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: Contracting: 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 QC =20 Quantity 24

Double Marginalization Problem Retail Price 24 Marginal Cost QC QC = 20 Quantity QM = 10 24

Double Marginalization Problem Retail Price Wholesale profits 24 Wholesale Price 14 Wholesale Margin 4 Marginal Cost QC = 20 Quantity 24 QM = 10 QDM =5

Double Marginalization Problem Retail Price Retail profits 24 Retail Margin 19 Wholesale Price 14 4 Marginal Cost QC = 20 Quantity 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 QC Quantity QDM 24 QM

Consumers Are Worse Off Too Retail Price Surplus Under monopoly 24 Wholesale Price Marginal Cost QC Quantity QDM 24 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?