Double Marginalization is the phenomenon in which different firms in the same industry that have their respective market powers but at different vertical levels in the supply chain (example, upstream and downstream) apply their own markups in prices.
Double marginalization is defined as the “exercise of market power at successive vertical layers in a supply chain.”
Due to these markups individually a deadweight loss is induced and because of both the markups the deadweight loss occurs twice thus making it worse off for the whole market due to double marginalization.
One way of avoiding the losses due to double marginalization is by integrating the two firms vertically and thus reducing at least one of the dead weight losses. This can be done through merger and acquisition of one of the firm by the other firm in the supply chain.
Diving Deeper into Double Marginalization
When firms have market power, they will set price above marginal cost, which causes a welfare loss. This problem is accentuated when we have a firm with market power that buys an input from another firm that also has market power. The producer of the input will price above marginal cost when it sells the input to the other firm, who will then price above marginal cost again when they sell the final product that uses the input. This means the input is being market up above marginal cost twice: once by the producer of the input, and once again by the firm that uses the input to make its final product – that’s double marginalization.
The basic story is that both firms want to extract their profits and in so doing end up creating a retail price that is significantly higher, and a quantity that is significantly lower, than it would be if they merged. Here is the graph to illustrate it better:
In the above graph, the demand curve for the downstream firm, or distributor, (denoted d) is given in blue. This is the demand for beer from retail establishments which (since they are highly competitive) closely resembles the demand for beer in the market. Since the distributor is a monopolist they make their price and quantity decision where their marginal revenue (denoted MRd) equals their marginal cost (denoted MCd). Their marginal cost is the price they have to pay the brewer. From this quantity (qu = qd ) they would charge their margin which is the difference between MCd and Pd. Thus the distributor gets a profit equal to the dark red shaded area.
So where does MCd come from? Well, note that depending on what the brewer (the upstream firm = u) charges, the quantity demanded will be read off of the downstream firm’s MR curve. Thus the downstream firm’s MR curve is the same as the upstream firm’s demand curve, creating an upstream firm MR curve. The brewer’s MC curve comes from the cost of making the beer and so they set MRu=MCu and lo and behold, the quantity demanded from the brewer is the same as a the quantity sold by the distributor, qu = qd. The brewer’s profits are given by the light red shaded area. So consumers would pay pd (assuming competitive retailers) and consume qu = qd beer.
We hope we were able to explain the concept of Double Marginalization in the article.
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