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##### Vertical Monopoly

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**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 Quantity 24**Double Marginalization Problem**Retail Price 24 Marginal Revenue Of retailer=demand Of wholesaler Quantity 24**Double Marginalization Problem**Retail Price 24 4 Marginal Cost Quantity QC =20 24**Double Marginalization Problem**Retail Price 24 Marginal Cost Quantity QC QC = 20 24 QM = 10**Double Marginalization Problem**Retail Price Wholesale profits 24 Wholesale Price 14 Wholesale Margin 4 Marginal Cost Quantity QC = 20 24 QM = 10 QDM=5**Double Marginalization Problem**Retail Price Retail profits 24 19 Retail Margin Wholesale Price 14 4 Marginal Cost Quantity QC = 20 24 QM = 10 QDM = 5**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 Quantity QC 24 QDM QM**Consumers Are Worse Off Too**Retail Price Surplus Under monopoly 24 Wholesale Price Marginal Cost Quantity QC 24 QDM QM**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?