When and When Not to Vertically Integrate

Vertical integration can be a highly important strategy, but it is notoriously difficult to implement successfully and — when it turns out to be the wrong strategy — costly to fix. Management’s track record on vertical integration decisions is not good.1 Our purpose in this paper is to help managers make better integration decisions. We discuss when to vertically integrate, when not to integrate, and when to use alternative, quasi-integration strategies. Then we present a framework for making the decision.

When to Integrate

“Vertical integration” is simply a means of coordinating the different stages of an industry chain when bilateral trading is not beneficial. Consider hot-metal production and steel making, two stages in the traditional steel industry chain. Hot metal is produced in blast furnaces, tapped into insulated ladles, and transported in molten form at about 2,500 degrees perhaps 500 yards to the steel shop, where it is poured into steel-making vessels. These two processes are almost always under common ownership, although occasionally hot metal is traded; for several months in 1991, Weirton Steel sold hot metal to Wheeling-Pittsburgh, almost ten miles away.

Such trading is rare, however. The fixed asset technologies and frequency of transactions would dictate a market structure of tightly bound pairs of buyers and sellers that would need to negotiate an almost continuous stream of transactions. Transaction costs and the risk of exploitation would be high. It is more effective, lower cost, and lower risk to combine these two stages under common ownership.

Table 1 lists the kinds of costs, risks, and coordination issues that should be weighed in the integration decision. The tough part is that these criteria are often at odds with each other. Vertical integration typically reduces some risks and transaction costs, but it requires heavy setup costs, and its coordination effectiveness is often dubious.

There are four reasons to vertically integrate:

  1. The market is too risky and unreliable — it “fails”
  2. Companies in adjacent stages of the industry chain have more market power than companies in your stage;
  3. Integration would create or exploit market power by raising barriers to entry or allowing price discrimination across customer segments; or
  4. The market is young and the company must forward integrate to develop a market, or the market is declining and independents are pulling out of adjacent stages.

Some of these are better reasons than others.

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References

1. See, for instance, R.P. Rumelt, Strategy, Structure, and Economic Performance (Cambridge, Massachusetts: Harvard University Press, 1974).

2. H.A. Simon, Models of Man: Social and Rational (New York: John Wiley, 1957), p. 198.

3. O.E. Williamson, Markets and Hierarchies: Analysis and Antitrust Implications (New York: Free Press, 1975).

4. D.J. Teece, “Profiting from Technological Innovation,” Research Policy 15 (1986): 285–305.

5. See E.R. Corey, The Development of Markets for New Materials (Cambridge, Massachusetts: Harvard University Press, 1956).

6. See K.R. Harrigan, Strategies for Declining Businesses (Lexington, Massachusetts: Lexington Books, 1980), ch. 8.