Vertical integration

In microeconomics and management, the term vertical integration describes a style of management control. Vertically integrated companies are united through a hierarchy with a common owner. Usually each member of the hierarchy produces a different product or (market-specific) 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. Nineteenth century steel tycoon Andrew Carnegie introduced the idea of vertical integration.  This led other businesspeople to use the system to promote better financial growth and efficiency in their companies and businesses.

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 parts 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 (both upstream and downstream) vertical integration.

• A company exhibits backward vertical integration when it controls 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.
• A company tends toward forward vertical integration when it controls distribution centers and retailers where its products are sold.
• Balanced vertical integration means a firm controls all of these components, from raw materials to final delivery.

The three varieties noted are only abstractions; actual firms employ a wide variety of subtle variations. Suppliers are often contractors, not legally owned subsidiaries. Still, a client may effectively control a supplier if their contract solely assures the supplier's profitability. Distribution and retail partnerships exhibit similarly wide ranges of complexity and interdependence. In relatively open capitalist contexts, pure vertical integration by explicit ownership is uncommon -- and distributing ownership is commonly a strategy for distributing risk.

Examples

Carnegie Steel

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 cooked, etc. The company also focused heavily on developing talent internally from the bottom up, rather than importing it from other companies.^[1] Later on, Carnegie even established an institute of higher learning to teach the steel processes to the next generation.

American Apparel

American Apparel is a fashion retailer and manufacturer that actually advertises itself as vertically integrated industrial company.^[2][3] The brand is based in downtown Los Angeles, where from a single building they control the dyeing, finishing, designing, sewing, cutting, marketing and distribution of the company's product.^[4][3][5] The company shoots and distributes its own advertisements, often using its own employees as subjects.^[6][2] It also owns and operates each of its retail locations as opposed to franchising.^[7] According to the management, the vertically integrated model allows the company to design, cut, distribute and sell an item globally in the span of a week.^[8] The original founder Dov Charney has remained the majority shareholder and CEO. ^[9] Since the company controls both the production and distribution of its product, it is an example of a balanced vertically integrated corporation.

Oil industry

Oil companies, both multinational (such as ExxonMobil, Royal Dutch Shell, ConocoPhillips or BP) and national (e.g. Petronas) often adopt a vertically integrated structure. This means that they are active along the entire 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, for sale to consumers.

Reliance

The Indian petrochemical giant Reliance Industries is a great example of vertical integration in modern business. Reliance's backward integration from textiles into polyester fibres and further into petrochemicals was started by Mukesh Ambani . Reliance has entered the oil and natural gas sector, along with retail sector. Reliance now has a complete vertical product portfolio from oil and gas production, refining, petrochemicals, synthetic garments and retail outlets.

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 market 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)
• Monopoly on intermediate components (with opportunity for price gouging) leads to a throwaway society

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.^{[citation needed]}

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 television shows.

See also

• Conglomerate (company)
• Vertical market
• Exclusive dealing
• Strategic management
• Zaibatsu (the Japanese approach to vertical integration)
• Chaebol (the South Korean counterpart to Zaibatsu)
• Horizontal integration
• Economic calculation problem (although mostly discussed in relation to command economies, it equally applies to firms)
• Vertical disintegration
• Alfred DuPont Chandler, Jr. (economist who wrote extensively on vertical integration)

References

Bibliography