4.7. Vertical integration

Question 1

Define vertical integration

Answer 1

The degree to which a firm owns its upstream suppliers (backward integration) and downstream buyers (forward integration)

Question 2

Forms of vertical integration

Answer 2

• Forward: Integration of distribution (retailers etc.)
• Backward: Integration of input provision
• Balanced: Includes production and distribution

Question 3

What do transaction costs include?

Answer 3

• Search costs (finding inputs)
• Negotiation costs (relationship costs, not necessarily the actual cost - money)
• Opportunism of market agents

Question 4

What do coordination costs include?

Answer 4

• Large groups
• Different interests
• Different processes (hand off)
• Information flows

Question 5

Why do firms choose to vertically integrate?

Answer 5

Transaction cost theory:

internal production costs + internal coordination costs (costs related to the management functions) < purchasing costs + external transaction costs (costs associated with the management of the transaction)

Question 6

Industry variations

Answer 6

• Some industries have historically been characterized by high degree of vertical integration
• However, in the same industry competitors may vary considerably in their degree of vertical integration
– Benetton produces internally almost all the phases
– Calvin Klein manages the brand but the production is outsourced
– Armani is in between

Question 7

Advantages of vertical integration

Answer 7

• Strategic threat to suppliers/customers (remember the 5 Forces Model)
– You no longer have transaction costs associated with that specific transaction
• Better control on product quality and scheduling (Alibaba vs. Amazon?) - encourages joint research and development into improved quality of supplies of components
• Able to control the promotion and pricing of its own product
• Easier to build barriers to entry (minimize competitors’ access to market)

Question 8

Disadvantages of vertical integration

Answer 8

• Costly
• Low flexibility (firm is locked into certain products and technologies) - demand has to be stable or else fixed costs might be too high, low utilization rate
• There may be government regulation (”anti-trust”) prohibiting vertical integration in different areas
• Lack of competition means the consumers have less choice => prices are higher => may react negatively (forward)
• Lack of experience

Question 9

Vertical integration - American Gangster

Answer 9

• control the whole value chain of heroin in the 1970’s in particular in NYC
• important considerations:
  + search/negotiation costs are high
  + opportunism of market agents (especially since it’s illegal)
  + difficulty of writing contracts
  + importance of barriers to entry
  => makes sense to vertically integrate

Question 10

Vertical integration - Apple

Answer 10

• To put together the iphone, Apple decided to own each step of the value chain….and build capabilities “organically”
Special case: no better strategies/solutions because problems are rooted from the supplier side
Takeaway:
• Anticipating coordination costs or even production
costs is almost impossible
– Transaction cost argument useful as guideline but decisions often made based on need/preference
– Given the new technology involved here, would it have been easier to buy from the market? Search costs?

Question 11

Influences on vertical integration decisions

Answer 11

– Economic convenience
– Strategic importance of an input
– Market forces(do suppliers exert a lot of power right now?)
– Stability of the industry (if it will change fast you don’t want to be stuck owning too much outdated technology)
– Regulation (e.g. anti trust laws that break vertical chains).