Product Differentiation when Competing with the Suppliers of Bottleneck Inputs

In this article, we analyze the product differentiation decision of a downstream entrant that purchases access to a bottleneck input from one of two vertically integrated incumbents, who will compete with him in the downstream market. We develop a three-stage model, where first an entrant chooses his product, then the entrant negotiates the access price with two incumbents, and finally the firms compete on retail prices. Contrary to what one might expect, both the entrant and the access provider prefer that the entrant chooses a product that is a closer substitute of the product of the access provider than of the product of the other incumbent. This occurs because the access provider interacts with the entrant both in the retail market and the wholesale market. We also consider the cases where both parties, rather than only the incumbents, make the access price offers, where the bargaining stage precedes the location stage, and where there is open access regulation.