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Business Growth Strategies
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, 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 controled not only the mills where the steel was manufactured, but 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.
Three Types
There are three varieties of this : backward vertical integration, forward vertical integration, and balanced vertical integration.
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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.
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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.
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In balanced vertical integration, the company sets up subsidiaries that both supply them with inputs and distribute their outputs.
Other Examples
Some in the music recording industry believe vertical integration is the best way to survive in the modern, post-Napster environment.
The idea would be to vertically integrate the record label with the radio station of its genre in local markets.
This would allow the label to more cheaply produce music (because many of the elements which make the production expensive are due to unnecessarily high standards of production required by the radio stations, and the system of payola).
It should also ensure that the record company better understands the wants of the radio listeners. The hope would be that anything the record label would play on their radio station, provided the listening habits and distribution system of music has not changed, would very likely be a hit.
Another example is the personal computer software company Microsoft. They produce the widely used Windows operating system which bundles with other Microsoft products such as the Internet Explorer web browser and Windows Media Player.
This article has been adapted from Wikipedia. All text is available under the terms of the GNU Free Documentation License.
What is a Hold-Up Problem?
It is a term used in economics to describe a situation where two parties (such as a supplier and a manufacturer) may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits.
For example: Imagine a scenario where there is profit to be made if agents X and Y work together, so they form an agreement to do so, after X buys the necessary equipment. The hold-up problem occurs when X might not be willing to accept that agreement, even though the outcome would be Pareto efficient, because after X buys the necessary equipment, Y would have bargaining power and might decide to demand a larger proportion of the profits than before. The source of Y's power lies in X's investment. Since X is now deeply invested in the project, but Y is not, X stands to lose money, should the deal not be completed, but Y has no such risk. Thus, Y has some bargaining power that did not exist before X's investment. In the extreme, Y could demand 100% of the profits, if X's only alternative is to lose the initial investment entirely.
One way to avoid the hold up problem is for the firms to merge, normally this is known as vertical integration.