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Vertical integration refers to a firms ownership of vertically related activities. The greater a

firms ownership extends over successive stages of the value chain for its product, the greater its

degree of vertical integration.

When to integrate vertically: Markets are not costless: making a purchase or sale involves

search costs, the costs of negotiating and drawing up a contract, the costs of monitoring to ensure

that the other partys side of the contract is being fulfilled and the enforcement costs ofarbitration or litigation should a dispute arise. All these costs are types of transaction costs. Ifthe transaction costs associated with organizing across markets are greater than the

administrative costs of organizing within firms, we can expect the coordination of productive

activity will be internalized within firms.

Types of VI : Vertical integration can be eitherbackward, where the firm takes over ownership

and control of producing its own components or other inputs, or forward, where the firm takes

over ownership and control of activities previously undertaken by its customers.

Benefits of Vertical Integration

VI eliminates hold-up problems ( the hold-up problem is a situation where two parties(such as a supplier and a manufacturer or the owner of capital and workers) may be able

to work most efficiently by cooperating, but refrain from doing so due to concerns thatthey may give the other party increasedbargaining power, and thereby reduce their ownprofits.)

New capabilities: Where one capability builds on capabilities in adjacent activities,vertical integration may help develop distinctive capabilities. For example: IBMs half-

century of success in mainframe computers owes much to its technological leadership insemiconductors and software. The efficiency of Wal-Marts retailing operations depends

critically on specialized IT and logistics from its in-house departments.

Extension of market power: Vertical integration can be used to extend a monopolyposition at one stage of an industrys value chain to adjacent stages. Doubleedge swordsince customer might be reluctant to buy from competitor. Disneys acquisition of the

ABC TV network adversely affected Disneys relationships with other TV networks andmade other studios (for example, Dreamworks) more reluctant to collaborate with ABC

in developing new TV productions.

Flexibility (System-Wide): Where system-wide flexibility is required, verticalintegration may allow for speed and coordination in achieving simultaneous adjustment

throughout the vertical chain. For example, Zara is another fashion clothing business thathas cut cycle times and maximized market responsiveness through a vertically integrated

strategy that challenges the industrys dominant model of contract manufacture

Costs of Vertical Integration

Optimal ScaleSuppose that Federal Express requires delivery vans that are designed andmanufactured to meet its particular needs. The transaction costs avoided by FederalExpress are likely to be trivial compared with the inefficiencies incurred inmanufacturing its own vans. Federal Express purchases over 40 000 trucks and vans eachyear, well below the 200 000 minimum efficient scale of an assembly plant.

Difficult to manage strategically different business: These strategic dissimilarities area key factor in the trend to vertical disintegration. Marriotts split into two separate

companies, Marriott International and Host Marriott, was influenced by the belief thatowning hotels is a strategically different business from operating hotels.

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Manage Cyclic demands: Where the required flexibility is rapid responsiveness touncertain demand, there may be advantages in market transactions. VI has larger fixed

costs and lower variable costs, firing employees and reducing capacity is more costly

than not renewing an outsourcing contract.