Definitions

efficient business

Vertical integration

In microeconomics and management, the term vertical integration describes a style of management 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. 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. Andrew Carnegie actually introduced the idea of vertical integration. This led other businessmen to using 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 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.

For example, a hamburger manufacturer that owns the farms where they raise the cows, chickens, potatoes and wheat as well as the factories that processes these agricultural products is practising backwards vertical integration. Forwards vertical integration would mean that they would own the regional distribution centers and shops or fast food restaurants where the hamburgers are sold. Balanced vertical integration would mean that they own all of these components.

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 coked, etc. The company also focused heavily on developing talent internally from the bottom up, rather than importing it from other companies. 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. 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. The company shoots and distributes its own advertisements, often using its own employees as subjects. It also owns and operates each of its retail locations as opposed to franchising. 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. The original founder Dov Charney has remained the majority shareholder and CEO. 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, 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:

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:

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 television shows.

See also

References

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

Joseph R. Conlin. "The American Past: A Survey of American History". Chapter 27 page 457 under "VERTICAL INTEGRATION". Thompson Wadsworth. Belmont, CA, 2007.

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