Vertical integration

In microeconomics and strategic management, the term vertical integration describes a style of ownership and control. Vertically integrated companies are united through a hierarchy and share a common owner. Usually each member of the hierarchy produces a different product or service, and the products combine to satisfy a common need. It is contrasted with horizontal integration. Vertical integration is one method of avoiding the hold-up problem.

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 manufactured, 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 coked, etc.

A monopoly produced through vertical integration is called a vertical monopoly, although it might be more appropriate to speak of this as some form of cartel.

Three types

There are three varieties: backward (upstream) vertical integration, forward (downstream) vertical integration, and balanced (horizontal) vertical integration.
* In backward vertical integration, the company sets up 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 minimise costs by centralising the production of cars and car parts.
* In forward vertical integration, the company sets up subsidiaries that distribute or market products to customers or use the products themselves. An example of this is a movie studio that also owns a chain of theaters.
* In balanced vertical integration, the company sets up subsidiaries that both supply them with inputs and distribute their outputs.

Examples

Oil Industry

One of the best examples of vertically integrated companies is the oil industry. Oil companies, both multinational (such as ExxonMobil, Royal Dutch Shell, or BP) and national (e.g. Petronas) often adopt a vertically integrated structure. This means that they are active all the way along the supply chain from locating crude oil deposits, drilling and extracting crude, transporting it around the world, refining it into petrochemicals such as gasoline, to distributing the fuel to company-owned retail stations, where it is sold to consumers.

Apple Computer

Until recently, Apple was one of the few vertically integrated businesses in the IT sector. The company made the computer hardware, accessories, operating system and some of the software itself. Today, Apple Computer still designs its computers, production however is outsourced to specialized suppliers such as Flextronics who also manufacture computers for other companies. This arrangement is found for most high-tech companies today.

Problems and Benefits

Some argue that vertical integration will eventually hurt a company because when new technologies are available, the company is forced to reinvest in its infrastructures in order to keep up with competition. Some say that today, when technologies evolve very quickly, this can cause a company to invest into new technologies, only to reinvest in even newer technologies later, thus costing a company financially. However, a benefit of vertical integration is that all the components that are in a company product will work harmoniously, which will lower downtime and repair costs.

Vertical integration: Encyclopedia BETA

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