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## Double Marginalization

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**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 Quantity 12**Double Marginalization Problem**Retail Price 12 Marginal Revenue Quantity 12**Double Marginalization Problem**Retail Price 12 4 Marginal Cost Quantity QC = 8 12**Double Marginalization Problem**Retail Price 12 Marginal Cost Quantity QC QC = 8 12 QM = 4**Double Marginalization Problem**Retail Price Wholesale profits 12 Wholesale Price 8 Wholesale Margin 4 Marginal Cost Quantity QC = 8 12 QM = 4 QDM =2**Double Marginalization Problem**Retail Price Retail profits 12 10 Retail Margin Wholesale Price 8 4 Marginal Cost Quantity QC = 8 12 QM = 4 QDM = 2**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 Quantity QC 12 QDM QM**Consumers Are Worse Off Too**Retail Price Surplus Under monopoly 12 Wholesale Price Marginal Cost Quantity QC 12 QDM QM**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