A Bottleneck Input Supplier's Opportunity Cost of Competing Downstream

Abstract

Should the supplier of a bottleneck input be prevented from vertically integrating downstream unless the (perhaps regulated) price of the input is set equal to costs? This issue has arisen with respect to the entry of incumbent local exchange carriers into the provision of long distance services. While competitors (and likely society) would prefer the bottleneck facility to be priced at marginal cost, this paper shows that entry by the bottleneck supplier when its price exceeds marginal cost will typically be welfare improving. The intuition is that the integrated firm behaves as if its marginal cost of the bottleneck input is lower than the price of the input, which results in lower prices, and increased welfare. This effect outweighs the potential distortions in the market caused by the artificial cost difference between the integrated firm and its competitors, and under plausible conditions can outweigh the effects of a competing firm exiting the market as a result of the integration.