Double Marginalization A Classroom Experiment

Overview Bad Economist Joke:Bad Economist Joke: –Q: Whats worse than one monopolist? –A: Two monopolists How does monopoly power work in vertical markets?How does monopoly power work in vertical markets? What is the double marginalization problem?What is the double marginalization problem? How can we fix the double marginalization problem?How can we fix the double marginalization problem?

Key Lessons: Part 1 Profit Maximizing PricingProfit Maximizing Pricing –Monopoly pricing –Look forward, reason back (for upstream firm)

Key Lessons: Part 2 Integration:Integration: –How much value is created by integrating? –Who captures this value? Contracting: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 powerConsider two independent firms, upstream and downstream, that each have market power Each firm then prices at a mark-up over marginal cost.Each firm then prices at a mark-up over marginal cost. Recall that pricing above MC yields deadweight lossesRecall that pricing above MC yields deadweight losses Now these are being incurred twice!Now these are being incurred twice!

Double Marginalization If upstream and downstream merge, then upstream ceases to try to capture surplus from downstream.If upstream and downstream merge, then upstream ceases to try to 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 Experiment Analysis Retail Demand 12 Quantity Retail Price 12

Double Marginalization Problem 12 Quantity Retail Price 12 Marginal Revenue

Double Marginalization Problem 12 Quantity Retail Price 12 Marginal Cost Q C = 8 4

Double Marginalization Problem 12 Quantity Retail Price 12 Marginal Cost QCQC Q M = 4 Q C = 8

Double Marginalization Problem 12 Quantity Retail Price 12 Marginal Cost Q C = 8 Q M = 4 Wholesale Price Q DM =2 4 8 Wholesale profits Wholesale Margin

Double Marginalization Problem 12 Quantity Retail Price 12 Marginal Cost Q C = 8 Q M = 4 Wholesale Price Q DM = Retail profits Retail Margin 10

Key Point Everyone is worse off under double marginalizationEveryone is worse off under double marginalization Firms are worse off in terms of industry profits:Firms are worse off in terms of industry profits: –Under Double Marginalization 2 units x ($10 - $4) = $122 units x ($10 - $4) = $12 –Under Monopoly 4 units x ($8 - $4) = $164 units x ($8 - $4) = $16

Consumers Are Worse Off Too 12 Quantity Retail Price 12 Marginal Cost QCQC QMQM Wholesale Price Q DM Surplus Under double marginalization

Consumers Are Worse Off Too 12 Quantity Retail Price 12 Marginal Cost QCQC QMQM Wholesale Price Q DM Surplus Under monopoly

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

Contractual Solutions Using two-part tariffs can also overcome the double marginalization problem.Using two-part tariffs can also overcome the double marginalization 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 valuePart 2: Use the fixed fee to capture value

Two-Part Tariffs in Action Part 1: Maximize Value CreatedPart 1: Maximize Value Created –The wholesaler can set the wholesale price at marginal cost –This maximizes the size of industry profits Part 2: Capture ValuePart 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?How should competition authorities in government view this type of firm behavior? Are there other contractual forms that might solve this problem?Are there other contractual forms that might solve this problem? Why might some firms solve the problem by merging while others prefer contracts?Why might some firms solve the problem by merging while others prefer contracts? Porter forces analysisPorter forces analysis