2Vertical Monopoly Bad Economist Joke: Q: What’s worse than one monopolist?A: Two monopolistsHow does monopoly power work in vertical markets?What is the double marginalization problem?How can we fix the double marginalization problem?
3Key Lessons: Part 1 Profit Maximizing Pricing Monopoly pricing Look forward, reason back (for upstream firm)
4Key Lessons: Part 2 Integration: Contracting: 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?
5Double Marginalization Consider two independent firms, upstream (monopoly wholesaler) and downstream (monopoly retailer), that each have market powerEach firm then prices at a mark-up over marginal cost.Recall that pricing above MC yields deadweight lossesNow these are being incurred twice!
6Double 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!
7Numerical Example Retail demand P=24-Q Upstream manufacturer with MC=4 Downstream retailer buys from wholesaler and incurs no other costs per unit.In an integrated firm MCintegrated=4First consider monopoly problem of an integrated firm.
92 firmsKey point 1: For any wholesale price W charged by upstream manufacturer, MC of downstream retailer is W.Downstream retailer is a monopolist that sets MCr=MRr => W= 24-2QKey point 2: Downstream market MR curve is the upstream market inverse demand curve (i.e., to sell each additional unit wholesale price must be reduced by 2)
102 firms TRw of upstream firm is (24 –2Q)Q MRw of upstream firm is 24-4QMRw=MCw => 24-4Q=4; Qw=5; W=24-10=14W is MC of downstream firmDownstream firm sets MCr=MRr=> W=24-2Q14=24-2Q => Qr=5; Pr=24-5=19
17Welfare is reduced Everyone is worse off under double marginalization Firms are worse off in terms of industry profits:Under Double Marginalization5 units x ($19 - $4) = $75Under Monopoly10 units x ($14 - $4) = $100
18Consumers Are Worse Off Too RetailPriceSurplus Under double marginalization24Wholesale PriceMarginal CostQCQuantityQDM24QM
19Consumers Are Worse Off Too RetailPriceSurplus Under monopoly24Wholesale PriceMarginal CostQCQuantityQDM24QM
20ExperimentIn the experiment, I used the retail demand function equal to P=12-Q.Wholesaler’s marginal cost MCw=4Wholesaler’s demand W=12-2QAs a result, W=8, Qw=2And Pr=10, Qr=2How do theoretical predictions compare to experimental evidence?
21Experiment Treatment 1: Integrated Vertical Monopoly (1 firm) Treatment 2: Wholesaler and retailer as 2 monopolies.
23Classic Example: GM and Fisher Body Fisher body had custom machines and dies to produce car bodies for GMGM’s chassis were likewise customized for Fisher’s bodies.There was upstream and downstream market power (double marginalization problem)GM acquires Fisher body
24Contractual Solutions Using “two-part tariffs” can also overcome the double marginalization problem.Recipe for Two-Part TariffsPart 1: Maximize value createdPart 2: Use the fixed fee to capture value
25Two-Part Tariffs in Action Part 1: Maximize Value CreatedThe wholesaler can set the wholesale price at marginal costThis maximizes the size of industry profitsPart 2: Capture ValueIt can then use the franchise fee to capture the bulk of this additional value created.
26Other IssuesHow 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?