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 Demand

24

Quantity

RetailPrice

24

Double Marginalization Problem

24

Quantity

RetailPrice

24

Marginal RevenueOf retailer=demandOf wholesaler

Double Marginalization Problem

24

Quantity

RetailPrice

24

Marginal Cost

QC =20

4

Double Marginalization Problem

24

Quantity

RetailPrice

24

Marginal Cost

QCQM = 10 QC = 20

Double Marginalization Problem

24

Quantity

RetailPrice

24

Marginal Cost

QC = 20QM = 10

Wholesale Price

QDM =5

4

14

Wholesale profits

WholesaleMargin

Double Marginalization Problem

24

Quantity

RetailPrice

24

Marginal Cost

QC = 20QM = 10

Wholesale Price

QDM = 5

4

14

Retail profits

RetailMargin

19

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

24

Quantity

RetailPrice

24

Marginal Cost

QC

QM

Wholesale Price

QDM

Surplus Under double marginalization

Consumers Are Worse Off Too

24

Quantity

RetailPrice

24

Marginal Cost

QC

QM

Wholesale Price

QDM

Surplus Under monopoly

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?