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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?
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!
12
Quantity
Marginal Revenue
12
Quantity
Marginal Cost
QC = 8
12
Quantity
Marginal Cost
QM = 4
QC = 8
12
Quantity
8
Wholesale Margin 4
Wholesale Price
Marginal Cost
QM QDM =2
=4
QC = 8
12
Quantity
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
Wholesale Price
Marginal Cost
QDM
QM
QC
12
Quantity
Wholesale Price
Marginal Cost
QDM
QM
QC
12
Quantity
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
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