Double Marginalization A Classroom Experiment Overview Bad Economist

Double Marginalization A Classroom Experiment

Overview • Bad Economist Joke: – Q: What’s 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 Retail Demand 12 12 Quantity

Double Marginalization Problem Retail Price 12 Marginal Revenue 12 Quantity

Double Marginalization Problem Retail Price 12 4 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 Wholesale profits 12 8 Wholesale Price 4 Marginal Cost Wholesale Margin QM QDM =2 =4 QC = 8 12 Quantity

Double Marginalization Problem Retail Price Retail profits 12 Retail Margin 10 8 Wholesale Price 4 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 Surplus Under double marginalization 12 Wholesale Price Marginal Cost QDM QM QC 12 Quantity

Consumers Are Worse Off Too Retail Price Surplus Under monopoly 12 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 • GM’s chassis were likewise customized for Fisher’s 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