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Double Marginalization

A Classroom Experiment

Overview
Bad Economist Joke:
Q: Whats worse than one monopolist? A: Two monopolists

How does monopoly power work in vertical markets? What is the double marginalization problem? How can we fix the double marginalization problem?

Key Lessons: Part 1


Profit Maximizing Pricing
Monopoly pricing Look forward, reason back (for upstream firm)

Key Lessons: Part 2


Integration:
How much value is created by integrating? Who captures this value?

Contracting:
How much value is created through franchise fees? Now who captures this value?

Double Marginalization
Consider two independent firms, upstream and downstream, that each have market power Each firm then prices at a mark-up over marginal cost. Recall that pricing above MC yields deadweight losses Now these are being incurred twice!

Double Marginalization
If upstream and downstream merge, then upstream ceases to try to capture surplus from downstream. Upstream prices (transfers) at MC. One deadweight loss eliminated. Like picking money up off the table!

Double Marginalization Experiment Analysis


Retail Price 12 Retail Demand

12

Quantity

Double Marginalization Problem


Retail Price 12

Marginal Revenue

12

Quantity

Double Marginalization Problem


Retail Price 12

Marginal Cost

QC = 8

12

Quantity

Double Marginalization Problem


Retail Price 12

Marginal Cost

QM = 4

QC = 8

12

Quantity

Double Marginalization Problem


Retail Price 12 Wholesale profits

8
Wholesale Margin 4

Wholesale Price

Marginal Cost

QM QDM =2

=4

QC = 8

12

Quantity

Double Marginalization Problem


Retail Price 12 Retail Margin 10 Retail profits

Wholesale Price

Marginal Cost

QM QDM =2

=4

QC = 8

12

Quantity

Key Point
Everyone is worse off under double marginalization Firms are worse off in terms of industry profits:
Under Double Marginalization
2 units x ($10 - $4) = $12

Under Monopoly
4 units x ($8 - $4) = $16

Consumers Are Worse Off Too


Retail Price 12 Surplus Under double marginalization

Wholesale Price

Marginal Cost

QDM

QM

QC

12

Quantity

Consumers Are Worse Off Too


Retail Price 12 Surplus Under monopoly

Wholesale Price

Marginal Cost

QDM

QM

QC

12

Quantity

GM and Fisher Body


Fisher body had custom machines and dies to produce car bodies for GM GMs chassis were likewise customized for Fishers bodies. There was upstream and downstream market power (double marginalization problem) GM acquires Fisher body

Contractual Solutions
Using two-part tariffs can also overcome the double marginalization problem. Recipe for Two-Part Tariffs Part 1: Maximize value created Part 2: Use the fixed fee to capture value

Two-Part Tariffs in Action


Part 1: Maximize Value Created
The wholesaler can set the wholesale price at marginal cost This maximizes the size of industry profits

Part 2: Capture Value


It can then use the franchise fee to capture the bulk of this additional value created.

Other Issues
How should competition authorities in government view this type of firm behavior? Are there other contractual forms that might solve this problem? Why might some firms solve the problem by merging while others prefer contracts? Porter forces analysis

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