Vertical integration
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In
Vertical integration can be desirable because it secures supplies needed by the firm to produce its product and the market needed to sell the product, but it can become undesirable when a firm's actions become anti-competitive and impede free competition in an open marketplace. Vertical integration is one method of avoiding the hold-up problem. A monopoly produced through vertical integration is called a vertical monopoly: vertical in a supply chain measures a firm's distance from the final consumers; for example, a firm that sells directly to the consumers has a vertical position of 0, a firm that supplies to this firm has a vertical position of 1, and so on.[2]
Vertical expansion
Vertical integration is often closely associated with vertical expansion which, in
The result is a more efficient business with lower costs and more profits. On the undesirable side, when vertical expansion leads toward monopolistic control of a product or service then regulative action may be required to rectify anti-competitive behavior. Related to vertical expansion is lateral expansion, which is the growth of a business enterprise through the acquisition of similar firms, in the hope of achieving economies of scale.
Vertical expansion is also known as a vertical acquisition. Vertical expansion or acquisitions can also be used to increase sales and to gain market power. The acquisition of
Scholars' findings suggest that a reduction in inefficiencies caused by the market vertical value chains including downstream prices, double mark-up can be negated with vertical integration. Application in more complex environments can help firms overcome market failures. (markets with high transaction costs or assets specificities) Scholars also identified potential risks and boundaries which may occur under vertical integration. This includes the potential competitor, the enhancements to horizontal collusion, development of barriers to entry. However, it is still debated over if vertical integration expected efficiencies can lead to competitive harm to the market. Some conclude that in many cases that the efficiencies outweigh the potential risks.[3]
Three types of vertical integration
Contrary to
- Backward vertical integration: A company exhibits backward vertical integration when it controls Ford River Rouge Complex. This type of integration also makes the barriers to entry into an industry more difficult. The control of subsidiaries that produce the raw materials needed in the production process gives a company the power to refuse access to resources to competitors and new entrants. They have the ability to cut off the chain of supply for competing buyers and thus, strengthen their position in their respective industry.[4]
- Forward vertical integration: A company tends toward forward vertical integration when it controls distribution centers and retailers where its products are sold. An example is a brewing company that owns and controls a number of bars or pubs. Unlike backward vertical integration, which serves to reduce costs of production, forward vertical integration allows a company to decrease its costs of distribution. This includes avoiding paying taxes for exchanges between stages in the chain of production, bypassing other price regulations, and removing the need for intermediary markets. In addition, a company has the power to refuse to support sales of competing distribution centers and retailers. Similar to backward vertical integration, this ability increases the barriers to entry into an industry.[4]
- Balanced vertical integration: A company demonstrates balanced vertical integration when it practices both backward vertical integration and forward vertical integration. Accomplishing this gives a company authority over the entire production and distribution process of a given product. A product that is produced in an integrated company as such exemplifies the result of a cost-efficient manufacture
Disintermediation is a form of vertical integration when purchasing departments take over the former role of wholesalers to source products.[5]
For vertical integration to succeed, managers must be able to adapt their managerial approach to compliment the changes in functional activities that their vertical shift accompanies. Managers should make sure that their firm can take advantage of existing functional knowledge through organisation, and simultaneously allow new functional knowledge to develop. However, environmental possibilities can be a factor in determining whether vertical integration is successful.[6]
Influence factors of vertical integration
- Technology : the probability of vertical integration between the two industries is less likely when the supply industry is more technology-intensive and the production industry is less technology-intensive. In addition, the impact of these factors is greater when inputs from the supply industry represent a large proportion of the total costs incurred by the production industry.[7]
- Switching cost and product differentiation : based on a new insight that pricing incentive choice of a downstream producer may change by vertical integration, downstream firms are more likely to switch to a different supplier if the investment by firms in a particular relationship is low, or if the input market is similar to the spot market. In this case, vertical M&A is more likely to have a positive impact on consumers. However, if supplier switching costs are high, the impact of a vertical integration on consumers depends on the degree of downstream product differentiation. If the downstream product is significantly differentiated, vertical integration is more likely beneficial to consumers. In contrast, if the downstream products are close substitutes, vertical integration is likely to harm consumers.[8]
Problems and benefits
There are many problems and benefits that vertical integration brings to an economic system. Problems that can stem from vertical integration can include large capital investments needed to set up and buy factories and maintain efficient profits. Rapid technology development can increase integration difficulties and further increase costs. The requirement of different business skills venturing into new portions of the supply chain can be challenging for the firm.[9] Another problem that may stem from vertical integration is the collapse of goals among the various firms in a supply chain. With each firm operating under different systems, integration may cause initial problems in management and production.[10] Vertical integration also proves to be dangerous when monopolistic problems arise in a capitalistic economy. When this happens, competition is removed and a corporation has the power to control all firms in its supply chain.[11]
One benefit is that the implementation of vertical integration can yield increased profit margins or eliminate the leverage that other firms or buyers may have over the firm.[12] It allows improved coordination between production and distribution firms and decreases the cost of exchange of goods between firms within a supply chain.[10] Operational routines also become more consistent and certain as the management of these firms gradually merge.[10] Vertically integrated firms rarely need to worry about the sufficiency in their supply of materials because they generally control the facilities that provide them.[13] A vertically integrated company also creates high barriers of entry into their respective economy, eliminating most potential competition.[13] Implementing vertical integration can be beneficial in that it reduces the distance that separates the suppliers and customers from the resources or information, which can then boost profits and efficiency.[14]
There are internal and external society-wide gains and losses stemming from vertical integration, which vary according to the state of technology in the industries involved, roughly corresponding to the stages of the industry lifecycle.[clarification needed][citation needed] Static technology represents the simplest case, where the gains and losses have been studied extensively.[citation needed] A vertically integrated company usually fails when transactions within the market are too risky or the contracts to support these risks are too costly to administer, such as frequent transactions and a small number of buyers and sellers.
Internal gains
- Lower transaction costs
- Synchronization of supply and demand along the chain of products
- Lower uncertainty and higher investment
- Capture of profit margins from upstream or downstream
- Ability to monopolize market throughout the chain by market foreclosure
- Strategic independence (especially if important inputs are rare or highly volatile in price, such as rare-earth metals).
- Enhancing the company's ties with its suppliers [14]
- Lower the threshold for entry. A sustained high surplus phase must be protected by barriers to entry. As a result, a vertically integrated entrant is able to extend these barriers at a lower cost than the value of existing surpluses.[15]
Internal losses
- Higher monetary and organizational costs of switching to other suppliers/buyers
- Weaker motivation for good performance at the start of the supply chain since sales are guaranteed and poor quality may be blended into other inputs at later manufacturing stages
- Specific investment, capacity balancing issue
- Developing new business competencies can compromise on existing competencies
- Conflicts in inventory management post-integration[10]
- Demand uncertainty may increase due to inventory instability[10]
- Assigning limited purchasing resources among the suppliers as well as the production of goods or services [14]
Benefits to society
- Better opportunities for investment growth through reduced uncertainty[citation needed]
- Local companies are often better positioned against foreign competition[citation needed]
- Lower consumer prices by reducing markup from intermediaries[16]
- Accomplishing the maximum profits for selling products or services.[14]
Losses to society
- Monopolization of markets
- Rigid organizational structure
- Manipulation of prices (if market power is established)
- Loss of tax revenue as fewer intermediary transactions are made.[citation needed]
Selected examples
The following are several case studies of vertical integration in play. Many examples center around American industries, where major companies like General Foods, Carnegie Steel Company, the Bell System, Apple, the U.S. entertainment studios, the U.S. meat industry, Ford Motor Company, CVS, and Amazon demonstrate vertical merging. Other examples like Alibaba and EssilorLuxottica cover vertical integration in other nations.
Birdseye
During a hunting trip American explorer and scientist Clarence Birdseye discovered the beneficial effects of "quick-freezing". For example, fish caught a few days previously that were kept in ice remained in perfect condition.
In 1924, Clarence Birdseye patented the "Birdseye Plate Froster" and established the General Seafood Corporation. In 1929, Birdseye's company and the patent were bought by Postum Cereals and Goldman Sachs Trading Corporation. It was later known as General Foods. They kept the Birdseye name, which was split into two words (Birds eye) for use as a trademark. Birdseye was paid $20 million for the patents and $2 million for the assets.
Birds Eye was one of the pioneers in the frozen food industry. During these times, there was not a well-developed infrastructure to produce and sell frozen foods. Hence Birds Eye developed its own system by using vertical integration. Members of the supply chain, such as farmers and small food retailers, could not afford the high cost of equipment, so Birdseye provided it to them.
Until now, Birds Eye has faded slowly[citation needed] because they have fixed costs associated with vertical integration, such as property, plants, and equipment that cannot be reduced significantly when production needs decrease. The Birds Eye company used vertical integration to create a larger organization structure with more levels of command. This produced a slower information processing rate, with the side effect of making the company so slow that it could not react quickly. Birds Eye did not take advantage of the growth of supermarkets until ten years after the competition did. The already-developed infrastructure did not allow Birdseye to quickly react to market changes.
Alibaba
In order to increase profits and gain more market share, Alibaba, a China-based company, has implemented vertical integration deepening its company holdings to more than the e-commerce platform. Alibaba has built its leadership in the market by gradually acquiring complementary companies in a variety of industries including delivery and payments.
Steel and oil
One of the earliest, largest and most famous examples of vertical integration was the
Telecommunications and computing
Telephone companies in most of the 20th century, especially the largest (the
Apple
Apple has used the vertical integration strategy for 35 years and is one of the most successful companies in the technology industry. Apple centered its business strategy on its own development of integrated hardware, software, and latterly services. They design most of their products in-house, and do not allow their hardware and operating system to be licensed out, which allows the company to apply its company vision to its products.
Large companies such as Apple are more likely than smaller companies to employ vertical integration, as they have more resources to manage each stage of production (e.g. major expansion and funding). Implementing a vertically integrated strategy has helped Apple become a leading platform company; integrating their software (through
Vertical integration allows Apple to control production from beginning to end. Other companies may follow the Apple model, but may not see success for some time, both due to the cost of entering the market and taking on the currently successful incumbent, but also by innovating their products to make them more appealing in the marketplace than the current incumbent. Vertical integration requires a company to focus not only on its core business, but also on several difficult areas such as sourcing materials and manufacturing partners, distribution, and finally selling the product.
Another major success of Apple's, is the forward integration with their retail stores, allowing them to sell their products directly to customers (helping customers to buy and use Apple's products and services), additionally helping them to control the prices of their products, and thus to maintain high-profit margins when they do.[20] Apple is also known as one of the world's leading "orchestrators" as they exert control over the entire value chain, but do not do everything in-house (e.g. assembly of iPhones by manufacturing partner Foxconn).[21]
Entertainment
From the early 1920s through the early 1950s, the American
The issue of vertical integration (also known as common ownership) has been the main focus of policy makers because of the possibility of anti-competitive behaviors affiliated with market influence. For example, in United States v. Paramount Pictures, Inc., the Supreme Court ordered the five vertically integrated studios to sell off their theater chains and all trade practices were prohibited (United States v. Paramount Pictures, Inc., 1948).[23] The prevalence of vertical integration wholly predetermined the relationships between both studios and networks[clarification needed] and modified criteria in financing. Networks began arranging content initiated by commonly owned studios and stipulated a portion of the syndication revenues in order for a show to gain a spot on the schedule if it was produced by a studio without common ownership.[24] In response, the studios fundamentally changed the way they made movies and did business. Lacking the financial resources and contract talent they once controlled, the studios now relied on independent producers supplying some portion of the budget in exchange for distribution rights.[25]
Certain
Agriculture
Vertical integration through production and marketing contracts have also become the dominant model for livestock production. Currently, 90% of poultry, 69% of hogs, and 29% of cattle are contractually produced through vertical integration.[26] The USDA supports vertical integration because it has increased food productivity. However, "... contractors receive a large share of farm receipts, formerly assumed to go to the operator's family".[27]
Under production contracts, growers raise animals owned by integrators. Farm contracts contain detailed conditions for growers, who are paid based on how efficiently they use feed, provided by the integrator, to raise the animals. The contract dictates how to construct the facilities, how to feed, house, and medicate the animals, and how to handle manure and dispose of carcasses. Generally, the contract also shields the integrator from liability.
Under marketing contracts, growers agree in advance to sell their animals to integrators under an agreed price system. Generally, these contracts shield the integrator from liability for the grower's actions and the only negotiable item is a price.[26]
Automotive industry
In the United States new automobiles can not be sold at dealerships owned by the same company that produced them but are protected by state franchise laws.[30]
Ford Motor Company vertically integrated due to high demand for their Model T automobile. With the development of Model T, the company required a system in which mass production was most efficient. The model called for the manufacture of additional devices, all of which had carefully-curated designs by Ford engineers. Instead of passing these instructions and duties off to external manufacture firms, vertical integration was exercised within the corporation. This allowed for manageable division of labor, decreased costs in delay and exchange of goods, and organized updates of each firm in the supply chain. Vertical integration enabled Ford Motor Company to be self-regulating and self-sufficient.[31]
Eyewear
Health care
Within healthcare systems, horizontal integration is generally much more prominent. However, in the United States, major vertical mergers have included CVS Health's purchase of Aetna, and Cigna's purchase of Express Scripts. The integration of CVS Health and Aetna resulted in the combination of one of the nation's largest health insurance companies with a pharmaceutical company seen all across the U.S. The vertical merge allowed CVS-Aetna to regulate more of the healthcare and delivery chain and gave them the ability to provide higher quality care to consumers. One of the most significant advantages to this integration is the reduction in costs for healthcare.[36]
General retail
Electric utilities
Before a wave of
Economic theory
An economic theory is a framework that defines how a particular economic system functions. Economists develop principles in which an economy adheres to, which provides insight onto the relationships between economic events, markets, companies, and the government.[39] In economic theory, vertical integration has been studied in the literature on incomplete contracts that was developed by Oliver Hart and his coauthors.[40][41] Consider a seller of an intermediate product that is used by a buyer to produce a final product. The intermediate product can only be produced with the help of specific physical assets (e.g., machines, buildings). Should the buyer own the assets (vertical integration) or should the seller own the assets (non-integration)? Suppose that today the parties have to make relationship-specific investments. Since today complete contracts cannot be written, the two parties will negotiate tomorrow about how to divide the returns of the investments. Since the owner is in a better bargaining position, he will have stronger incentives to invest. Hence, whether vertical integration is desirable or not depends on whose investments are more important. Hart's theory has been extended by several authors. For instance, DeMeza and Lockwood (1998) have studied different bargaining games,[42] while Schmitz (2006) has introduced asymmetric information into the incomplete contracting setup.[43] In these extended models, vertical integration can sometimes be optimal even if only the seller has to make an investment decision.
See also
- Vertical and horizontal market
References
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- ^ "What Is Vertical Integration?". The Balance. Retrieved 28 March 2023.
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- ^ Edwards, Janice (12 September 2014). "Vertical Integration Strategies".
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- Sloan Management Review, 34(3), 71–83.
- ^ DOJ and FTC Propose Highly Anticipated Vertical Merger Guidelines
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- ^ Irwin, Manley; McKee, Robert (3 February 1968). "Vertical Integration and the Communication Equipment Industry: Alternatives for Public Policy". scholarship.law.cornell.edu. Retrieved 2 June 2019.
- JSTOR 2487925.
- ^ Claici, Claici; Basalisco, Bruno. "The Economic Rationale For Vertical Integration In The Tech Sector" (PDF). Copenhagen Economics. Retrieved 1 May 2022.
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- ^ Lotz, Amanda D. (2007) "The Television Will Be Revolutionized". New York, NY: New York University Press. p.87
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- ^ a b c Paul Stokstad, Enforcing Environmental Law in an Unequal Market: The Case of Concentrated Animal Feeding Operations, 15 Mo. Envtl. L. & Pol’y Rev. 229, 234-36 (Spring 2008)
- ^ "USDA ERS - Farmers' Use of Marketing and Production Contracts". Ers.usda.gov. Archived from the original on 24 April 2015. Retrieved 24 April 2015.
- ISBN 9780517524541. Retrieved 24 April 2015.
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- ^ Surowiecki, James (4 September 2006). "Dealer's Choice". The New Yorker. Retrieved 1 October 2016.
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- ^ "Sticker shock: Why are glasses so expensive?". 60 Minutes. CBS News. 7 October 2012. Retrieved 19 October 2012.
- ^ Goodman, Andrew (16 July 2014). "There's More to Ray-Ban and Oakley Than Meets the Eye". Forbes. Retrieved 1 October 2016.
- ^ Swanson, Ana (10 September 2014). "Meet the Four-Eyed, Eight-Tentacled Monopoly That is Making Your Glasses So Expensive". Forbes. Retrieved 1 October 2016.
- ^ Knight, Sam (10 May 2018). "The spectacular power of Big Lens | The long read". The Guardian – via www.theguardian.com.
- ^ Kish, Natalie; Bhagat, Maulik (26 February 2018). "CVS-Aetna: A blockbuster in vertical integration". Chain Drug Review. 40 (4): 17–18.
- ^ Willis & Philipson 2018, pp. 12–14.
- ^ Aagaard & Kleit 2022, p. 84.
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Bibliography
- Kathryn H. (1986). "Matching Vertical Integration strategies". Strategic Management Journal. 7: 535–555. .
- Matthew Lewis (2013). "On Apple And Vertical Integration". Retrieved 11 April 2015.
- Paul Cole-Ingait; Demand Media (2013). "Vertical Integration Examples in the Smartphone Industry". Retrieved 11 April 2015.
- Robert D. Buzzell (January 1983). "Is Vertical Integration Profitable?". Harvard Business Review. Retrieved 11 April 2015.
- Wharton (2012). "How Apple Made 'Vertical Integration' Hot Again — Too Hot, Maybe". Time. Retrieved 13 April 2015.
- "Idea Vertical Integration". 30 March 2009. Retrieved 12 April 2015.
- Grossman SJ, Hart OD (1986). "The costs and benefits of ownership: A theory of vertical and lateral integration" (PDF). The Journal of Political Economy. 94 (4): 691–719. S2CID 215807368.
- "Iglo History". Archived from the original on 3 May 2015. Retrieved 2 May 2015.
- Willis, H. Lee; Philipson, Lorrin (3 October 2018). "Vertically Integrated Utilities". Understanding Electric Utilities and De-Regulation (2 ed.). CRC Press. pp. 12–. ISBN 978-1-4200-2826-3.
Sources
- Aagaard, Todd; Kleit, Andrew N. (2022). "Too Much Is Never Enough: Constructing Electricity Capacity Market Demand" (PDF). Energy Law Journal. 43 (1). Washington: 79–124.
Further reading
- Bramwell G. Rudd, 2014, "Courtaulds and the Hosiery & Knitwear Industry," Lancaster, PA:Carnegie.
- Joseph R. Conlin, 2007, "Vertical Integration", in The American Past: A Survey of American History, p. 457, Belmont, CA:Thompson Wadsworth.