1. Vertical Monopoly
Econ 311

2. 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?

3. Key Lessons: Part 1 Profit Maximizing Pricing Monopoly pricing
Look forward, reason back (for upstream firm)

4. 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?

5. 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!

6. 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!

7. 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.

8. Integrated Firm P=24-Q TR=24Q-Q^2 MR=24-2Q
MR=MCintegrated => 24-2Q=4 =>Qm=10, Pm=24-10=14

9. 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)

10. 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

11. Double Marginalization Analysis Graphically
Retail
Price
Retail Demand 24
Quantity 24

12. Double Marginalization Problem
Retail
Price 24
Marginal Revenue
Of retailer=demand
Of wholesaler
Quantity 24

13. Double Marginalization Problem
Retail
Price 24 4
Marginal Cost
QC =20
Quantity 24

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

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

16. 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

17. 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

18. Consumers Are Worse Off Too
Retail
Price
Surplus Under double marginalization 24
Wholesale Price
Marginal Cost QC
Quantity
QDM 24 QM

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

20. 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?

21. Experiment Treatment 1: Integrated Vertical Monopoly (1 firm)
Treatment 2: Wholesaler and retailer as 2 monopolies.

23. 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

24. 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

25. 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.

26. 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?