Vertical integration
Overview
 
In microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

 and management
Management
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...

, the term vertical integration describes a style of management control. Vertically integrated companies in a supply chain
Supply chain
A supply chain is a system of organizations, people, technology, activities, information and resources involved in moving a product or service from supplier to customer. Supply chain activities transform natural resources, raw materials and components into a finished product that is delivered to...

 are united through a common owner. Usually each member of the supply chain produces a different product
Product (business)
In general, the product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced...

 or (market-specific) service, and the products combine to satisfy a common need
Need
A need is something that is necessary for organisms to live a healthy life. Needs are distinguished from wants because a deficiency would cause a clear negative outcome, such as dysfunction or death. Needs can be objective and physical, such as food, or they can be subjective and psychological,...

. It is contrasted with horizontal integration
Horizontal integration
In microeconomics and strategic management, the term horizontal integration describes a type of ownership and control. It is a strategy used by a business or corporation that seeks to sell a type of product in numerous markets...

.

Vertical integration is one method of avoiding the hold-up problem
Hold-up problem
In economics, the hold-up problem is a situation where two parties may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits...

.
Encyclopedia
In microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

 and management
Management
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...

, the term vertical integration describes a style of management control. Vertically integrated companies in a supply chain
Supply chain
A supply chain is a system of organizations, people, technology, activities, information and resources involved in moving a product or service from supplier to customer. Supply chain activities transform natural resources, raw materials and components into a finished product that is delivered to...

 are united through a common owner. Usually each member of the supply chain produces a different product
Product (business)
In general, the product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced...

 or (market-specific) service, and the products combine to satisfy a common need
Need
A need is something that is necessary for organisms to live a healthy life. Needs are distinguished from wants because a deficiency would cause a clear negative outcome, such as dysfunction or death. Needs can be objective and physical, such as food, or they can be subjective and psychological,...

. It is contrasted with horizontal integration
Horizontal integration
In microeconomics and strategic management, the term horizontal integration describes a type of ownership and control. It is a strategy used by a business or corporation that seeks to sell a type of product in numerous markets...

.

Vertical integration is one method of avoiding the hold-up problem
Hold-up problem
In economics, the hold-up problem is a situation where two parties may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits...

. A monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

 produced through vertical integration is called a vertical monopoly, although it might be more appropriate to speak of this as some form of cartel
Cartel
A cartel is a formal agreement among competing firms. It is a formal organization of producers and manufacturers that agree to fix prices, marketing, and production. Cartels usually occur in an oligopolistic industry, where there is a small number of sellers and usually involve homogeneous products...

.

Nineteenth century steel tycoon Andrew Carnegie
Andrew Carnegie
Andrew Carnegie was a Scottish-American industrialist, businessman, and entrepreneur who led the enormous expansion of the American steel industry in the late 19th century...

 introduced the concept and use of vertical integration. This led other businesspeople to use the system to promote better financial growth and efficiency in their businesses.

Three types

Vertical integration is the degree to which a firm owns its downstream suppliers and its upstream buyers. Contrary to horizontal integration
Horizontal integration
In microeconomics and strategic management, the term horizontal integration describes a type of ownership and control. It is a strategy used by a business or corporation that seeks to sell a type of product in numerous markets...

, 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
    Ford Motor Company
    Ford Motor Company is an American multinational automaker based in Dearborn, Michigan, a suburb of Detroit. The automaker was founded by Henry Ford and incorporated on June 16, 1903. In addition to the Ford and Lincoln brands, Ford also owns a small stake in Mazda in Japan and Aston Martin in the UK...

     and other car companies in the 1920s, who sought to minimize costs by centralizing
    Centralization
    Centralisation, or centralization , is the process by which the activities of an organisation, particularly those regarding planning and decision-making, become concentrated within a particular location and/or group....

     the production of cars and car parts.
  • A company tends toward forward vertical integration when it controls distribution centers and retailers where its products are sold.

Examples

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
Steel
Steel is an alloy that consists mostly of iron and has a carbon content between 0.2% and 2.1% by weight, depending on the grade. Carbon is the most common alloying material for iron, but various other alloying elements are used, such as manganese, chromium, vanadium, and tungsten...

 was made, but also the mines where the iron ore was extracted, the coal mines that supplied the coal
Coal
Coal is a combustible black or brownish-black sedimentary rock usually occurring in rock strata in layers or veins called coal beds or coal seams. The harder forms, such as anthracite coal, can be regarded as metamorphic rock because of later exposure to elevated temperature and pressure...

, the ships that transported the iron ore and the railroads that transported the coal to the factory, the coke
Coke (fuel)
Coke is the solid carbonaceous material derived from destructive distillation of low-ash, low-sulfur bituminous coal. Cokes from coal are grey, hard, and porous. While coke can be formed naturally, the commonly used form is man-made.- History :...

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

American Apparel

American Apparel
American Apparel
American Apparel is a clothing manufacturer in the United States. It is a vertically integrated clothing manufacturer, wholesaler, and retailer that also performs its own design, advertising, and marketing...

 is a fashion retailer and manufacturer that advertises itself as a vertically integrated industrial company. The brand is based in downtown Los Angeles
Los Ángeles
Los Ángeles is the capital of the province of Biobío, in the commune of the same name, in Region VIII , in the center-south of Chile. It is located between the Laja and Biobío rivers. The population is 123,445 inhabitants...

, where from a single building they control the dyeing, finishing, designing, sewing, cutting, marketing and distribution of the company's product. The company shoots and distributes its own advertisements, often using its own employees as subjects. It also owns and operates each of its retail locations as opposed to franchising
Franchising
Franchising is the practice of using another firm's successful business model. The word 'franchise' is of anglo-French derivation - from franc- meaning free, and is used both as a noun and as a verb....

. According to the management, the vertically integrated model allows the company to design, cut, distribute and sell an item globally in the span of a week. The original founder Dov Charney
Dov Charney
Dov Charney is the founder and CEO of American Apparel, a clothing manufacturer, wholesaler, and retailer. Charney is known for his success as an entrepreneur, passion for simple clothing and love for Strictly Rhythm. His "contrarian" leadership style, which he feels promotes creativity, has drawn...

 has remained the majority shareholder and CEO. Since the company controls both the production and distribution of its product, it is an example of a balanced vertically integrated corporation.

Oil industry

Oil
Petroleum
Petroleum or crude oil is a naturally occurring, flammable liquid consisting of a complex mixture of hydrocarbons of various molecular weights and other liquid organic compounds, that are found in geologic formations beneath the Earth's surface. Petroleum is recovered mostly through oil drilling...

 companies, both multinational (such as ExxonMobil
ExxonMobil
Exxon Mobil Corporation or ExxonMobil, is an American multinational oil and gas corporation. It is a direct descendant of John D. Rockefeller's Standard Oil company, and was formed on November 30, 1999, by the merger of Exxon and Mobil. Its headquarters are in Irving, Texas...

, Royal Dutch Shell
Royal Dutch Shell
Royal Dutch Shell plc , commonly known as Shell, is a global oil and gas company headquartered in The Hague, Netherlands and with its registered office in London, United Kingdom. It is the fifth-largest company in the world according to a composite measure by Forbes magazine and one of the six...

, ConocoPhillips
ConocoPhillips
ConocoPhillips Company is an American multinational energy corporation with its headquarters located in the Energy Corridor district of Houston, Texas in the United States...

 or BP
BP
BP p.l.c. is a global oil and gas company headquartered in London, United Kingdom. It is the third-largest energy company and fourth-largest company in the world measured by revenues and one of the six oil and gas "supermajors"...

) and national (e.g. Petronas
Petronas
PETRONAS, short for Petroliam Nasional Berhad, is a Malaysian oil and gas company that was founded on August 17, 1974. Wholly owned by the Government of Malaysia, the corporation is vested with the entire oil and gas resources in Malaysia and is entrusted with the responsibility of developing and...

) often adopt a vertically integrated structure. This means that they are active along the entire supply chain from locating crude oil deposits, drilling and extracting crude, transporting it around the world, refining
Refinery
A refinery is a production facility composed of a group of chemical engineering unit processes and unit operations refining certain materials or converting raw material into products of value.-Types of refineries:Different types of refineries are as follows:...

 it into petroleum products such as petrol/gasoline
Gasoline
Gasoline , or petrol , is a toxic, translucent, petroleum-derived liquid that is primarily used as a fuel in internal combustion engines. It consists mostly of organic compounds obtained by the fractional distillation of petroleum, enhanced with a variety of additives. Some gasolines also contain...

, to distributing the fuel to company-owned retail stations, for sale to consumers.

Reliance

The India
India
India , officially the Republic of India , is a country in South Asia. It is the seventh-largest country by geographical area, the second-most populous country with over 1.2 billion people, and the most populous democracy in the world...

n petrochemical giant Reliance Industries
Reliance Industries
Reliance Industries Limited is an Indian conglomerate company headquartered at Mumbai, India. The company operates through three business segments: petrochemicals, refining, and oil and gas, other segment of the company includes textile, retail business, special economic zone development and...

 is a great example of vertical integration in modern business. Reliance's backward integration into polyester
Polyester
Polyester is a category of polymers which contain the ester functional group in their main chain. Although there are many polyesters, the term "polyester" as a specific material most commonly refers to polyethylene terephthalate...

 fibres from textiles and further into petrochemical
Petrochemical
Petrochemicals are chemical products derived from petroleum. Some chemical compounds made from petroleum are also obtained from other fossil fuels, such as coal or natural gas, or renewable sources such as corn or sugar cane....

s was started by Dhirubhai Ambani
Dhirubhai Ambani
Dhirajlal Hirachand Ambani also known as Dhirubhai, was an Indian-Gujarati business magnate and entrepreneur who founded Reliance Industries, a petrochemicals, communications, power, and textiles conglomerate and the only privately owned Indian company in the Fortune 500. Ambani took his company...

. Reliance has entered the oil and natural gas
Natural gas
Natural gas is a naturally occurring gas mixture consisting primarily of methane, typically with 0–20% higher hydrocarbons . It is found associated with other hydrocarbon fuel, in coal beds, as methane clathrates, and is an important fuel source and a major feedstock for fertilizers.Most natural...

 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.

Motion picture industry

From the early 1920s through the early 1950s, the American motion picture industry was led by five vertically integrated studios--Metro-Goldwyn-Mayer
Metro-Goldwyn-Mayer
Metro-Goldwyn-Mayer Inc. is an American media company, involved primarily in the production and distribution of films and television programs. MGM was founded in 1924 when the entertainment entrepreneur Marcus Loew gained control of Metro Pictures, Goldwyn Pictures Corporation and Louis B. Mayer...

, Paramount
Paramount Pictures
Paramount Pictures Corporation is an American film production and distribution company, located at 5555 Melrose Avenue in Hollywood. Founded in 1912 and currently owned by media conglomerate Viacom, it is America's oldest existing film studio; it is also the last major film studio still...

, Warner Bros.
Warner Bros.
Warner Bros. Entertainment, Inc., also known as Warner Bros. Pictures or simply Warner Bros. , is an American producer of film and television entertainment.One of the major film studios, it is a subsidiary of Time Warner, with its headquarters in Burbank,...

, 20th Century Fox
20th Century Fox
Twentieth Century Fox Film Corporation — also known as 20th Century Fox, or simply 20th or Fox — is one of the six major American film studios...

, and RKO. The studios were responsible for showing films in a large network of theaters that they controlled. 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.
United States v. Paramount Pictures, Inc.
United States v. Paramount Pictures, Inc., 334 US 131 was a landmark United States Supreme Court anti-trust case that decided the fate of movie studios owning their own theatres and holding exclusivity rights on which theatres would...

, the five vertically integrated studios were ordered to sell off their theater chains, more so their exhibition stage from vertical integration production and distribution stages. (United States v. Paramount Pictures, Inc., 1948). The prevalence of vertical integration wholly redetermined the relationships between both studios and networks and modified criterion 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.

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
    Supply and demand
    Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

     along the chain of products
  • Lower uncertainty and higher investment
  • Ability to monopolize
    Monopoly
    A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

     market throughout the chain by market foreclosure
    Market foreclosure
    Market foreclosure is the exclusion that results when a downstream buyer is denied access to an upstream supplier or when an upstream supplier is denied access to a downstream buyer...

  • Strategic independence (especially if important inputs are rare or highly volatile in price, such as REM)

Internal losses

  • 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 is guaranteed and poor quality may be blended into other inputs at later manufacturing stages

Benefits to society

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

Losses to society

  • Monopolization of markets
  • Rigid organizational structure, having much the same shortcomings as the socialist economy (cf. John Kenneth Galbraith
    John Kenneth Galbraith
    John Kenneth "Ken" Galbraith , OC was a Canadian-American economist. He was a Keynesian and an institutionalist, a leading proponent of 20th-century American liberalism...

    's works)

Vertical expansion

Vertical expansion, in economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, 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
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...

 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
Lateral expansion
Lateral expansion , in economics, is the growth of a business enterprise through the acquisition of similar companies, in the hope of achieving economies of scale or economies of scope...

, which is the growth of a business enterprise through the acquisition of similar firms, in the hope of achieving economies of scale
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...

.

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
News Corporation
News Corporation or News Corp. is an American multinational media conglomerate. It is the world's second-largest media conglomerate as of 2011 in terms of revenue, and the world's third largest in entertainment as of 2009, although the BBC remains the world's largest broadcaster...

 is an example of forward vertical expansion or acquisition. DirectTV 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
NBC
The National Broadcasting Company is an American commercial broadcasting television network and former radio network headquartered in the GE Building in New York City's Rockefeller Center with additional major offices near Los Angeles and in Chicago...

 by Comcast Cable is an example of forward 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
Federal Communications Commission
The Federal Communications Commission is an independent agency of the United States government, created, Congressional statute , and with the majority of its commissioners appointed by the current President. The FCC works towards six goals in the areas of broadband, competition, the spectrum, the...

.

See also

  • Conglomerate (company)
    Conglomerate (company)
    A conglomerate is a combination of two or more corporations engaged in entirely different businesses that fall under one corporate structure , usually involving a parent company and several subsidiaries. Often, a conglomerate is a multi-industry company...

  • Vertical market
    Vertical market
    A vertical market is a group of similar businesses and customers that engage in trade based on specific and specialized needs. Often, participants in a vertical market are very limited to a subset of a larger industry...

  • Exclusive dealing
    Exclusive dealing
    Exclusive dealing refers to when a retailer or wholesaler is ‘tied’ to purchase from a supplier on the understanding that no other distributor will be appointed or receive supplies in a given area...

  • Strategic management
    Strategic management
    Strategic management is a field that deals with the major intended and emergent initiatives taken by general managers on behalf of owners, involving utilization of resources, to enhance the performance of firms in their external environments...

  • Zaibatsu
    Zaibatsu
    is a Japanese term referring to industrial and financial business conglomerates in the Empire of Japan, whose influence and size allowed for control over significant parts of the Japanese economy from the Meiji period until the end of World War II.-Terminology:...

     (the Japan
    Japan
    Japan is an island nation in East Asia. Located in the Pacific Ocean, it lies to the east of the Sea of Japan, China, North Korea, South Korea and Russia, stretching from the Sea of Okhotsk in the north to the East China Sea and Taiwan in the south...

    ese approach to vertical integration)
  • Chaebol
    Chaebol
    Chaebol refers to a South Korean form of business conglomerate. They are global multinationals owning numerous international enterprises. The term is often used in a context similar to that of the English word "conglomerate"...

     (the South Korean counterpart to Zaibatsu)
  • Horizontal integration
    Horizontal integration
    In microeconomics and strategic management, the term horizontal integration describes a type of ownership and control. It is a strategy used by a business or corporation that seeks to sell a type of product in numerous markets...

  • Economic calculation problem
    Economic calculation problem
    The economic calculation problem is a criticism of central economic planning. It was first proposed by Ludwig von Mises in 1920 and later expounded by Friedrich Hayek. The problem referred to is that of how to distribute resources rationally in an economy...

     (although mostly discussed in relation to command economies, it equally applies to firms)
  • Vertical disintegration
    Vertical disintegration
    Vertical Disintegration refers to a specific organizational form of industrial production. As opposed to integration, in which production occurs within a singular organization, vertical disintegration means that various diseconomies of scale or scope have broken a production process into separate...

  • Alfred DuPont Chandler, Jr. (economist who wrote extensively on vertical integration)
The source of this article is wikipedia, the free encyclopedia.  The text of this article is licensed under the GFDL.
 
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