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Vertical integration, a risky strategy

When a company plans to expand it's business into areas at different points on the production path, such as when a manufacturer owns it's supplier or distributor, vertical integration can help companies reduce costs and improve efficiency by decreasing transportation expenses and reducing turnaround time, among other advantages. However, sometimes it is more effective for a company to rely on the expertise and economies of scale of other vendors rather than be vertically integrated.

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Vertical integration can be either backward, where the firm takes over ownership and control of producing it's own components or other inputs a solar power firm that produces photovoltaic products and owns a manufacturer of cells, wafers and modules to create the solar panels or forward, where the firm takes over ownership and control of activities previously undertaken by it's customers a mortgage company that both originates and services mortgages by lending money to homebuyers and collects their monthly payments.

Vertical integration can be beneficial because it allows superior coordination and reduced risk, or detrimental because it reduces flexibility and negates firms to concentrate on those activities where they possess superior capabilities. Moreover, many of the coordination benefits associated with vertical integration can be achieved through collaboration between vertically-related companies.

When to integrate

Since market transactions are not costless, what determines which particular activity is undertaken within a firm and which through the market is relative cost. If the transaction costs associated with organizing across markets are greater than the administrative costs of organizing within firms, the coordination of productive activity is internalized within firms.

Vertical integration emphasizes the technical economies such as the cost savings that arise from the physical integration of processes. However, although these considerations explain the need for the co-location of plants, they do not explain why vertical integration in terms of common ownership is necessary, since different stages of the production path can be undertaken by separate firms that own facilities physically integrated with one another.

Consider the value chain for carbon electrodes, which extends from oil extraction to delivering electrodes to steel and aluminum smelting companies. Between the production of oil distillates and petroleum coke, most production is vertically integrated. Between the production of petroleum coke and carbon electrodes, there is none or very little vertical integration.

Vertical integration and market contracts in the value chain of carbon electrodes

Vertical integration predominates across oil refining and petroleum coke because technical economies exist. If separate companies owns the two stages, they must invest in integrated facilities, between which a competitive market is impossible since the companies are so tied to become a bilateral monopolies.

The predominance of market contracts between petroleum coke and carbon electrodes production is the result of low transaction costs in the market for petroleum coke: there are many buyers and sellers, information is available and the switching costs are low. Carbon electrodes producers are specialist companies that purchase petroleum coke from refining companies on contracts.

The culprits are transaction-specific investments. When a carbon electrode maker buys petroleum coke, neither the petroleum coke producer nor the carbon electrode maker needs to invest in equipment or technology that is specific to the needs of the other party. In the case of the oil refinery and the petroleum coke producer, each companys plant is built to match the other partys plant. Once built, the plants value depends upon the availability of the other partys complementary facilities each seller is tied to a single buyer, which gives each the potential to hold up the other. The problem of hold-up could be eliminated by contracts that fully specify prices, quality, quantities, and other terms of supply under all possible circumstances, but contracts are inevitably incomplete.

A risky strategy

Vertical integration is complex, expensive and hard to revers. Transaction costs in intermediate markets do not mean that vertical integration is necessarily an efficient solution. Vertical integration avoids the costs of using the market, but internalizing a transaction imposes administrative cost, putting at stake the future of the firms.

Suppose that a carbon electrodes maker requires petroleum coke that is manufactured to meet it's particular needs. To the extent that the petroleum coke manufacturer must make transaction-specific investments, there is an incentive for the carbon electrodes maker to avoid the ensuing transaction costs by producing it's own petroleum coke, but the differences in optimal scale between different stages of production would not make the solution efficient since the transaction costs avoided by the carbon electrodes maker are likely to be trivial compared with the inefficiencies incurred in producing it's own petroleum coke.

Differences in managing different businesses can generate other transaction costs since the management systems and organizational capabilities required for the two companies can be strategically very different or the development of distinctive capabilities is not encouraged since every department serves the in-house needs of the vertically integrated firm.

Vertical integration changes the incentives between vertically related businesses. Where a market interface exists between a buyer and a seller, profit incentives ensure that the buyer is motivated to secure the best possible deal and the seller is motivated to pursue efficiency and service in order to attract and retain the buyer. With vertical integration, internal supplier-customer relationships are subject to low-powered incentives.

Vertical integration can be used to extend a monopoly position at one stage of an industrys value chain to adjacent stages. However, economists have shown, once a company monopolizes one stage of the industrys value chain, there is no additional monopoly profit to be extracted by extending that monopoly to other stages. A more common situation is that a company which is strong at one vertical stage can disadvantage it's market position by vertical integration since the firms suppliers and customers are less willing to do business with the company.

Vertical integration can be disadvantageous in responding flexibly to new product development opportunities that require new combinations of technical capabilities. Extensive outsourcing has been a key feature of fast-cycle product development throughout the electronics sector.

Different way of vertical relationship

Alternatives to vertical integration are given by different types of vertical relationship such as long-term contacts, supplier partnership or franchising.

Long-term contracts involve a series of transactions and specify the responsibilities of each party. Where closer supplier-customer ties are needed, then a longer term contract can help avoid opportunism and provide the security needed to make the necessary investment.

Supplier partnerships, based on trust and mutual understanding, can provide the security needed for transaction-specific investments, the flexibility to meet changing circumstances, and the incentives to avoid opportunism.

Franchising brings business systems of the large corporation with the entrepreneurship and local knowledge of small firms. It can facilitate the close coordination and investment in transaction-specific assets that vertical integration permits with the high-powered incentives, flexibility and cooperation between strategically dissimilar businesses that market contracts make possible.

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Posted in Real Estate Post Date 10/11/2018


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