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