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Aa

Double Marginalization

Game Description

Each market is represented by a wholesaler-retailer pair where downstream demand is known. Without integration the wholesaler posts a price and the retailer decides how much quantity to purchase at that price. With integration, prior to making decisions about price and quantity, the wholesaler and retailer bargain over an integration contract. If there is a merger (or a franchise) then one firm acts as a monopolist during that round.

Learning Objective 1: Marginal Revenue and Monopoly Pricing

Students review concepts of marginal revenue and monopoly pricing.

Learning Objective 2: Effects of Market Power

In the absence of communication or contract to help coordinate decisions, the successive exercise of market power leads to higher market prices and a loss in economic efficiency.

Learning Objective 3: Acquisition and Franchising

Explore two potential solutions to this double marginalization problem: acquisition and franchise fees. Show that under these different contractual options prices are lower, consumer surplus is higher, and industry profits are higher.

Brief Instructions

The retail market inverse demand is P=1200 - 100Q and the per unit cost to the wholesaler is MC=200 (all parameters in pennies). The retailer has no retailing cost. If the firms merged then the merged firm solves the monopoly problem and chooses {P=700 (or \$7), Q=5}. Industry profits would be \$25 and consumer surplus would be \$12.50. In the absence of some mechanism to coordinate this monopoly outcome there will be a double marginalization problem {P=950 (or \$9.50,Q=2.5} leading to industry profits of \$18.75 and consumer surplus of one \$3.12.

In the absence of vertical integration the wholesaler sets their price and the retailer chooses a quantity to purchase at the wholesaler’s price.

With the merger and acquisition setting each round we allow for free form bargaining. The retailer and wholesaler can both submit offers to acquire each other. Offers can be accepted or declined. When an offer is accepted the acquired firm receives payment equal to the proposal and the merged firm faces market demand as a monopolist. When an offer is rejected there are opportunities to continue to make counteroffers. However, if no agreement is reached when time expires both the wholesaler and retailer revert to equilibrium profits for double marginalization.

In the franchise setting each round we allow the wholesaler to offer a two-part deal to the retailer. First, the wholesaler sets a one-time franchise fee. Second, the wholesaler sets a price for the retailer to purchase bags of coffee. The retailer can accept or decline any offer. When an offer is accepted the franchisee chooses a quantity to purchase at the wholesaler’s price and also pays the one-time franchise fee. When an offer is rejected the wholesaler can make additional offers. However, if no agreement is reached when time expires both the wholesaler and retailer revert to equilibrium profits for double marginalization.

Key Treatment Variations

1. Merger and Acquisition - Allowing for the upstream or downstream firm to acquire each other allows one firm to control both cost and quantity to penetrate the market more effectively.
2. Franchise - A contractual solution to the double marginalization problem. A retailer considers whether wholesaler offers that include a franchise fee and per unit price would be profitable.
3. Communication - In the absence of legal arrangements firms can communicate to reach an outcome approaching monopoly. In addition to communication, indefinite repetition also helps to facilitate collusive arrangements.

Results

The first results graph plots average wholesale and retail prices against double mark up and monopoly equilibrium benchmarks. In Figure 1 below, Rounds 1-4 were without integration followed by Rounds 5-8 with merger and acquisition.

The second results graph plots average profit and consumer welfare across rounds with double mark up and monopoly equilibrium benchmarks. Again, Rounds 1-4 were without integration followed by Rounds 5-8 with vertical integration.

With the merger and acquisition treatment you may want to know how firm profits differ with forward integration (Wholesaler acquires Retailer) and backward integration (Retailer acquires Wholesaler). Figure 3 shows how profits are distributed between firms in both cases. Dynamics are not captured on a single graph.

Finally, you might be interested in bargaining outcomes in the Franchise treatment. Figure 4 plots accepted Franchise Fee and Wholesale Price pairs. Dynamics are not captured on a single graph.