Vertical Monopoly
Econ 311
Vertical Monopoly
• 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
(monopoly wholesaler) and downstream
(monopoly retailer), 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!
Numerical 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=4
• First consider monopoly problem of an
integrated firm.
Integrated Firm
•
•
•
•
P=24-Q
TR=24Q-Q^2
MR=24-2Q
MR=MCintegrated => 24-2Q=4 =>Qm=10,
Pm=24-10=14
2 firms
• Key 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= 24-2Q
• Key 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)
2 firms
•
•
•
•
•
•
TRw of upstream firm is (24 –2Q)Q
MRw of upstream firm is 24-4Q
MRw=MCw => 24-4Q=4; Qw=5; W=24-10=14
W is MC of downstream firm
Downstream firm sets MCr=MRr=> W=24-2Q
14=24-2Q => Qr=5; Pr=24-5=19
Double Marginalization Analysis
Graphically
Retail
Price
Retail Demand
24
24
Quantity
Double Marginalization Problem
Retail
Price
24
Marginal Revenue
Of retailer=demand
Of wholesaler
24
Quantity
Double Marginalization Problem
Retail
Price
24
4
Marginal Cost
QC =20
24
Quantity
Double Marginalization Problem
Retail
Price
24
Marginal Cost
QM = 10
QC = 20
24
Quantity
Double Marginalization Problem
Retail
Price
Wholesale profits
24
14
Wholesale Price
4
Marginal Cost
Wholesale
Margin
QM
QDM
=5
= 10
QC = 20
24
Quantity
Double Marginalization Problem
Retail
Price
Retail profits
24
Retail
Margin
19
14
Wholesale Price
4
Marginal Cost
QM
QDM
=5
= 10
QC = 20
24
Quantity
Welfare is reduced
• Everyone is worse off under double
marginalization
• Firms are worse off in terms of industry
profits:
– Under Double Marginalization
• 5 units x ($19 - $4) = $75
– Under Monopoly
• 10 units x ($14 - $4) = $100
Consumers Are Worse Off Too
Retail
Price
Surplus Under double marginalization
24
Wholesale Price
Marginal Cost
QDM
QM
QC
24
Quantity
Consumers Are Worse Off Too
Retail
Price
Surplus Under monopoly
24
Wholesale Price
Marginal Cost
QDM
QM
QC
24
Quantity
Experiment
• In the experiment, I used the retail demand
function equal to P=12-Q.
• Wholesaler’s marginal cost MCw=4
• Wholesaler’s demand W=12-2Q
• As a result, W=8, Qw=2
• And Pr=10, Qr=2
• How do theoretical predictions compare to
experimental evidence?
Experiment
• Treatment 1: Integrated Vertical Monopoly (1
firm)
• Treatment 2: Wholesaler and retailer as 2
monopolies.
Classic Example: 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?