Abstract
Abstract In this paper, we study how input prices affect product differentiation in network industries. In particular, we study whether the principle of vertical differentiation (Choi and Shin 1992, “A Comment on a Model of Vertical Product Differentiation.” The Journal of Industrial Economics 40 (2):229–31; Wauthy 1996, “Quality Choice in Models of Vertical Differentiation.” The Journal of Industrial Economics 44 (3):345–53) remains valid when an entrant purchases an essential input from an incumbent at a regulated price. We find that the higher quality firm always chooses the best available quality, whereas the lower quality firm chooses an intermediate quality, which increases with the input price. If the higher quality firm is the incumbent, a cost-oriented input price maximizes welfare, but comes at the cost of a lower average quality, a higher degree of product differentiation, and therefore stronger downstream market power.
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