Question: 4.

Suppose a manufacturer and its

retailer face the problem of double
marginalization described i...

4. Suppose a manufacturer and its retailer face the problem of double

marginalization described in my notes, Section 11.1. If the manufacturer sets
the wholesale price equal to its marginal cost c and in addition, requires the
retailer to pay a fraction (? [0? 1]) of the dealer’s profit.
4.1. Write down the retailer’s profit maximization problem. Will this practice
solve the double marginalization problem? (That is, will this practice
maximize their joint profit?)
4.2. If the retailer is required to pay a fraction of its sales (i.e., total
revenue), will that solve the double marginalization problem?
NOTES ON DOUBLE MARGINALIZATION (11.1)
11.1 Double Marginalization • Suppose the manufacturer is a monopoly with a
constant marginal cost c. It sells its product to its only retailer at a wholesale
price p W. The retailer has no other cost and sets a retail price p R. The
inverse demand function is p R = a – bQ.
• Let’s first look at the typical monopoly problem where there is no retailer.
The manufacturer will set = (a+c)/2, = (a-c)/2b and the profit is ?^M
=

• Now introduce the retailer. Notice that the retailer faces a marginal cost
(> c) and will set higher than this level. (Two markups ? double
marginalization).

– The retailer's problem is, given

max ?^R = (a – bQ) Q - Q

F.O.C. a – 2bQ – p^W = 0
Q = (a – p^w) /2b, and p^R = (a + p^W) /2.
– Given the retailer’s reaction function, the manufacturer wants to solve
max ?W = (p^w – c)∙ (a – p^w) /2b
F.O.C. (a – p^ W) /2b – (p^W – c) /2b = 0
p^W = (a + c) /2 and Q = (a – c)/4b.
• The joint profit of the manufacturer and the retailer is 3(a-c)^2 /16b < ? M—
the profit level without the retailer. This is because the retailer marks up the
price one more time and the consumers end up facing a much higher price.
• Both the manufacturer and the retailer have incentives to solve this double
marginalization problem in order to increase joint profit. We’ll discuss possible
solutions below.
1. Vertical integration. Obviously, if the manufacturer and the retailer merge
as a single firm, their joint profit can be maximized.
Vertical integration, however, is not always possible or cost effective. As
shown below, joint profit can still be maximized by imposing vertical restrains
—contractual terms different from just a single wholesale price.
2. The manufacturer can have a pricing scheme similar to a two-part tariff: a
fixed charge f (franchise fee) and a usage charge p^w (wholesale price). In
this example, p^w should be set equal to c so that the retailer faces the
“right” marginal cost. As a result, the retailer will set p^R = p^M and the joint
profit is maximized. The franchise fee only determines how the joint profit is
distributed between the manufacturer and the retailer.
3. Another way to maximize the joint profit is for the manufacturer to impose a
vertical restrain requiring the retailer to charge a price no greater than p^M
(i.e., there is a maximum retail price). As a result, the retailer will set the
retail price equal to p^M and the joint profit is maximized. The wholesale
price p^W only determines how the joint profit is distributed between the two
firms