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Double Marginalization

Article by Sam Mishra, MBA (MIT Sloan)

Double marginalization happens when there is market power at two channel segments. This produces a double whammy effect of lower total channel profits, and higher retail prices.

For example, let’s take a simple channel with two segments: manufacturer, and retailer. If both the retailer and manufacturer are monopolists, there is market power in both the segments of the channel. This is a simple case of double marginalization. which results in lower total channel profits, and higher retail prices.

In a simple example of double marginalization below, it is illustrated that if market power exists in both the segments of a two layer channel, the end consumer pays a higher retail price of $10.70 as opposed to $ 7.13 in case of no double marginalization (only the manufacturer has market power, and not the retailer). Further, it is illustrated that in case of double marginalization, the total channel profits of $ 6625.36 are lower compared to the profits of $ 8838.76 in case of no double marginalization.

I. No double marginalization: only the Manufacturer has Monopoly Power

Let us assume the demand curve is:

            Q_D = 2480 – 174P

Let’s assume the monopoly price demanded by the Manufacturer is P_M. Assuming that the retail channel has perfect competition, using the profit maximization formula MR = MC, we get the retail price as:

P = MR = MC = P_M

Where MR = Marginal Revenue

            MC = Marginal Cost

So, profit of the manufacturer is given by:

                        ∏         = Q_D * P_M

                                                = (2480 – 174 P) * P_M

                                    = 2480 P_M – 174 (P_M)²           

                               

So, profit is maximized at:

                        ∂∏ ∕ ∂P_M = 2480 – 2 * 174 * P_M = 0

                        or 2480 = 348 P_M

                        or P_M = 2480 / 348 = $ 7.13

 

Since the retailers make no profits, all profits are retained by the monopolist manufacturer, and the total channel profits are

                        ∏         = 2480 P_M – 174 (P_M)²

                                    = 2480 * 7.13 – 174 * (7.13)²

                                    = 17682.4 - 8845.62

                                    = $ 8838.76

Continued on Double Marginalization Part II