Vertical integration

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A diagram illustrating vertical integration and contrasting it with horizontal integration

In microeconomics and management, the term vertical integration describes a style of growth and management control. Vertically integrated companies in a supply chain are united through a common owner. Usually each member of the supply chain 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 has also described management styles that bring large portions of the supply chain not only under a common ownership, but also into one corporation (as in the 1920s when the Ford River Rouge Complex began making much of its own steel rather than buying it from suppliers).

Vertical integration is one method of avoiding the hold-up problem. A monopoly produced through vertical integration is called a vertical monopoly.

Nineteenth-century steel tycoon Andrew Carnegie's example in the use of vertical integration[1] led others to use the system to promote financial growth and efficiency in their businesses.

Three types[edit]

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 integrating the production of cars and car parts as exemplified in the Ford River Rouge Complex.
  • A company tends toward forward vertical integration when it controls distribution centers and retailers where its products are sold.

Examples[edit]

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 made, 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.[2] Later on, Carnegie even established an institute of higher learning to teach the steel processes to the next generation.

Oil industry[edit]

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 deposits, drilling and extracting crude oil, 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.

Telephone[edit]

Telephone companies in most of the 20th century, especially the largest (the Bell System) were integrated, making their own telephones, telephone cables, telephone exchange equipment and other supplies.

Reliance[edit]

The Indian petrochemical giant Reliance Industries has integrated back into polyester fibres from textiles and further into petrochemicals, beginning with Dhirubhai 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.

Media industry[edit]

From the early 1920s through the early 1950s, the American motion picture had evolved into an industry controlled by a few companies, a condition known as a "mature oligopoly". The film industry was led by eight major film studios. The most powerful of these studios were the fully integrated Big Five studios: MGM, Warner Brothers, 20th Century Fox, Paramount Pictures, and RKO. These studios not only produced and distributed films, but also operated their own movie theaters. Meanwhile, the Little Three studios: Universal Studios, Columbia Pictures, and United Artists produced and distributed feature films, but did not own their own theaters.

The issue of vertical integration (also known as common ownership) has been a main focus of policy makers because of the possibility of anti-competitive behaviors affiliated with market influence. For example, in United States v. Paramount Pictures, Inc., the Supreme Court ordered the five vertically integrated studios to sell off their theater chains and all trade practices were prohibited (United States v. Paramount Pictures, Inc., 1948).[3] The prevalence of vertical integration wholly predetermined the relationships between both studios and networks[clarification needed] and modified criteria in financing. Networks began arranging content initiated by commonly owned studios and stipulated a portion of the syndication revenues in order for a show to gain a spot on the schedule if it was produced by a studio without common ownership.[4] In response, the studios fundamentally changed the way they made movies and did business. Lacking the financial resources and contract talent they once controlled, the studios now relied on independent producers supplying some portion of the budget in exchange for distribution rights. [5]

Certain media conglomerates may, in a similar manner, own television broadcasters (either over-the-air or on cable), production companies that produce content for their networks, and also own the services that distribute their content to viewers (such as television and internet service providers). Bell Canada, Comcast, and BSkyB are vertically integrated in such a manner—operating media subsidiaries (in the case of Bell and Comcast, Bell Media and NBCUniversal respectively), and also both provide "triple play" services of television, internet, and phone service in some markets (such as Bell TV/Bell Internet, Xfinity, and Sky's satellite TV services).

Apple[edit]

Apple Inc. is an example of a vertically integrated company. Specifically, it controls many elements of the ecosystem for the iPhone and iPad, such as the processor and hardware designs, operating system and application software, and related cloud services.[6] Hardware itself is not typically manufactured by Apple, but is outsourced to contract manufacturers such as Foxconn or Pegatron who build Apple's branded products to Apple's specifications. Apple's hardware and software are sold directly to consumers primarily through the company's own brick-and-mortar and online retail stores, while cloud services are available through the devices themselves.

Agriculture industry[edit]

Vertical integration through production and marketing contracts have also become the dominant model for livestock production. Currently, 90% of poultry, 69% of hogs, and 29% of cattle are contractually produced through vertical integration.[7] The USDA supports vertical integration because it has increased food productivity. However, ". . . contractors receive a large share of farm receipts, formerly assumed to go to the operator's family.”[8]

Under production contracts, growers raise animals owned by integrators. Form contracts contain detailed conditions for growers, who are paid based on how efficiently they use feed, provided by the integrator, to raise the animals. The contract dictates how to construct the facilities, how to feed, house, and medicate the animals, and how to handle manure and dispose of carcasses. Generally, the contract also shields the integrator from liability.[7]

Under marketing contracts, growers agree in advance to sell their animals to integrators under an agreed price system. Generally, these contracts shield the integrator from liability for the grower’s actions and the only negotiable item is price.[7]

Problems and benefits[edit]

There are internal and external society-wide gains and losses stemming from 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[edit]

This is the simplest case, where the gains and losses have been studied extensively.

Internal gains[edit]

Internal losses[edit]

  • Higher coordination costs
  • Higher monetary and organizational costs of switching to other suppliers/buyers
  • Weaker motivation for good performance at the start of the supply chain since sales are guaranteed and poor quality may be blended into other inputs at later manufacturing stages

Benefits to society[edit]

  • Better opportunities for investment growth through reduced uncertainty
  • Local companies are often better positioned against foreign competition

Losses to society[edit]

Vertical expansion[edit]

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 product. 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 DirecTV by News Corporation is an example of forward vertical expansion or acquisition. DirecTV is a satellite TV company through which News Corporation can distribute more of its media content: news, movies, and television shows. The acquisition of NBC by Comcast Cable is an example of backward vertical integration.

In the United States, protecting the public from communications monopolies that can be built in this way is one of the missions of the Federal Communications Commission.

See also[edit]

References[edit]

  1. ^ http://www.slu.edu/x28249.xml
  2. ^ Folsom, Burton The Myth of the Robber Barons 5th edition. 2007. pg 65 "only we can develop ability and hold it in our service. Every year should be marked by the promotion of one or more of our young men."
  3. ^ Oba, Goro, and Chan-Olmstead, Sylvia. "Self-Dealing or Market Transaction?: An Exploratory Study of Vertical Integration in the U.S. Television Syndication Market." Journal of Media Economics 19.2 (2006): 99-118. Communication & Mass Media Complete.
  4. ^ Lotz, Amanda D. (2007) "The Television Will Be Revolutionized".New York, NY: New York University Press. p.87
  5. ^ McDonald, P. & Wasko, J. (2008). The Contemporary Hollywood Film Industry. Australia: Blackwell Publishing Ltd. pp. 14–17. ISBN 9781405133876. .
  6. ^ Newsweek article
  7. ^ a b c Paul Stokstad, Enforcing Environmental Law in an Unequal Market: The Case of Concentrated Animal Feeding Operations, 15 Mo. Envtl. L. & Pol’y Rev. 229, 234-36 (Spring 2008)
  8. ^ USDA Economic Research, http://www.ers.usda.gov/publications/aer-agricultural-economic-report/aer747.aspx#.UpaBmsRONqU

Bibliography[edit]

  • 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.