Input-Quality Sabotage and the Welfare Consequences of Parity Rules

Abstract

We analyze the welfare effects of “parity” rules that force a vertically-integrated input monopolist (VIM) to treat downstream affiliates and competitors alike in terms of price and quality. We find that input-quality parity can lower social welfare when input pricing is unregulated. In contrast, the VIM may either find it profitable to engage in “rival sabotage” or even “self sabotage” which can be welfare maximizing. When parity input prices are set at marginal cost, the input monopolist has an incentive to degrade the input sold to its downstream rival, and possibly to excessively upgrade the quality supplied to its affiliate. Thus, the desirability of input-quality parity is highly dependent on the nature of the input pricing policy. We additionally find that input quality parity not only creates an incentive for the VIM to set a higher input price to its retail rivals, but to price above marginal cost to its affiliate as well.