Input-Quality Sabotage and the Welfare Consequences of Parity Rules

We analyze the welfare effects of parity rules, prevalent in telecommunications and other regulated industries, that force a vertically-integrated input monopolist to treat its own downstream affiliate and downstream competitors comparably in terms of input price and quality. When input pricing is unconstrained, our results show that input-quality parity requirements may lower social welfare. Either no private incentive exists to engage in input-quality discrimination, or the presence of rival input-quality sabotage (or possibly self-sabotage) is both a profit-maximizing and welfare-maximizing outcome. With cost-based input-pricing parity requirements, the input monopolist has incentive to inefficiently downgrade its downstream rival's input quality and possibly to excessively upgrade the input quality of its downstream affiliate. Thus, the desirability of input-quality parity requirements is highly dependent on the nature of the input-pricing policy. We also find that input-quality parity not only creates an incentive for the input monopolist to set a higher input price to its downstream rivals, but to set price above marginal cost to its downstream affiliate as well