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In microeconomics and managing management, the term vertical integration
describes a style of ownership and control. The degree to which a firm owns its
upstream suppliers and its downstream buyers determines how vertically
integrated it is. 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. 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.
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. Later on, Carnegie even established an institute of
higher learning to teach the steel processes to the next generation.
Three types
Vertical integration is the degree to which a firm owns its upstream suppliers
and its downstream buyers. Contrary to horizontal integration, 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
minimize costs by centralizing 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.
If you view McDonald's, for example, as primarily a food manufacturer, backwards
vertical integration would mean that they would own the farms where they raise
the cows, chickens, potatoes and wheat as well as the factories that processes
everything and turns it all into food. Forwards vertical integration would imply
that they own the distribution centers for every area and the fast food
retailers. Balanced vertical integration would mean that they own all of the
mentioned components.
Examples
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 Petrol/Gasoline, to
distributing the fuel to company-owned retail stations, where it is sold to
consumers.
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.
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:
Monopolization of markets
Rigid organizational structure, having much the same shortcomings as the
socialist economy (cf. John Kenneth Galbraith's works), etc...
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.
Vertical expansion
Vertical expansion, in economics, is the growth of a business enterprise through
the acquisition of companies that produce the intermediate goods needed by the
business or help market and distribute its final goods. Such expansion is
desired because it secures the supplies needed by the firm to produce its
product and the market needed to sell the product. The result is a more
efficient business with lower costs and more profits.
Related 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 scales and to gain market power.
The acquisition of DirectTV by News Corporation is an example of vertical
expansion or acquisition. DirectTV is a satellite TV company through which News
Corporation can distribute more of its media content: news, movies, and
televsion shows.
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