Vertical Integration

Abstract

Vertical integration is an action taken by a business to expand its operations or reduce operating costs, by taking control of more stages of the supply chain, by acquisition of other companies or by other means. When this integration results in a business controlling all or most of the supply chain, that can lead to a monopoly or monopolistic effects, but integration need not be so complete, nor is it inherently anticompetitive. Often, vertical integration is a way to centralize expertise and increase quality and efficiency.

Overview

Vertical integration is a means of expanding a company, or making it more cost-effective, by taking direct control of more steps in the supply chain—the process of delivering a product or service to the customer and all the steps necessary to complete that process. Both vertical and horizontal integration are strategies for expanding a company or its market share through changes to the organizational structure; while horizontal integration acquires more businesses operating at the same phase of the supply chain, vertical integration collapses the links in the supply chain. Apple, for example, makes computers and mobile devices, but it controls more than design and manufacturing—it sells its products at Apple-owned stores; it not only assembles its products but also manufactures its own microchips and other key components; and it operates a research laboratory developing technologies for use in its products.

Vertical integration is not always an advantage—not every company has the competence or resources to supply and process raw materials, manufacture goods, and sell those goods, while also providing transportation, customer and business-to-business (B2B) service, and warehousing. But neither is it novel: the farmers and craftsmen who created, transported, and sold their own goods were the most familiar form of business for much of human history. It is largely with the rise of the merchant class that specialization became the norm in commercial activity, with numerous business entities providing what are now called B2B services, in providing or transporting raw materials or finished goods. Further, some degree of vertical integration remains standard in most industries. Book publishers, for instance, consolidate in one entity a variety of processes: acquisition, editing, production, publicity, and sales. Self-publishing and boutique publishing have given rise to an industry of a la carte service providers—editors, designers, marketers, and publishing platform/retailers such as Amazon. While this development was enthusiastically embraced by many established and aspiring writers, some author service providers have already begun to vertically integrate, a model that may eventually replicate the organizational structure of a traditional publisher.

With the Industrial Revolution, sufficient wealth and transportation advantages were created that a wave of vertical integration happened throughout the West. Carnegie Steel remains one of the exemplar cases of vertical integration, as the company controlled the mines that supplied both coal and iron ore, ships and railroads for transporting those raw materials, and the mills where the steel was made. Andrew Carnegie sold the company in 1901, nine years after its creation (though thirty years after he opened his first steel mill) and became one of the richest men in history from the profits. Carnegie Steel’s integration helped give it the resources necessary to be the major innovator in the industry in the late nineteenth century, improving both steel technologies and production and materials-handling systems. It also gave the company the leverage to exploit its workers and quell the objections of its workforce. It survived the 1892 Homestead strike by hiring members of the Pinkerton National Detective Agency—then working as a private security force—as strikebreakers against the Amalgamated Association of Iron and Steel Workers. The strike was the third most violent conflict in American labor history, resulting in a dozen deaths and twice as many wounded.

Vertical integration occurs for a variety of reasons. In many cases, as with the American meat industry, it occurs through acquisition or other control by the central company or companies at other points in the supply chain. In other cases, though, it develops because there is not sufficient infrastructure to support the entire supply chain, or to provide the level of support the company requires; this is one of the factors in Apple’s decision to manufacture its own chips, which gives it a level of quality control and specification in addition to reducing costs. The need for such infrastructure is a factor in industries in which multiple segments of the supply chain, or related businesses with overlapping concerns, developed at once—the early integration between motion picture studios, film manufacturers, distributors, and theaters, for instance, four different types of business, each of which was dependent on the other three. Similar integration developed in the late twentieth and early twenty-first centuries when cable television providers became the main Internet service providers and both services underwent steady growth in subscribership. While Internet and television are separate concerns in terms of the type of service they provide, vertical integration gave these companies considerable sway in content distribution, and the growth of their power contributed to the media mega-mergers—occurring both vertically and horizontally—that characterized the changing media landscape of the twenty-first century, with Comcast, for instance, acquiring NBC (a content distributor acquiring a content provider).

Integration can be considered either forward or backward, in reference to which direction a business’s control is moving along the supply chain. Forward integration takes control of elements of the supply chain “downstream” from the business, such as distribution or sales. A farmer selling his crops at a farmer’s market instead of to a distribution center, for instance, or an artisan selling direct to the customer through Etsy or some other online shop, is integrating forward. Random House and other publishers sell their books primarily through distributors and bookstore chains. Forward integration would involve purchasing a distributor or bookstore chain or transitioning to principally e-books sold exclusively through the company’s website, app, or e-reader. For instance, if a publisher were able to acquire Amazon, it could publish its books direct on the Kindle, eliminating the middle man.

Backward integration moves upstream in the supply chain. If Amazon were to purchase a publishing house, that would integrate some of its operations backward. (As it stands, Amazon is a publisher of a limited number of books, as well as operating a self-publishing service.) When Comcast acquired NBC, that was in many ways backward integration—both companies’ holdings are complex enough that it cannot be neatly characterized, but NBC creates content in the form of television programs, while Comcast distributes content through its cable television service. In the twenty-first century, one of the moves taken by some high-end restaurants has been to purchase or operate a farm where some of the food is grown. Chain restaurants similarly often control the distribution of the ingredients for the food they cook (especially for sale to franchisees) or have a stake in the producers of those ingredients. Backward integration is a meaningful way for a company to improve the efficiency and reduce costs associated with acquiring the products or services it sells, or the materials needed to provide those products or services.

Applications

In the twentieth century, AT&T was one of the most significant integrated companies. Comprising a nationwide system of regional subsidiaries collectively known as the Bell System, commonly referred to as Ma Bell, this group of companies began providing telegraph and telephone services in the 1870s, as well as manufacturing telephones and telephone equipment, which they sold direct to telephone service customers. Holding a monopoly on local and long-distance telephone service at multiple times in history, the Bell System was forcibly broken into separate companies—the so-called “baby bells”—by the Department of Justice (DOJ) in 1983. AT&T was reduced to a long-distance telephone service provider, but within a few decades, through mergers and acquisitions, AT&T again emerged as a large conglomerate with elements of both vertical and horizontal integration. By the 1990s, Southwestern Bell (later SBC Communications) was swallowing its sibling baby bells, ultimately acquiring AT&T itself and rebranding as AT&T. In 2018, having reconstituted almost half of the original baby bells, along with an array of other properties, AT&T acquired Time Warner to become not only the largest telecommunications company in the world but also the largest media company. The DOJ objected to the merger as a case of vertical integration in which a major communications company offering cable and payTV services would be gaining control of a major content provider.

Vertical integration has become central to the operations of the American meat industry. The modern meat industry developed after World War II, as “factory farming” techniques for poultry became the dominant means of producing chickens for market. Economies of scale and technological changes resulted in chickens being raised more cheaply and far more quickly; in constant dollars, a modern chicken is considerably more affordable than was a chicken at the beginning of the twentieth century, despite being transported much further to come to market. The rest of the meat industry gradually followed suit (though a much larger segment of the poultry sector is integrated than in the pork, beef, or lamb sectors). Animals are either raised on large farms or, increasingly, raised on smaller farms that are contracted by the large agribusinesses. In the former case, it is common for animal feed to be grown and processed on the same farm where the animals are raised, reducing or eliminating transportation and storage costs. In the latter case, contract farmers purchase the feed from the same company for whom they are raising the animals, which also dictates the facilities in which animals will be raised, the medications they receive, and the disposal of manure; the same contract usually limits the agribusiness’s liability. In these contract farming cases, vertical integration is accomplished through different means than by merger as in the Bell System or Carnegie Steel cases: rather than outright purchasing the business entities up and downstream in the supply chain, the business assumes control of the business processes through contract terms, while also enjoying a monopoly on these other entities’ production. Just as there were concerns with the Bell System, so too with the modern meat industry; for example, low-cost meat production comes with increased risk of disease and bacterial contamination both for the consumer and the worker.

Issues

Securing a near or total monopoly on the market is difficult or illegal to achieve in most industries. There are, however, numerous financial and strategic advantages to vertical integration even at a much smaller scale than monopoly. When a company controls most of the supply chain, supply and demand are in harmony, at least at some stages of the chain. Apple, because it manufactures the chips for iPhones, can suffer a shortage only when there is a shortage of raw materials, which would have a more significant industry-wide impact. Related to the supply and demand issue, uncertainty is reduced; the company need not worry about renegotiating terms with upstream or downstream businesses. Uncertainty can never be eliminated—end users still have the greatest impact on demand, and raw materials and other resources an irreducible impact on supply and cost—but it is much lower for integrated businesses. Transaction costs, too, are lowered. The business has “eliminated the middle man.” Instead of materials or services being sold at every stage of the chain, with some entity making a profit from each transaction, only operating expenses need be paid for, with profit centralized.

One of the biggest disadvantages, especially in integrations that do not result in near monopolies, is the transition cost. Reorganizing large companies is an expensive process—facilities may need to be relocated, executives may need to have their contracts bought out, processes and departments may need to be consolidated. Reorganizing is also time-consuming and complicated. Positions may be eliminated that it later turns out are still needed. Institutional knowledge may become lost in the shuffle, reducing the benefits to quality and efficiency that were expected. Production may be slowed, and unexpected developments are almost inevitable. Further, integration is difficult to undo and incurs all of those transition costs all over again. Further, an integrated company runs the risk of becoming a large, bulky, slow to react company that gives new or more agile competitors a lead.

In theory, the advantages of vertical integration are passed along to the consumer. More efficient supply chains play a key role in controlling inflation. Integration can lead to a higher quality of product because control of the supply chain ensures that the business receives exactly the goods, materials, or services it needs to deliver the final product. Other economic effects, however, occur as well: tax revenue and jobs are lost to the same factors that reduce transaction costs; a business that can provide its product more efficiently is a business that is, at some stage of production, paying less in workforce costs through lower wages, reduced benefits, or layoffs, or in some cases the transfer of roles and responsibilities from expensive skilled labor to less expensive, less specialized labor.

Vertical integration also comes with the concern that the more control the business has, the greater the chances that it develops into a monopoly. The disadvantages of monopolies are well-attested: Businesses are better able to engage in behaviors that would result in a loss of business or profit in a competitive market. There is less incentive to improve the quality of the product when there is no competitor producing a similar product, and prices can be raised independent of cost increases, because the customer’s choice is no longer between Business 1 and Business 2, but between having the product and not having the product. Some of the disadvantages of removing competition impact the business itself, too—internally, there may be less incentive to innovate or to be efficient.

The benefits and drawbacks of vertical integration impact different segments of society. Layoffs, for example, are generally bad for workers but good for investors. Integration makes a company a good investment; with a publicly held company, what is good for the company is good for its shareholders. When that advantage is offset by an increase in price or decrease in quality on the consumer end, the question is who bears the brunt of that offset. People who are well-off enough to have significant investments are less impacted by price increases in common goods; further, with some products, the end user and the investor come from different segments of society, so that the disadvantage is felt by one group and the advantage is enjoyed by another.

Terms & Concepts

Downstream: In reference to the supply chain, along the supply chain in the direction of the consumer. A retail store is downstream from a manufacturer.

Horizontal Integration: A means of increasing a company’s size at the same level of the supply chain, such as through acquisitions of other companies.

Merger: An agreement between two business entities to reorganize as a new solitary entity.

Monopoly: A market condition in which one company controls all or nearly all of the supply or trade of its product or service. Under most circumstances, monopolies are illegal under U.S. law, and actions that could result in monopolies, or that could make a monopoly inevitable by making it impossible for other companies to compete, are subject to federal approval.

Organizational Structure: In reference to a business or other organization, its hierarchy, rules, and roles, as well as the way processes and responsibilities are divided up, such as among departments, divisions, or subsidiaries.

Supply Chain: All the steps it takes to deliver a product or service to a customer, and all the organizations and other entities involved in those steps, for example, the suppliers of raw materials, the manufacturer, the wholesaler, the retailer, and the transportation and warehousing necessary along the way.

Upstream: In reference to the supply chain, along the supply chain in the direction opposite the consumer. A manufacturer is upstream from a wholesaler.

Vertical Integration: A strategy by which a company increases the size, and especially efficiency, of its business processes by integrating different stages of the supply chain within the same company.

Bibliography

Albalate, D., Bel, G., & Richard Geddes, R. (2017). How much vertical integration? Contractual choice and public-private partnerships in the United States. Review of Industrial Organization, 51(1), 25–42. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124133377&site=ehost-live

Argyres, N., & Mostafa, R. (2016). Knowledge inheritance, vertical integration, and entrant survival in the early U.S. auto industry. Academy of Management Journal, 59(4), 1474–1492. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=117524421&site=ehost-live

Crawford, G. S., Lee, R. S., Whinston, M. D., & Yurukoglu, A. (2018). The welfare effects of vertical integration in multichannel television markets. Econometrica, 86(3), 891–954. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=129954737&site=ehost-live

Filippini, L., & Vergari, C. (2017). Vertical integration smooths innovation diffusion. B.E. Journal of Economic Analysis & Policy, 17(3), 1–22. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124430094&site=ehost-live

Nocke, V., & Rey, P. (2018). Exclusive dealing and vertical integration in interlocking relationships. Journal of Economic Theory, 177, 183–221. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=131633346&site=ehost-live

Zhou, Y. M., & Wan, X. (2017). Product variety and vertical integration. Strategic Management Journal, 38(5), 1134–1150. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=122304027&site=ehost-live

Suggested Reading

Cardinale, I. (2018). A bridge over troubled water: A structural political economy of vertical integration. Structural Change & Economic Dynamics, 46, 172–179. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=131787999&site=ehost-live

Lambie-Hanson, L., & Lambie-Hanson, T. (2017). Agency and incentives: Vertical integration in the mortgage foreclosure industry. Review of Industrial Organization, 51(1), 1–24. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124133372&site=ehost-live

Wadeson, N. (2017). Profit-maximising rigid prices and vertical integration. International Journal of the Economics of Business, 24(1), 53–72. Retrieved September 15, 2018, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=120749176&site=ehost-live