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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 (business) 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 (fuel) 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 Motor Company and other car companies in the 1920s, who sought to minimize costs by centralization the production of cars and car parts.
- In forward vertical integration, the company sets up subsidiaries that Distribution (business) or marketing 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,
refinery it into petroleum products such as
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 Monopoly 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
business 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.
See also
Lists
References
Martin K. Perry. "Vertical Integration: Determinants and Effects". Chapter 4 in: Handbook of Industrial Organization. North Holland, 1988.
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 (business) 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 (fuel) 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 Motor Company and other car companies in the 1920s, who sought to minimize costs by centralization the production of cars and car parts.
- In forward vertical integration, the company sets up subsidiaries that Distribution (business) or marketing 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, refinery it into petroleum products such as 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 Monopoly 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
business 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.
See also
Lists
References
Martin K. Perry. "Vertical Integration: Determinants and Effects". Chapter 4 in: Handbook of Industrial Organization. North Holland, 1988.
Vertical integration - Wikipedia, the free encyclopedia
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