Managerial Economics - Vertical Integration

Running head: MANAGERIAL ECONOMICS
MANAGERIAL ECONOMICS
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MANAGERIAL ECONOMICS1
Executive Summary
The paper deals in the study of a trade-off between technical efficiency and agency efficiency
under vertical integration system. This trade off, widely affects the profit of each firm with
respect to the integration system. The paper seeks to understand the factors that affect this trade
off and how does firms protect themselves from lower falling profits.

MANAGERIAL ECONOMICS2
Table of Contents
Introduction......................................................................................................................................3
Discussion........................................................................................................................................4
Reasons for vertical integration of firms.....................................................................................4
Effects of vertical integration......................................................................................................4
Factors denoting the trade-off between the two efficiency parameters.......................................6
Diagrammatic representation of technical versus agency efficiency...........................................8
Empirical evidence on vertical integration................................................................................10
The impact on the firms.............................................................................................................11
Conclusion.....................................................................................................................................12
Reference List................................................................................................................................14

MANAGERIAL ECONOMICS3
Introduction
Vertical integration is a term used in management and microeconomics, which refers to
the ownership of the supply chain management of a company by that company. Under this
system, each member of the supply chain yields a different good or service that is solely market
specific. The products are produced as per the needs of the customers. It is important as it
determines the growth of the firms, be it backward or forward. The aim of the process is to
improve the management and service of the supply chains by lowering the overall production
costs. The purpose of the system is to coordinate the activities of the network. Vertical
integration works like a retailer who has various brands under its own store and does not stick to
the production of their own good (Abate, Francesconi, and Getnet 2014). The integration
removes the buying and selling costs that is rendered when separate companies undergo two
production stages which raises the cost of a product. It differs from horizontal integration where
the firm produces products that can be related to one another.
Vertical integration can bring about a few challenges to the organization and they have to
decide things efficiently that will render positive profits. It leads to a trade-off between agency
and technical efficiency. Agency efficiency is the extent to which products are exchanged in the
vertical integration so as to reduce the agency, coordination and transaction cost (Arcas-Lario,
Martín-Ugedo and Mínguez-Vera 2014). Technical efficiency is attained when maximum output
is being produced by minimum inputs at a low time. When goods are sourced from other firms
then it increases the technical efficiency because it does not need any input for production,
however it hampers the supply coordination and therefore leads to a fall in the agency efficiency
(Bojnec et al. 2014). The aim of the paper is to understand the extent to which vertical