Question

Question (Double Marginalization)

Suppose that Michelin is the only producer of tires and Toyota the only producer of cars. The demand function for cars is given by Q = 40 − 4P. Michelin's (constant) cost of production for a set of five tires is 3. The production of one car requires a set of five tires and a bundle of inputs, which Toyota can obtain at a price of 6.
- Suppose first that Michelin and Toyota are just two departments within the same firm.

1. (a) What price would the firm charge for cars and how many cars would it produce?

- Suppose now that Michelin and Toyota are separate firms. Michelin quotes a price w for a set of five tires and Toyota decides how many sets to buy at that price.

2. (b) What price will Michelin set? How many cars will Toyota sell and at what price?

3. (c) Are consumers better off when Michelin and Toyota are an integrated firm [Part (a)] or when they are separate firms [Part (b)]?

Answer 1

Double Marginalization is defined as the " exercise of the market power at successive vertical layers in a supply chain.

We have one firm Michelin who provides tire and other firm Toyota which uses those tires to make cars.

So Toyota is the downstream firm and Michelin is the upstream firm.

Michelin will set the price above its marginal cost and then sell it to the Toyota on the other hand Toyota will also set the price of its cars above the marginal cost and hence input tire is being marked up twice. This is why we called this double marginalization.

1.)

2.)

3.)

It is clear after solving above two questions that consumers are better of when both firms are not separated as then there is only one markup over marginal cost hence, P = 8 for one car but when both firms are separated each firm markup its product once and thus double marginalization causes the final product car's price P to be equal to 8.25 which is greater than P =8. Hence consumer are paying more for the same product and hence they are worse off.