today we deal with a classic problem in
economics the double marginalization
problem this has a lot of applications
not just to development but also to
industrial organization to Innovation
Theory particularly about patents and to
a lot of other different areas let's
take a
look we can get an intuitive
understanding of the double
marginalization Problem by looking at
the Rin River now tourists love to sail
down the Rin River because every few
miles there are the these beautiful
castles these castles however were not
the vacation homes of the rich they were
actually toll booths they were put there
in order to charge people coming down
the river now the problem is that the
upper river monopolists the upper river
castles the more that they charged the
less were the revenues for the
downstream monopolists but the upper
stream monopolists they don't care about
the downstream monopolists so they would
set their prices really high in order to
charge in order to make a lot of money
not taking into account the fact that
this would reduce the profits of the
downstream monopolists of course the
downstream monopolists are actually in
the same situation the more they charge
the fewer people want to come down the
river to begin with and they charge a
high price as well not taking into
account the fact that this is going to
reduce the profits of the other king of
the other prince who is further up or
higher up on the river so the fact that
there are multiple monopolists means
that prices are set too high and output
is too low notice I don't mean that
prices are too high simply from the
point of view of the consumers I mean
that prices are actually too high from
the point of view of the monopolists
taken as a group so if the monopolist
could get together if there was a single
King controlling all the river then he
would just have one Castle perhaps one
Monopoly price that would maximize
profits instead we get lots of different
monopolies they charge too high prices
collectively this reduces trade and all
of the monopolies together are actually
worse off than if they could coordinate
so that's the double marginalization
problem it says that two
monopolies two vertical monopolies are
much worse than one they're more than
twice as bad as one Monopoly let's take
a look at this using some
graphs okay here's the standard Monopoly
profit maximization story which you can
find in any principles of economics
textbook of course I recommend modern
principles by C and tab Rock so here's
the demand curve for the monopolist's
product here's the marginal revenue
curve and here's the marginal cost curve
the marginal revenue curve tells the
monopolist what is the addition to
revenue from selling one more unit the
marginal cost curve tells the monopolist
what is the addition to cost from
producing one more unit what the monopis
wants to do is keep producing so long as
the marginal revenue the addition to
revenue from selling one more unit
exceeds the addition to cost from
selling one more unit thus the
monopolist wants to produce until
marginal revenue is equal to marginal
cost at this point point a we find the
profit maximizing quantity
and then we ask what is the most the
monopolist can sell this quantity for
per unit it's $3 per
unit okay the profit is then given by
this green area The Profit to the
monopolist and the dead weight loss is
given by this area here this is the dead
weight loss happens
because consumers are willing to pay
they value the product more than its
marginal cost but the monopolist is not
willing to sell to these consumers
because to do so would require that he
lower the price and thus lower his
profits okay now one slight twist here
we can think about the marginal cost
curve here imagine that this monopolist
is buying its inputs from a competitive
industry so the marginal cost to the
monopolist is the price of the inputs
let's follow that up a little bit
more okay here's our previous diagram
we're now going to assume this is a
monopoly retailer which is going to be
supplied by a monopoly
wholesaler now from the point of view of
the retailer this is its marginal cost
and that's the price which is set by the
wholesaler and to make things simple
we're going to assume that every unit
produced by the retailer requires one
input from the wholesaler so think about
cars and engines the retailer sells cars
for every car it sells it needs one
engine from the wholesaler now what this
tells us from the point of view of the
wholesaler is that if the wholesaler
sets a price of $1 then it will sell 100
units to the retailer imagine that the
wholesaler sets a different price so
suppose the wholesaler set the price of
$1.75 well then we know that the retail
Monopoly is going to want to choose the
point where marginal revenue is equal to
marginal cost that is let's say at a
quantity of 80 so the whaler knows that
if the price is a
$1.75 the quantity it sells is 80 now
notice that means that the marginal
revenue curve for the retailer is
actually the demand curve for the
wholesaler this curve tells us whatever
price the wholesaler sets it tells us
the quantity demanded by the retailer so
we can think about this as the demand
curve for the
wholesaler okay let's get rid of that
and now let's add well what price will
the wholesaler want to set well if this
is the demand curve for the wholesaler
we need to find the marginal revenue
curve for the whol Sailor that's a curve
with just twice the slope similar to
what we had before we can now see that
the uh wholesaler will choose the point
where marginal revenue is equal to
marginal cost okay this is now the true
marginal cost for the wholesaler and
sets a price of let's say
$3 okay now that we know the
wholesaler's price that tells us what
the input price is going to be for the
retailer so let's go back and see what
the retailer
does so now we know the price which is
going to be set by the wholesale
and that of course is equal to the
marginal cost from the point of view of
the retailer the retailer will choose
that price and quantity such that
marginal revenue is equal to its
marginal cost therefore it's going to
choose a profit maximizing quantity of
50 and a profit maximizing price of $4
let's say this gives us the retailer
profit notice that the retailer profit
is much lower than it was
before some of that profit has been
gobbled up by the
wholesaler however the total amount of
profit is now less than when the uh
retailer was buying from a competitive
industry how do we know that well we
know that because the retailer could
have set a price of $4 before but it
chose not to its profit maximizing price
was lower it was $3 so the total amount
of profits has actually Fallen the
retailer profit Plus the wholesaler
profit is lower than when the monopolist
was buying from a competitive industry
another way of putting that is if these
two
monopolies the retailer and the
wholesaler could combine they would
choose to set a lower price but they
don't they don't unless they can make
some bargain and that may be hard
because of transactions cost especially
if we have multiple uh
wholesalers finally notice that the dead
weight loss has increased
dramatically so the double Monopoly
problem makes everyone worse off it
makes the monopolis worse off than if
they were to combine into a single
Monopoly and it makes consumers worse
off and quantity quantity Falls by a lot
quantity with the two monopolies has
fallen in half where it was when if
there was just one Monopoly so the
double Monopoly markup problem is really
serious it reduces the size of the
economy dramatically and it does so in a
way which makes everybody worse off
let's look at some
applications here's some applications of
this model as I've already mentioned it
means that vertical integration of two
monopolies can improve social welfare
monopolies overall aren't great but if
you're going to have a monopoly it's
better to have one vertically integrated
Monopoly than two vertical monopolies
classic example of this is Microsoft
Microsoft was accused of sort of
leveraging its Monopoly in operating
systems in order to get a monopoly in
browsers but consider would you rather
have Microsoft with a monopoly and
operating systems and let's say Netscape
with a monopoly in browsers or Microsoft
would Monopoly in both well it's better
for consumers for Microsoft to have a
monopoly in both because you will get
lower prices you will get increased
output and from Microsoft's point of
view Microsoft will actually have higher
profits as well so in this case it's
better to have one big Monopoly
vertically integrated Monopoly than two
vertical
monopolies patents and cumulative
Innovation is another application so
patents create a monopoly that's fine if
we're talking about a monopoly on a
consumer item a consumer good like a
chair or something like that that
Monopoly may be necessary in order to
generate the research and development
needed to produce this new product
things get tricky however when the
monopolists are selling to other
producers when you have monopolies which
build upon monopolies when you when one
product requires many different
monopolized uh inputs in that case then
the total production may be lower when
you have each one of these monopolists
trying to grab up a larger share of the
pi the actual Pi may get
smaller finally and most importantly for
our point of view is the application to
development and the idea here is the
monopolies or inefficiencies in
intermediate Goods could really shrink
the economy so for example if we have
intermediate good of electricity it's
really bad to have a monopoly in
electricity production because that is
going to make every other uh sector of
the economy which uses electricity
also worse off um same thing with
inefficiencies if you have an
inefficient financial sector and the
financial sector is an input into many
other Goods then that's really going to
shrink the economy so anytime you have
Goods intermediate Goods that is Goods
which are used to produce other goods or
services which are used to produce other
services it's especially important to
have competitive markets in those
intermediate
Goods bad to have monopolies in consumer
goods but it's much worse to have
monopolies in intermediate Goods because
those inefficiencies and those
monopolies are then expanded throughout
the
economy further reading on this there's
a very nice piece by Steven lansburg and
slate on the Microsoft operating system
browser uh dilemma that's called
Monopoly shopping you can look at my
book tabo's launching The Innovation
Renaissance for more on patents and
there's good pieces on uh intermediate
goods and Monopoly uh in the case of
development one is by Charles Jones
intermediate goods and weak links in the
theory of Economic Development and the
other is by parenti and Prescott
Monopoly rights a barrier to riches
there's an article of that name there's
also a book by parenti and Prescott
which makes the same point thanks