Vertical Integration

In microeconomics and managing management, the term vertical integration describes a style of ownership and control. The degree to which a firm owns its upstream suppliers and its downstream buyers determines how vertically integrated it is. Vertically integrated companies are united through a hierarchy and share a common owner. Usually each member of the hierarchy produces a different product or service, 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. A monopoly produced through vertical integration is called a vertical monopoly, although it might be more appropriate to speak of this as some form of cartel.

One of the earliest, largest and most famous examples of vertical integration was the Carnegie Steel company. The company controlled not only the mills where the steel was manufactured, but also 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. Later on, Carnegie even established an institute of higher learning to teach the steel processes to the next generation

Three types

Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers. Contrary to horizontal integration, which is a consolidation of many firms that handle the same part of the production process, vertical integration is typified by one firm engaged in different aspects of production (e.g. growing raw materials, manufacturing, transporting, marketing, and/or retailing).

There are three varieties: backward (upstream) vertical integration, forward (downstream) vertical integration, and balanced (horizontal) vertical integration.

• 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 minimize costs by centralizing the production of cars and car parts.
• 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.
• In balanced vertical integration, the company sets up subsidiaries that both supply them with inputs and distribute their outputs.

If you view McDonald's, for example, as primarily a food manufacturer, backwards vertical integration would mean that they would own the farms where they raise the cows, chickens, potatoes and wheat as well as the factories that processes everything and turns it all into food. Forwards vertical integration would imply that they own the distribution centers for every area and the fast food retailers. Balanced vertical integration would mean that they own all of the mentioned components.

Examples

One of the best examples of vertically integrated companies is the oil industry. Oil companies, both multinational (such as ExxonMobil, Royal Dutch Shell, or BP) and national (e.g. Petronas) often adopt a vertically integrated structure. This means that they are active all the way along the supply chain from locating crude oil deposits, drilling and extracting crude, transporting it around the world, refining it into petroleum products such as Petrol/Gasoline, to distributing the fuel to company-owned retail stations, where it is sold to consumers.