A Comprehensive Report on Vertical Integration in Managerial Economics

This report delves into the concept of vertical integration within the realm of managerial economics. It defines vertical integration as a business strategy where a company owns multiple stages of its supply chain. The report explores both backward and forward integration, illustrating these concepts with a diagram. It highlights the advantages of vertical integration, such as increased competitiveness, greater process control, increased market share, improved supply chain coordination, decreased costs, and differentiation. Conversely, it also addresses the disadvantages, including capacity balancing issues, high costs, low flexibility, potential for new core competency conflicts, and decreased potential for product range expansion. The report provides examples of vertical integration in practice, including Apple, Alibaba, and Carnegie Steel. The report concludes by summarizing the key aspects of vertical integration, emphasizing its importance in business strategy and its implications for market dynamics and operational efficiency. It also discusses the concept of asset specificity and efficiencies in make-or-buy decisions.

MANAGERIAL
ECONOMICS

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Concept of Vertical Integration...................................................................................................1
Advantage of vertical integration................................................................................................3
Disadvantages of Vertical Integration.........................................................................................4
Examples of Vertical Integration in business world....................................................................5
CONCLUSION................................................................................................................................6
REFERENCES................................................................................................................................7

INTRODUCTION
Managerial economics is that branch of knowledge which helps in applying the relevant
concepts to the situations of the business. It is very resourceful in making of the decisions and
offers a rational solution of the problems which are confronted. The purpose of this report is to
understand a term called vertical integration and its uses. It also shows wider economic
implications of vertically integrated firms. It discusses the factors which encourages the
companies to adopt strategy like vertical integration.
Concept of Vertical Integration
In microeconomics and management, vertical integration is regarded as an arrangement
in which the supply chain of a firm is owned by that firm. Generally each member of the chain
develops a different product or service and all the products jointly fulfil a common need (Akerlof
and Kranton, 2010). It brings large portion of operations under a common ownership and it
becomes a one corporation. The company tries to own its upstream suppliers and its downstream
buyers. With respect to cost, differentiation and other strategic issues, it can have a significant
impact on the business position (Griffiths and Wall, 2008). The vertical scope of a company is
considered as an important aspect in the development of a corporate strategy (De Grauwe, 2014).
The concept of this kind of integration can be identifiable on the basis of value chain. Here is an
example of backward and forward integration.
Figure 1: Backward and Forward Integration
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(Source: Fujita and Thisse, 2013)
There are two issues which are to be considered while performing the vertical integration
which includes cost and control. The cost has an impact on the internal activities of the company.
Control affects the barriers to entry and also assures cooperation of key value adding players
(Schumacher, 2011). There are many benefits associated with vertical integration. It can also be
referred as a kind of business strategy which is used to achieve expansion through gaining
ownership of the company’s previous supplier or distributor. Many of the firms use vertical
integration as a method to reduce the cost and to increase the efficiency. It results in increased
competitiveness (Caravle, 2002). Now it has been clear that there are two types of vertical
integration that is backward and forward.
Forward integration is a kind of vertical integration under which a company make efforts
to gain ownership of its distributors. On the other side, under backward integration a company
tries to gain ownership of its supplier (Choudhury and Hoque, 2004). However business can
utilize either a forward or backward approach or may use a combination of the two which is
known as balanced integration approach (Moschandreas, 2000).
Figure 2: Figure illustrating vertical integration and contrasting it with horizontal integration
(Source: Pesaran and Pesaran, 2010)
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Implementing a vertical integration strategy whether backward or forward, facilitates the
company to have greater control over its process. For example, A’s family is having a sheep farm
and the farm makes just enough that supports his family. A wants to attain a competitive edge
against the other farmers in the market and also to increase his profits (Sentance, Taylor and
Wieladek, 2012). He reads an article about vertical integration and decides to apply a forward
integration strategy. A is of the opinion that he has the best sheep in the market and if he starts
his own shop he could increase the profits. He owns the farm where the sheep are raised, hence
he better understands about the aspects such as quality and cost. After the application of the
strategy, the shop did very well and the profits were soared (Venugopal, 2006). After that he
decides to utilize a backward integration strategy as well and buy the feed store that supplied him
with food for his sheep.
Advantage of vertical integration
There are many advantages associated with vertical integration. These are as follows:
Increased competitiveness - It creates many competitive advantages for the business. It is
essential because it helps in fighting the competition with other companies. It also makes the
competition tougher and harder (Allen, Doherty and Mansfiled, 2013).
Greater Process Control – Another thing which is offered is the greater process control. It has
to be noted that vertical integration brings control over all the activities because a company takes
all the things into its control (Akerlof and Kranton, 2010). They are able to control the quality of
the raw materials which is supplied.
Increased market share – At this stage, efforts are made to achieve the expansion. More and
more people are invited to get associated with the business. Focus is paid on various stakeholders
such customers, shareholders, employees, suppliers etc. (De Grauwe, 2014). This helps in
increasing the market share for the company.
Increased supply chain coordination – It is also a great advantage as it brings coordination in
all the supply chain activities. Supply chain is something which requires very smooth and flat
level of operations that means the products or services are to be reached at right place at right
time and in right manner (Fujita and Thisse, 2013). This coordination also increases the level of
effectiveness. They are also able to coordinate the delivery of raw materials or other supplies.
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Decreased Cost – Many firms are using this strategy so that they can reduce the cost through
eliminating price mark-ups associated with purchasing a product from a third party seller
(Schumacher, 2011). For example, Starbucks is not just a coffee house as the company also
grow its coffee beans. The coffee can also be found packaged available for sale in a grocery
store.
Differentiation – It is another advantage offered from vertical integration. It facilitates access to
more production inputs, distribution process and retail channels. In this way company can
differentiate itself from the competitors on the basis of effective marketing (Caravle, 2002).
Company can quickly design its strategies according to the changing customer needs.
Disadvantages of Vertical Integration
Apart from many advantages, vertical integration also holds some drawbacks. These are
as follows:
Capacity balancing issues – There can be problem with the balancing of potential. Company
may opt to create an excess upstream capacity for the purpose of assuring that downstream
business operations have sufficient supply under all demand conditions (Choudhury and Hoque,
2004).
High Costs – It is another major drawback. High costs arise from low competition which results
from lack of supplier competition. High costs can disturb all the operations of the business. It
also increases the bureaucratic costs (Pesaran and Pesaran, 2010).
Low flexibility – Low level of flexibility is seen due to previous upstream and downstream
investments. However it is to be noted that flexibility to coordinate vertically related activities
may get increase (Sentance, Taylor and Wieladek, 2012).
Establishing new core competencies – New core competencies may compromise with the
existing competencies. This can put negative impact on the business of the organization.
Decrease in potential – the Strategy may also result in decreased ability related to increasing the
range of products (Venugopal, 2006). It occurs when if significant in-house development is
needed.
There are many examples associated with vertical integration. These are as follows:
 Recently Google bought mobile device maker Motorola Mobility and will soon start
producing smart phones and television top boxes (Allen Doherty and Mansfiled 2013)
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 Amazon’s Kindle Fire Tablet reflect its bridge between hardware and e-commerce
 Oracle bought Sun Microsystems and champions engineered systems (Porter 2008).
 Microsoft has now started making hardware for its Xbox gaming system (Sentance,
Taylor and Wieladek 2012).
Examples of Vertical Integration in business world
This type of integration states that one organization controls the end products as well as its
component parts. In the area of technology, Apple has been featured as a champion company. It
offers, a vertical model which consists of integrated hardware and software approach. For
instance, iPad and iPhone are having hardware and software designed by the Apple which also
manufactures its own processors for its devices (Akerlof and Kranton, 2010). This integration
has facilitated the organization to open the door for mobile computing. Despite of having the
advantage of specialization, company can make sense to have everything under one roof.
Through implementing this strategy, Apple has become a leading platform company. It has
helped the company to control production right from the beginning till the end. Other
organizations may follow the Apple Model but may not be able to see success for long period of
time (Apple, Annual reports 2014). The vertical integration needs a company to not only focus
on its core business but also on several difficult areas such as sourcing materials, producing and
then ultimately selling the product. Another major success of Apple is its forward integration
with its retail stores. It helps the company to control the prices for its products as they are able to
sell the products directly to the customers.
Another great example of this strategy is of Alibaba which is China based retailing company.
They have used this strategy in order to increase the profits and gain more market share. Full use
of vertical integration makes it more than an e-commerce stage (Allen, Doherty and Mansfiled,
2013). Alibaba has strengthened its leadership within the market through acquiring
complementary firm in a variety of industries which includes payment and deliveries. This shows
their intention to create a completely vertically-integrated e-commerce powerhouse (Alibaba,
Annual reports 2014). Plans are also being made by the company to go global. In the year 2013,
it authoritatively opened an office in San Francisco and has also done some investments in IT
companies of US. It can be said that integration strategy has proved to be very successful for
them and has made them the most profitable internet retailer in China.
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One of the largest and the most famous example of the vertical integration was the Carnegie
Steel company. The company established control on several aspects such as on mills where the
steel was made, on the mines where the iron ore was extracted, the coal mines that supplied the
coal, the railroads that transported the coal to the factor etc. (Carnegie and the Steel Industry.
2014). Rather that importing talent from other companies, Carnegie Steel focused largely on
developing talent from within the organization. After some time, Carnegie also established an
institute to impart the learning related to steel processes to the next generation (Griffiths and
Wall, 2008).
Asset Specificity is a term showing the inter-party relationship of a transaction. It is widely
used in several management and economic fields such as marketing, accounting, organizational
behaviour and management information systems (Sloman and Sutcliffe, 2007). This concept is in
close integration with opportunism. The economists of the traditional world had assumed that the
existence of the perfectly rational economic man. The previous theories related top economics
often believes that two contractually bounded companies will stick to the contract as they are
supposed to. Although the recent scholars such as Oliver E. Williamson has highlighted the issue
of opportunism (Akerlof and Kranton, 2010). A party attached to the transaction could of
opportunistic nature by manufacturing poor quality products, supplying the product late and not
following the provision of a contract.
There are two major efficiencies in any kind of maker or buy decision. These includes
technical and agency efficiency. Trade-offs exists between both the concepts. The technical
aspect is an efficiency in the physical production of the goods and services (Fujita and Thisse,
2013). It is dominated by economies of scale and scope. The company makes an attempt to adopt
the most efficient or least cost method of production. Agency efficiency is the efficiency in the
transactions needed to obtain the goods and services. It is dominated by transaction costs and the
company makes an attempt to reduce the transactions costs of exchange (Lipczynski and Wilson,
2003).
CONCLUSION
From the above study it can be concluded that managerial economics provides the
opportunity to build business strategies. Vertical Integration has been adopted by many big
corporate houses across the globe. This type of integration states that one organization controls
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the end products as well as its component parts. It is helping them in attaining competitive edges
and in increasing the revenue and profits (Sloman and Sutcliffe, 2007).
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