the entry. At the same time, a collusive effect exists, whereby the entrant’s loss from staying out of the final-good market is compensated through their sourcing transaction. We find that entry-deterring sourcing in general has ambiguous effect on social welfare. However, there exist scenarios where it enhances not only social welfare, but also consumers’ surplus.     

Mobile phone termination charges with asymmetric regulation

We model competition between two unregulated mobile phone companies with price-elastic demand and less than full market coverage. We also assume that there is a regulated full-coverage fixed network. In order to induce stronger competition, mobile companies could have an incentive to raise their reciprocal mobile-to-mobile access charges above the marginal costs of termination. Stronger competition leads to an increase of the mobiles’ market shares, with the advantage that (genuine) network effects are strengthened. Therefore, ‘collusion’ may well be in line with social welfare.      

Quality distortions in vertical relations

This paper examines how delivery tariffs and private quality standards are determined in vertical relations that are subject to asymmetric information. We consider an infinitely repeated game where an upstream firm sells a product to a downstream firm. In each period, the firms negotiate a delivery contract comprising the quality of the good as well as a non-linear tariff. Assuming asymmetric information about the actual quality of the product and focusing on incentive compatible contracts, we show that from the firms’ perspective delivery contracts lead to more efficient contracts and thus higher overall profits the lower the firms’ outside options, i.e. the higher their mutual dependency. Buyer power driven by a reduced outside option of the upstream firm enhances the efficiency of vertical relations, while buyer power due to an improved outside option of the downstream firm implies less efficient outcomes.     

Putting Foxes in Charge of the Hen-House: The Political Economy of Harvest Quota Regulations

This paper considers a dynamic common agency model of natural resource harvest quota regulation in which both conservationists and harvesters vie to influence the regulator’s quota allocations as well as the choice of regulator. Conservationists tend to benefit from the adoption of regulation since the regulator will reduce the aggregate harvest quota relative to the unregulated equilibrium. Harvesters, however, only support the adoption of regulation if the regulator places sufficient weight on their welfare. Because harvester’s support of regulation is conditional while conservationist’s support of regulation is unconditional, harvester’s interests tend to be over-represented in the truthful Markov Perfect equilibrium.     

Catching-Up Investment without Regulatory Commitment

This paper analyses a regulated firms incentives to undertake catching-up investments when the firm has private information about the initial technology and the regulator is unable to commit himself to incentive contracts prior to the firms investment decision. In the absence of commitment power, the firm takes into account that the investment decision may serve as a signal to the regulator about the firms initial technology. Any pure strategy equilibrium of the signaling game is shown to be pooling in the sense that the efficient type mimics the inefficient type by investing. By not following this strategy, the efficient type reveals its efficiency to the regulator, who responds by inducing the firm to produce without rents. Restricting attention to undefeated pooling equilibria, the level of investment is shown to be lower than the first-best level.     

The welfare effects of entry: the role of the input market

In a successive Cournot oligopoly, we show the welfare effects of entry in the final goods market with no scale economies but with cost difference between the firms. If the input market is very concentrated, entry in the final goods market increases welfare. If the input market is not very concentrated, entry in the final goods market may reduce welfare if the entrant is moderately cost inefficient. Hence, entry in the final goods market is more desirable if (1) the input market is very concentrated or (2) the cost difference between the incumbents and the entrant is either very small or very large. It follows from our analysis that entry increases the profits of the incumbent final goods producers if their marginal costs are sufficiently lower than the entrant’s marginal cost.     

中国研发投入的动态演化

R&D investment is enterprises’ strategy based on the market demand on innovative products and its production capacity for them. Enlarging market demand would spur the enterprises’ R&D input and the enhancement of technology state in production ability could have a complex effect on less developed countries’ R&D expenditure. With the measurement of China’s technology state compared to the United States and Japan, this paper explores with the state space model the dynamic effects of determinants on China’s R&D expenditure with the data during 1987–2006. The result illustrates that the growing national income, a proxy of domestic market demand, impedes the further R&D investment in China due to the enormous demand for necessities dominated by lower income class, and the income inequality is the major incentive for R&D investment via the higher pricing on the wealthy group, and that the improvement of technology state reduces the innovation risk and plays an important role in stimulating R&D expenditure.      

FDI and environmental regulation: pollution haven or a race to the top?

Increasing foreign direct investment (FDI) flows accompanied with globalization have raised the concern of a “race to the bottom” phenomenon in environmental protection. This is because footloose investors of “dirty” industries tend to relocate to “pollution havens” of the developing world. However when pollutant is transboundary (as in the case of greenhouse gases), the source country’s incentive to relocate and the recipient country’s willingness to host such industries are not straightforward. This article studies the relationship between FDI and environmental regulation using a North–South market share game model in a two-country setting, when pollution is transboundary. Contrary to the pollution haven hypothesis, our model shows that if market sizes of the two countries are small, FDI will raise the emission standard of the host country, resulting in a “race-to-the-top” phenomenon; but if market sizes are large enough, FDI will not change the emission standard of the South (from its laxest form), a finding that is consistent with the “regulatory chill” argument. Equilibrium FDI is contingent on the fixed cost of FDI, as the traditional proximity–concentration tradeoff theory predicts.     

Incentive mechanisms for cost revelation with intermodal competition

To set regulated utility prices that are sustainable against uneconomic bypass alternatives, regulators must estimate the costs of the alternative bypass technologies; this entails a series of theoretical and institutional problems that regulators cannot practically resolve. This paper now develops a simple incentive mechanism that effectively solves those problems associated with producing an optimal amount of bypass. In the suggested procedure, regulators use readily available accounting data to specify one two-part tariff that covers the utility's revenue requirements and is deemed fair by regulators and consumers; as long as it offers this fair tariff, the company may subsequently offer as many alternative tariffs as it sees fit, including some particularly aimed to deter bypass. This procedure gives a utility the correct incentive to determine its own and its rivals' cost structures; with accurate cost information, the utility will design a menu of tariffs that would eliminate uneconomic bypass and would be responsive to changing cost conditions in the emerging bypass markets.     

On the performance of endogenous access pricing

Endogenous access pricing (ENAP) is an alternative to the traditional procedure of setting a fixed access price that reflects the regulator’s estimate of the supplier’s average cost of providing access. Under ENAP, the access price reflects the supplier’s actual average cost of providing access, which varies with realized industry output. We show that in addition to eliminating the need to estimate industry output accurately and avoiding a divergence between upstream revenues and costs, ENAP can enhance the incentive of a vertically integrated producer to minimize its upstream operating cost. However, ENAP can sometimes discourage surplus-enhancing investment.     

Welfare effects of unbundling under different regulatory regimes in natural gas markets

In this paper, we develop a theoretical model that enriches the literature on the pros and cons of ownership unbundling vis-à-vis lighter unbundling frameworks in the natural gas markets. For each regulatory framework, we compute equilibrium outcomes when an incumbent firm and a new entrant compete à la Cournot in the final gas market. We find that the entrant’s contracting conditions in the upstream market and the transmission tariff are key determinants of the market structure in the downstream gas market (both with ownership and with legal unbundling). We also study how the regulator must optimally set transmission tariffs in each of the two unbundling regimes. We conclude that welfare maximizing tariffs often require free access to the transmission network (in both regulatoy regimes). However, when the regulator aims at promoting the break-even of the regulated transmission system operator, the first-best tariff is unfeasible in both regimes. Hence, we study a more realistic set-up, in which the regulator’s action is constrained by the break-even of the regulated firm (the transmission system operator). In this set-up, we find that, for a given transmission tariff, final prices in the downstream market are always higher with ownership unbundling than with legal unbundling.