Advantages and Disadvantages of Vertical Integration - Example

Running Head: VERTICAL INTEGRATION Vertical Integration [The Writer’s Name] [The Name of the Institution] Vertical Integration Introduction Vertical integration may be defined as the integration beside a supply chain. It may be illustrated in this way that, if a merchant begins manufacturing the products it puts on the market, it is escalating its intensity of vertical integration. There are two kinds of vertical integration i.e. backward or forward. Advantages and Disadvantages of Vertical Integration The advantages of vertical integration comprise the capability to protect supply chain management and prospective orders. It may also signify that the fractions of the business protected from contest can become less competent as they are no more subject to the regulation of challenging in an open market now. As regards to this, Vertical integration is in many cases permissible where it directs to either some other source of strategic advantage or operational efficiencies. (Riordan, 1990, 94-111) In the current globalized scenario, businesses have more and more enthused to outsourcing numerous purposes. This may often be termed as a noteworthy shift away from vertical integration - for example the partition of marketing and design from producing that has taken place in electronics. Another advantage of vertical integration is the choice the business has to integrate in a horizontal position. Another great advantage of vertical integration is that it frequently forms economies of scale and lessens production costs since it removes many of the unnecessary price markups in all production phases. In this way, vertically integrated enterprises also attain cost efficiencies by scheming quality at all steps, which lessens returns, repair costs, and downtime. (Valletti, 2000, 395-409) Furthermore, vertically-integrated enterprises do not have to assign means to contracting, pricing, coordinating and paying, with third-party vendors. As far as homogeneous suppliers and non-linear upstream prices are concerned; it has been observed that integration has no impact of any kind on downstream marginal costs. While, on the other hand, post-integration costs may decrease on the basis of economies of scope between downstream and upstream production. (Besanko et al. 2003, 173) This theoretical defense of profit-seeking vertical integration is particularly persuasive in an industry characterized by seriously imperfect competition in its various horizontal strata. A nonintegrated industry is subject to the pyramiding of monopoly surcharges through each of its successive stages of production and distribution. The levels that are characterized by seriously imperfect competition fix sales prices (and hence the cost prices for the next stage) that include either a supernormal return on investment, or costs that might have been lower had competition been more effective. The vertically integrating firm can avoid these exactions by making the product or performing the function itself. (Williamson, 1985, 85-102) Of course, there is no advantage, necessarily, in avoiding payment of profits to suppliers or distributors; the cost to the integrated firm as well must include a necessary return on the capital committed to the upstream or downstream operations. The real gains from vertical integration must rest on one or more of the following advantages: superior efficiency, lower costs of capital, or circumvention of monopoly. It can obtain materials or have its forward functions performed at cost. (Shelanski, 1995, 335-61) If vertical integration does not of itself tip the balance of power in favor of sellers or buyers in intermediate markets, or reduce the number of sellers at the final level; and if, on the other hand, it may well permit firms to reduce the cost of getting goods and services to the customer, it would seem never to be a proper subject of suspicion. Some economists have argued to this effect. (Spengler, 1950: 347) Vertical integration, they aver, does not impair competition and cannot enhance monopoly power. It can only serve the public interest to leave companies free to integrate vertically or not, as they choose: they will find it profitable to do so only if it reduces their costs or enhances their ability to compete for one or another of the reasons indicated above. Manifestly, if integration conferred no additional monopoly power, a rational seller would integrate backward ("upstream") or forward ("downstream") only if he thought he could perform supplier or distributor functions more cheaply than they were previously being performed. (Bork, 1954: 157) If these hopes materialized both he and the public might benefit: with effective competition in final product markets, the integrating firm would be forced to pass some of the cost savings on to the consumer; if it were a monopolist instead, it would at worst pocket the cost savings, since it would presumably have already been exploiting its monopoly to the fullest. If, on the other hand, the hopes of lower costs or higher realization were frustrated, only the company itself would suffer. If the mistaken integrator were a monopolist who had failed to charge his optimum monopoly toll, he might find it possible to pass on some or the entire burden of his error to the consumer. The evil here, however, would be not vertical integration, but (horizontal) monopoly, which can penalize the public for its mistakes, whatever their source. Long-term contracts, joint ventures, strategic alliances, technology licenses, asset ownership, and franchising tend to involve lower capital costs and greater flexibility than vertical integration. Also, they often provide adequate protection from market power held by customers or suppliers. (Bardhan, 2000, 1020-34) Joint ventures and strategic alliances allow firms to exchange certain goods, services, information, or expertise while maintaining a formal trade relationship on others. Such mechanisms also allow the companies involved to retain their corporate identities and to avoid the risk of antitrust prosecution. The potential mutual advantages of vertical integration, in this way, can be maximized, and the natural conflict in trade relationships can be minimized. (Bardhan, 2000, 1020-34) There is basic truth in the assertion that it is horizontal monopoly that is the major threat to a freely competitive economy. The theory under consideration here, however, minimizes unrealistically the threat that vertical integration, when combined with seriously imperfect competition in some segments of an industry, may itself pose for horizontal competition. (Rabin, 1993, 51-76) In juxtaposition with the view that vertical integration cannot impair competition may be set the somewhat more pessimistic theory that it is through the "countervailing power" organized spontaneously in opposition to "original" monopoly (or monopsony) power that society must hope to work out a reasonably acceptable market balance. (Walter, 1953, 469-92) The big buyer, or an organized group of buyers, may exert significant pressure on the sales terms of sellers even if few and powerful, because the volume of their business is important enough to any single seller to make serious the threat of taking it to a competitor. It would seem to follow that to the extent sellers can preclude the emergence of countervailing buying groups or make themselves independent of them, by forward integration, they may be better able to cement their common front against the cracks that only a big, independent buyer can probe and widen. A powerful buyer may also split or encroach upon the monopoly power of sellers by integrating backward and supplying his own requirements; or he may go only part way backward, by supplying capital and making long-term purchase contracts with an established manufacturer in exchange for something like a cost-plus arrangement. Why should a big buyer be better able to do this than an unorganized group of small ones? First, the volume of his business will enable him to offer a manufacturing subsidiary or affiliate the most convincing kind of guarantee of a market large enough to permit the achievement of economies of scale. Second, size is associated ordinarily with superior access to capital. Vertical integration forestalled the threatened entry of new competition at both levels of the industry. Were market position and power fixed and immutable quanta, vertical integration could do no harm and might do only good. It could not of itself enhance horizontal market power; and by causing complementary functions to be performed at cost, it might induce even monopolists to lower their ultimate prices. In fact, however, market positions are subject constantly to encroachment and market power to erosion in a dynamic economy. Every business in the real world, therefore, must devote a good deal of attention to securing itself against the inroads of competition. Vertical integration is one important and familiar way of trying to do this. Like others of the tactics companies use to protect or extend their market positions, it may be a competitive phenomenon, productive of social benefit. But it may also be a method of forestalling potential competitive or countervailing pressures. Economists have placed increasing emphasis, in recent years, on freedom of entry as the hallmark of workable competition. (Edward, 1954, 215-41)An industry dominated by a small number of vertically integrated companies is likely to be much more impervious to competitive entry than a disintegrated one, with an identical number of sellers at each level. With flourishing intermediate markets, a nonintegrated entrant enjoys fair assurances of ability to command supplies and find customers on equal terms with his rivals. The prices he pays for certain materials and services and the margins that are added to his product as it moves downstream may be subject to monopolistic manipulation; but his competitors are in the same position as he in this regard and must live within the same margins. Globalization and Vertical Integration In many industry chains, the costs and risks of trading have been reduced by increases in the number of buyers or sellers or both. Industries such as telecommunications and banking are being deregulated to allow the entry of new players into national monopolies and oligopolies. Also, growth of the newly industrialized countries, including Korea, Taiwan, Hong Kong, and Mexico, has greatly increased the universe of potential suppliers in many industries, such as consumer electronics. Similarly, the globalization of consumer markets and the pressures on individual firms to become "insiders" in each national market they serve are prompting many companies to build new manufacturing facilities in countries to which they previously exported. (Grossman, 1986, 691-719) This, of course, increases the number of components buyers. However, Working in opposition to these forces is a tendency toward consolidation. As multinationals for example Beatrice Foods are disintegrated, the sections are place themselves into the segments of companies that utilize them to enhance their own shares of specific markets. (Harrigan, 1999, 30-37) Market experiences propose, nevertheless, that the forces encouraging and expanding globally competitive business structures are normally winning out. In addition to the pressures to disintegrate industry chains, there are pressures on firms to disintegrate the business systems within their own stages. Low-cost foreign competitors are pressuring corporations to be more cost effective. Progressions in communications and information techniques are dropping the costs of mutual trading. Widespread vertical integration, particularly if it encompasses strata in which competition is seriously deficient, eliminates these characteristics of a "fair field and no favors." (Valletti, 2000, 395-409) The nonintegrated competitor lacks equal assurances of supplies and markets. He faces the possibility of active competition with companies that need not live within the same margins as those which limit his profits, because their activities embrace other, possibly more monopolistic, markets. He faces the possibility, too, of being the victim of discriminatory applications of economic power by his integrated competitors, whether or not the latter are motivated by consciously predatory intentions. The integrated company is rarely in perfect balance. Ordinarily it will be buying from and selling to nonintegrated companies with which it also competes. If it enjoys substantial monopoly power in some of its markets, it may therefore be in a position to apply squeezes on its rivals -by transferring more of the function of processing its materials or supplying its requirements to its own affiliate, or by compressing the margin within which nonintegrated firms must operate by raising the price at which it sells to them relative to the price at which it sells in competition with them. It is not unlikely, of course, that the pressures of the squeeze are in part at least the natural and inevitable concomitants of market change in an imperfect world rather than of deliberate policy. Even so, their impact would be concentrated on the nonintegrated firm by the partial insulation of its integrated competitors, whose losses or gains at one level of production are offset or modified by gains or losses at another. The important question is whether integration unduly constricts the competitive opportunities of independent firms, regardless of whether it is typically used deliberately to that end. In this connection, Waterson found that greater downstream market power led to a more inelastic derived demand for the upstream firm which in turn led to higher price cost margins. (Waterson, 1993, 41-57) In the face of these uncertainties the potential entrant may fear to make the effort unless he, too, can enter in full integrated regalia. This means, however, that the capital requirements of entry are greatly increased, and the doors of opportunity are more tightly closed to all but the already established and the already wealthy. This may mean, in turn, that such companies as do still find it possible to enter will be the more likely, because of the necessity for integration, to be in "responsible" hands -- hands that will reach for additional business only in ways that do not upset profitable markets.( Joel, 1954, 235-38) Manifestly, vertical integration could not intelligently be subjected to attack in and of itself in any industry. It is a legitimate method of pursuing profit, often highly beneficial to the consumer. If it does raise threats to nonintegrated competitors and to competition itself, it is only because it may be associated with (horizontal) monopoly power; the social ideal, in such cases, would be to attack that power directly, rather than the vertical integration that may possibly, in certain circumstances, make perverse use of it, or further protect it. On the other hand, equally clearly, vertical integration associated with horizontal monopoly power may threaten excessively the well- being of competitors and customers. Price squeezes in a vertically integrated industry will continue to occur as long as supply adjusts itself to changes in market conditions with varying rapidity at different industry levels, as will be abundantly illustrated hereafter. Yet vertical integration at the same time may make positive contributions to the intensity and effectiveness of competitive rivalry from the viewpoint of the consuming public. Similar problems arise in the evaluation of business practices like price discrimination and the insistence on exclusive dealing. Beyond a certain point, the demands of fairness cannot be subsumed under the heading of "workable competition" but must be regarded as a separate, though not necessarily inferior, criterion of the social performance of industry. Fair competition is a goal in itself for the American people. It means the dispersion of private economic power and opportunity for private economic initiative. It is also prized because, in general, it is expected to conduce to economic efficiency and progress. This present discussion is not intended, therefore, to conclude that cost reduction, quality improvement, conservation, and equity for competitors are necessarily incompatible with vital competition. Yet beyond some imperfectly definable point, they may best be regarded as separate and possibly even contradictory goals. It is not the function of the authors to choose between this goal and that when they conflict; but they must be alert, in appraising vertical integration in an industry, to point out the implications of its present structure and behavior not only for effective competition but for these other social values as well. References Bardhan, Pranab K., "Imports, Domestic Production and Transnational Vertical Integration: A Theoretical Note." Journal of Political Economy, October 1982, 1020-34. Besanko, D., D. Dranove, M. Shanley, S. Schaefer. 2003. Economics of Strategy. Wiley, New York. 73 Bork, Robert "Vertical Integration and the Sherman Act: The Legal History of an Economic Misconception", University of Chicago Law Review, 22 ( 1954), 157. Edward H. Chamberlin, ed., Monopoly and Competition and Their Regulation (London, Macmillan, 1954), pp. 215-241. Grossman, Sanford J., and Oliver D. Hart, (1986) "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, 94(4), 691-719. Harrigan, K.R., (1999) "A Framework for Looking at Vertical Integration," Journal of Business Strategy, 3(3), 30-37 Joel B. Dirlam, and Alfred E. Kahn, Fair Competition, the Law and Economics of Antitrust Policy (Ithaca, Cornell University Press, 1954), 235-238. Rabin, Matthew, (1993) "Information and the Control of Productive Assets," Journal of Law, Economics, and Organization, 9(1), 51-76. Riordan, Michael H., (1990) "What is Vertical Integration?" in Masahiko Aoki, Bo Gustafsson, and Oliver E. Williamson (eds.), The Firm as a Nexus of Treaties, Swedish Collegium for Advanced Study in the Social Sciences series, Newbury Park, CA: Sage, 94-111. Shelanski, H. A. and P. Klein (1995), "'Empirical Research in Transaction Cost Economics: A Review and Assessment,'" Journal of Law, Economics and Organization, 11, 335-361. Spengler, J. J. "Vertical Integration and Antitrust Policy", Journal of Political Economy, 58 (1950), 347 Valletti, Tommaso M. 2000. Switching costs in vertically related markets. Review of Industrial Organization 17:395-409. Walter Adams, "Competition, Monopoly and Countervailing Power", Quarterly Journal of Economics, 67 (1953), 469-492 Waterson, M. (1993) ‘Vertical integration and vertical restraints’, Oxford Review of Economic Policy, Vol.9, No.2, pp.41-57. Williamson, Oliver E., (1985) "Vertical Integration: Theory and Evidence," Economic Institutions of Capitalism, New York: The Free Press, chapter 4, 85-102. Read More