Vertical integration

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This article defines the term vertical integration.

In microeconomics and strategic management, the term vertical integration is a type of related diversification that describes a style of nearly total ownership and control. The degree to which a firm owns its upstream suppliers and its downstream buyers determines how vertically integrated it is. Note, however, that there is no ratio or quantifiable measure to denote this.

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 are combined to satisfy a common need. It is contrasted with horizontal integration, in which one part of the production process is expanded across several different market segments. A common successful horizontal integration example is how Intel (INTC) has dominated the computer processor market, supplying such chips to several different manufacturers, such as Dell (DELL) , Toshiba (TOSBF) , and the Hewlett-Packard Company (HPQ) .

Vertical integration is one method of avoiding the hold-up problem. 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.

[edit] Types of Vertical Integration

Vertical Integration comes in three flavors: backward (upstream) vertical integration, forward (downstream) vertical integration, and balanced (equal) vertical integration.

[edit] 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 minimize costs by centralizing the production of cars and car parts.

[edit] Forward Vertical Integration

The company sets up subsidiaries that distribute or market products to the end market or use the products themselves. An example of this is a movie studio that also owns a chain of theaters.

[edit] Balanced Vertical Integration

The company sets up subsidiaries that both supply them with inputs and distribute their outputs.

If you view McDonald's (MCD), for example, as primarily a food manufacturer, backwards vertical integration would mean that they would own the farms where they raise the cows, chickens, potatoes and wheat as well as the factories that processes everything and turns it all into food. Forwards vertical integration would imply that they own the distribution centers for every area and the fast food retailers. Balanced vertical integration would mean that they own all of the mentioned components.

[edit] Examples

[edit] Carnegie Steel

Among the most popular examples of vertical integration is the Carnegie Steel Company. Owning the process from beginning to end, the Company controlled the iron ore mines, the coal mines, the transport methods (ships for iron ore and trains for coal), the factories that processed the raw materials, etc...

[edit] Oil Companies

From Rockefeller to Exxon Mobil (XOM) oil companies have favored vertically integrating. They start from the very beginning, locating oil deposits, drilling and extracting it, transporting it to refineries, and distributing to its own gas stations (and others).

[edit] References

1. http://en.wikipedia.org/wiki/Vertical_integration