Vertical integration

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In microeconomics and strategic management, the term vertical integration describes a style of ownership and control. Vertically integrated companies are united through a hierarchy and share a common owner. Usually each member of the hierarchy produces a different product or service, and the products combine to satisfy a common need. It is contrasted with horizontal integration. Vertical integration is one method of avoiding the hold-up problem.

One of the earliest, largest and most famous examples of vertical integration was the Carnegie Steel company. The company controlled not only the mills where the steel was manufactured, but also the mines where the iron ore was extracted, the coal mines that supplied the coal, the ships that transported the iron ore and the railroads that transported the coal to the factory, the coke ovens where the coal was coked, etc.

A monopoly produced through vertical integration is called a vertical monopoly, although it might be more appropriate to speak of this as some form of cartel.

Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers.

Contents

[edit] Three types

Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers. Contrary to horizontal integragion, which is a consolidation of many firms that handle the same part of the production process, vertical integration is typified by one firm engaged in different aspects of production (e.g. growing raw materials, manufacturing, transporting, marketing, and/or retailing).

There are three varieties: backward (upstream) vertical integration, forward (downstream) vertical integration, and balanced (horizontal) vertical integration.

  • In backward vertical integration, the company sets up subsidiaries that produce some of the inputs used in the production of its products. For example, an automobile company may own a tire company, a glass company, and a metal company. Control of these three subsidiaries is intended to create a stable supply of inputs and ensure a consistent quality in their final product. It was the main business approach of Ford and other car companies in the 1920s, who sought to minimise costs by centralising the production of cars and car parts.
  • In forward vertical integration, the company sets up subsidiaries that distribute or market products to customers or use the products themselves. An example of this is a movie studio that also owns a chain of theaters.
  • In balanced vertical integration, the company sets up subsidiaries that both supply them with inputs and distribute their outputs.

It means, using McDonald's as an example, that they would own the farms where they raise the cows and chickens, the potatoes and the wheat. Own the plant that processes everything and turns it all into food, the distribution centers for every area, and the fast food retailers.

[edit] Examples

[edit] Oil Industry

One of the best examples of vertically integrated companies is the oil industry. Oil companies, both multinational (such as ExxonMobil, Royal Dutch Shell, or BP) and national (e.g. Petronas) often adopt a vertically integrated structure. This means that they are active all the way along the supply chain from locating crude oil deposits, drilling and extracting crude, transporting it around the world, refining it into petroleum products such as gasoline, to distributing the fuel to company-owned retail stations, where it is sold to consumers.

[edit] Apple Computer

Apple is one of the few vertically integrated businesses in the IT sector. The company designs the computer hardware, accessories, operating system and much of the software itself. Production, however, has been transferred to specialized suppliers such as Flextronics, which also manufactures computer hardware for other companies. This arrangement is similar to that of most high-tech companies today. Although no longer participating in the actual manufacturing process, Apple has recently established a chain of high-profile upscale retail outlets, establishing a type of forward vertical integration which ensures that it retains some measure of control over its product image and marketing strategy.

[edit] AT&T prior to 1996 and 1984

Prior to the 1984 Bell System Divestiture, AT&T was structured as 22 Bell Operating Companies, a research division, Bell Labs, the Long Lines division, and their manufacturing division, Western Electric. Bell Labs researched new technologies, such as Touch-Tone Dialing, Dataphone Service, PicturePhone Service, electronic switching, the UNIX operating system, and the transistor. Western Electric manufactured products based on Bell Labs research, and the Bell Operating Companies deployed those products to the field. After 1984 AT&T no longer owned the Bell Operating Companies, however it remained vertically integrated through the Long Lines, Bell Labs, and manufacturing operations. In 1996 AT&T divested itself of Bell Labs and manufacturing because those divisions were losing business because competitors to AT&T's network operations were often hesitant to buy AT&T equipment.

[edit] Problems and Benefits

There are internal and external (e.g. society-wide) gains and losses due to vertical integration. They will differ according to the state of technology in the industries involved, roughly corresponding to the stages of the industry lifecycle.

[edit] Static technology

This is the simplest case, where the gains and losses have been studied extensively.

Internal gains:

  • Lower transaction costs
  • Synchronization of supply and demand along the chain of products
  • Lower uncertainty and higher investment
  • Ability to monopolize markets throughout the chain by market foreclosure

Internal losses:

  • Higher monetary and organizational costs of switching to other suppliers/buyers

Benefits to society:

  • Better opportunities for investment growth through reduced uncertainty

Losses to society:

[edit] Dynamic technology

Some argue that vertical integration will eventually hurt a company because when new technologies are available, the company is forced to reinvest in its infrastructures in order to keep up with competition. Some say that today, when technologies evolve very quickly, this can cause a company to invest into new technologies, only to reinvest in even newer technologies later, thus costing a company financially. However, a benefit of vertical integration is that all the components that are in a company product will work harmoniously, which will lower downtime and repair costs.

[edit] See also

[edit] Lists

[edit] References

Martin K. Perry. "Vertical Integration: Determinants and Effects". Chapter 4 in: Handbook of Industrial Organization. North Holland, 1988.

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