When Do Input Prices Matter For Make-Or-Buy Decisions?
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We investigate input pricing regimes that induce efficient make-or-buy decisions by entrants when there is constant returns in the production of the input(s) and simultaneous noncooperative price competition in downstream retail markets. A necessary and sufficient condition for efficient make-or-buy decisions is derived. This condition shows that input prices are relevant for make-or-buy decisions except under restrictive and often unverifiable assumptions on the demand structure, and that the least informationally-demanding way to ensure efficient make-or-buy decisions is to price inputs at marginal cost. The extent to which input prices can depart from marginal cost while still inducing efficient make-or-buy decisions depends on the relative efficiency of the incumbent and the demand displacement ratio, with significant departures possible even for modest efficiency differences when products are nearly homogeneous.
Department of Economics, 2007