vertical integration

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Vertical Integration

A business strategy in which a company expands its operations to offer similar goods and services at a different point on the supply chain. For example, a widget wholesaler may expand into retailing widgets directly with consumers. More concretely, an oil exploration company may also begin refining oil in addition to its exploration operations. Vertical integration always occurs at different points on the supply chain: a retailer does not expand into retailing other products. Rather, it may move into wholesaling. See also: Horizontal integration.

vertical integration

the combining in one firm of two or more vertically related activities, as opposed to these activities being performed separately in different firms and then being synchronized through arms-length market transactions. For example, a firm engaged in assembly operations may integrate backwards (‘upstream’) to produce its own components, or forwards (‘downstream’) to distribute its products. Vertical integration may involve ORGANIC GROWTH on the part of the firm, or firms may choose to expand by MERGER with, or TAKEOVER of, established suppliers and distributors.

Vertical integration may be advantageous to firms if it permits them to lower their operating costs by production savings arising from the linking of technically related processes (for example the linking together of casting and rolling operations in steel mills, and continuous motorcar assembly operations), and reduce STOCKHOLDING COSTS by a closer matching of inventory and production requirements. Vertical integration also enables firms to avoid various TRANSACTION COSTS in dealing with outside suppliers/distributors, including the costs of finding suppliers/ dealers, agreeing contract terms and conditions, and ensuring that there is strict adherence to these undertakings. Additionally, vertical integration gives firms greater security of supplies and access to customers, as well as the potential for applying competitive pressure on non-integrated rivals by depriving them of supplies/outlets (FORECLOSURE) or PRIZE SQUEEZING.

On the other hand the firm may experience increasing costs because ‘captive’ transfers of inputs within the firm puts little pressure on divisions to hold costs in check while such transfers may make the firm myopic to ‘outside'buying and selling opportunities (see VERTICAL DISINTEGRATION). Moreover, there are limits to vertical integration as a growth strategy for the firm. Vertical integration ‘converts’ a variable cost (buying in the market) into a fixed investment cost (self-supply) thus increasing the firms exposure (risk) to cyclical and secular downturns in demands. The former causes profits to vary and leads to ‘ripple-on’ effects down the vertical chain thus exacerbating cash-flow problems while the latter threatens the very survival of the firm (see PRODUCT LIFE CYCLE). Vertical disintegration can help but in many cases DIVERSIFICATION may be necessary to sustain the expansion of the firm. In addition, firms' ability to expand vertically, particularly by merger and takeover, may be restricted by the OFFICE OF FAIR TRADING, because of anticompetitive effects. See MAKE OR BUY DECISION, COMPETITIVE ADVANTAGE, BUSINESS STRATEGY, TRANSFER PRICE, VALUE ADDED, VALUE ADDED CHAIN, VALUE ADDED ANALYSIS, DISTRIBUTION CHANNEL, VERTICAL MARKETING SYSTEM, INTERNALIZATION, OUTSOURCING, INTERNAL CUSTOMER, INTERNAL MARKET, COMPETITION POLICY (UK), AGENCY COSTS.

vertical integration

an element of MARKET STRUCTURE in which a firm undertakes a number of successive stages in the supply of a product, as opposed to operating at only one stage (HORIZONTAL INTEGRATION). BACKWARD INTEGRATION (‘upstream’) occurs when a firm begins producing raw materials that were previously supplied to it by other firms (for example, a camera producer making glass lenses); FORWARD INTEGRATION (‘downstream’) occurs when a firm undertakes further finishing of a product, final assembly or distribution (for example, an oil company that sells petrol through its own petrol stations).

From the firm's point of view, vertical integration may be advantageous because it enables the firm to reduce its production and distribution costs by linking together successive activities or because it is vital for it to secure reliable supplies of inputs or distribution outlets in order to remain competitive (see below). On the other hand, the firm may experience increasing costs because ‘captive’ transfers of inputs within the firm put little pressure on divisions to hold costs in check while such transfers may make the firm myopic to ‘outside’ buying and selling opportunities (see VERTICAL DISINTEGRATION). Moreover, there are limits to vertical integration as a growth strategy for the firm. Vertical integration ‘converts’ a variable cost (buying in the market) into a fixed investment cost (self-supply), thus increasing the firm's exposure (risk) to cyclical and secular downturns in demands. The former causes profits to vary and leads to ‘ripple-on’ effects down the vertical chain, thus exacerbating cash-flow problems, while the latter threatens the very survival of the firm (see PRODUCT LIFE CYCLE). Vertical disintegration can help, but in many cases DIVERSIFICATION may be necessary to sustain the expansion of the firm.

In terms of its wider impact on the operation of market processes, vertical integration may, on the one hand, promote greater efficiency in resource use, or, on the other hand, by limiting competition, lead to a less efficient allocation of resources.

Various efficiency gains may accrue through vertical integration. These include technical economies from combining together successive production processes, for example, the savings made in reheating costs by combining steel furnace operations. Stockholding economies can also arise from the reduction in intermediate contingency and buffer stocks. Vertically integrated firms can eliminate some purchasing and selling expenses in negotiating outside supply and advertising/selling contracts by internalizing these transactions within the firm (see INTERNALIZATION, ASSET SPECIFICITY, MAKE OR BUY, OUTSOURCING). Managerial economies may accrue by having a single administrative system to handle several production activities, and financial economies may accrue through more advantageous bulk-buying discounts and by lowering the cost of raising capital. Where firms achieve such efficiency gains through vertical integration, their average costs will tend to fall, thus facilitating a lowering of market prices and an increase in output.

However, vertical integration can lead to higher TRANSACTION COSTS associated with larger internal organizations (e.g. higher administration costs) as well as ‘agency’ problems (see AGENCY COST). See TRANSACTION for further discussion.

Where a firm already dominates one or more vertical stages, vertical integration may lead to various anti-competitive effects. Forward integration can secure a market, but it can also foreclose it to competitors; similarly, backward integration can guarantee supply sources, but it can also be used to prevent rivals gaining access to those sources. Moreover, if a firm acquires the supplier of a scarce raw material that is used by both itself and by its competitors, then it may be in a position to operate a PRICE SQUEEZE, that is, to squeeze the profit margins of its competitors by raising their costs by charging them a higher price for the raw material than the price charged for its own use, while setting a relatively low final product price. Such tactics serve not only to discipline existing competitors but also act as BARRIERS TO ENTRY to potential new competitors. Denied access to markets or materials or offered access only on disadvantageous terms, potential competitors would need to set up with the same degree of integration as existing firms, and the large initial capital requirements of such large-scale entry can be prohibitive.

Thus, vertical integration may produce, simultaneously, both beneficial or detrimental effects. Under the FAIR TRADING ACT 1993, vertical integration by an established monopoly firm or a proposed MERGER between two vertically related firms (or a TAKEOVER of one by the other), involving assets in excess of £70 million, can be referred to the COMPETITION COMMISSION to determine whether or not it operates against the public interest. See also VALUE-ADDED CHAIN, VALUE-CREATED MODEL, VALUE CHAIN ANALYSIS, TRANSFER PRICE, FORECLOSURE, COMPETITION POLICY (UK), COMPETITION POLICY (EU).

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