Make-or-buy decisions in vertically differentiated input marketsty

We study the optimal regulatory policy when two qualitatively differentiated upstream inputs are available. We consider a setting where a vertically integrated incumbent invests in upgrading the quality of the basic upstream input it owns, whereas a rival entrant chooses between making its own upgraded input and buying either input from the incumbent at regulated prices. We show that each of the three options available for the entrant can be socially optimal, depending on the investment cost parameters. However, the socially optimal input pricing policy is quite unlikely to resolve the trade-off between promoting welfare and encouraging investment in quality.