Double Double MarginalizationMarginalization

A Classroom ExperimentA Classroom Experiment

OverviewOverview

• Bad Economist Joke: Bad Economist Joke: – Q: What’s worse than one monopolist?Q: What’s worse than one monopolist?– A: Two monopolistsA: Two monopolists

• How does monopoly power work in How does monopoly power work in vertical markets?vertical markets?

• What is the double marginalization What is the double marginalization problem?problem?

• How can we fix the double How can we fix the double marginalization problem?marginalization problem?

Key Lessons: Part 1Key Lessons: Part 1

• Profit Maximizing PricingProfit Maximizing Pricing– Monopoly pricingMonopoly pricing– Look forward, reason back (for Look forward, reason back (for

upstream firm)upstream firm)

Key Lessons: Part 2Key Lessons: Part 2

• Integration:Integration:– How much value is created by How much value is created by

integrating?integrating?– Who captures this value? Who captures this value?

• Contracting:Contracting:– How much value is created through How much value is created through

franchise fees?franchise fees?– Now who captures this value?Now who captures this value?

Double MarginalizationDouble Marginalization

• Consider two independent firms, Consider two independent firms, upstream and downstream, that upstream and downstream, that eacheach have market power have market power

• Each firm then prices at a mark-up Each firm then prices at a mark-up over marginal cost.over marginal cost.

• Recall that pricing above MC yields Recall that pricing above MC yields deadweight lossesdeadweight losses

• Now these are being incurred Now these are being incurred twice!twice!

Double MarginalizationDouble Marginalization

• If upstream and downstream merge, If upstream and downstream merge, then upstream ceases to try to then upstream ceases to try to capture surplus from downstream.capture surplus from downstream.

• Upstream prices (transfers) at MC.Upstream prices (transfers) at MC.• One deadweight loss eliminated.One deadweight loss eliminated.• Like picking money up off the table!Like picking money up off the table!

Double Marginalization Double Marginalization Experiment AnalysisExperiment Analysis

Retail Demand

12

Quantity

RetailPrice

12

Double Marginalization Double Marginalization ProblemProblem

12

Quantity

RetailPrice

12

Marginal Revenue

Double Marginalization Double Marginalization ProblemProblem

12

Quantity

RetailPrice

12

Marginal Cost

QC = 8

4

Double Marginalization Double Marginalization ProblemProblem

12

Quantity

RetailPrice

12

Marginal Cost

QCQM = 4 QC = 8

Double Marginalization Double Marginalization ProblemProblem

12

Quantity

RetailPrice

12

Marginal Cost

QC = 8QM = 4

Wholesale Price

QDM =2

4

8

Wholesale profits

WholesaleMargin

Double Marginalization Double Marginalization ProblemProblem

12

Quantity

RetailPrice

12

Marginal Cost

QC = 8QM = 4

Wholesale Price

QDM = 2

4

8

Retail profits

RetailMargin

10

Key PointKey Point

• EveryoneEveryone is worse off under double is worse off under double marginalizationmarginalization

• Firms are worse off in terms of Firms are worse off in terms of industry profits:industry profits:– Under Double MarginalizationUnder Double Marginalization

• 2 units x ($10 - $4) = $122 units x ($10 - $4) = $12

– Under MonopolyUnder Monopoly• 4 units x ($8 - $4) = $164 units x ($8 - $4) = $16

Consumers Are Worse Consumers Are Worse Off TooOff Too

12

Quantity

RetailPrice

12

Marginal Cost

QC

QM

Wholesale Price

QDM

Surplus Under double marginalization

Consumers Are Worse Consumers Are Worse Off TooOff Too

12

Quantity

RetailPrice

12

Marginal Cost

QC

QM

Wholesale Price

QDM

Surplus Under monopoly

GM and Fisher BodyGM and Fisher Body

• Fisher body had custom machines and Fisher body had custom machines and dies to produce car bodies for GMdies to produce car bodies for GM

• GM’s chassis were likewise GM’s chassis were likewise customized for Fisher’s bodies.customized for Fisher’s bodies.

• There was upstream and downstream There was upstream and downstream market power (double marginalization market power (double marginalization problem)problem)

• GM acquires Fisher bodyGM acquires Fisher body

Contractual SolutionsContractual Solutions

• Using “two-part tariffs” can also Using “two-part tariffs” can also overcome the double marginalization overcome the double marginalization problem.problem.

• Recipe for Two-Part TariffsRecipe for Two-Part Tariffs• Part 1: Maximize value createdPart 1: Maximize value created• Part 2: Use the fixed fee to capture Part 2: Use the fixed fee to capture

valuevalue

Two-Part Tariffs in Two-Part Tariffs in ActionAction

• Part 1: Maximize Value CreatedPart 1: Maximize Value Created– The wholesaler can set the wholesale The wholesaler can set the wholesale

price at marginal costprice at marginal cost– This maximizes the size of industry This maximizes the size of industry

profitsprofits

• Part 2: Capture ValuePart 2: Capture Value– It can then use the franchise fee to It can then use the franchise fee to

capture the bulk of this additional value capture the bulk of this additional value created. created.

Other IssuesOther Issues

• How should competition authorities in How should competition authorities in government view this type of firm government view this type of firm behavior?behavior?

• Are there other contractual forms that Are there other contractual forms that might solve this problem?might solve this problem?

• Why might some firms solve the Why might some firms solve the problem by merging while others problem by merging while others prefer contracts?prefer contracts?

• Porter forces analysisPorter forces analysis