6.

2 Integration
• It refers to the operations by a firm in two or more industries
representing successive stages in the flow of materials or products
from an earlier to later stage of production or vice versa.
• Thus, it is a type of diversification but it may be looked as ‘vertical
concentration’, and if the process takes place by merging of two
different firms then it is ‘vertical merger'. However, vertical
integration is a popular term for all these.
• Essentially, it is the integration among intermediate products used
in production of a commodity. It may be initiated in either way,
i.e., a firm itself starts manufacturing all of them or different firms
producing goods at different stages of the process and merge
together.
• No vertically integrated firms buy the inputs or services
they need for their production or distribution processes
from other firms.
• A nonintegrated firm may write long term binding
contracts with the firms with which it deals, in which it
specifies price, other terms, or forms of behavior. Such
contractual restraints are called vertical restrictions.
• For example, manufactures commonly restrict their
distributors by determining their sales territories,
setting inventory requirements, and, where legal,
setting the minimum retail price they can charge.
• Some firms choose to vertically integrate and perform all
production and distribution activities themselves. Other
partially vertically integrates.
• For example, they may produce themselves but rely on
others to market the products. Some firms are not
vertically integrated, but buy from a small number of
suppliers or sell through a small number of distributors.
• Any firm that engages in successive steps in its
production process is at least partially integrated. For
example, a restaurant that bakes its own pies instead of
buying them readymade is partially integrated.
• A firm that participates in more than one successive
stage of the production or distribution of goods or
services is vertically integrated.
• A nonintegrated firm may write long term binding
contracts with the firms with which it deals, in which
it specifies price, other terms, or forms of behavior.
6.2.1 Types of Integration
• Integration of firms may be either horizontal or vertical in
nature, or conglomerate.
• Horizontal integration occurs when a business merges with or
acquires another business. It is the acquisition of additional
business activities at the same level of the value chain.
• Vertical integration is the process in which several steps in the
production and/or distribution of a product or service are
controlled by a single company or entity, in order to increase
that company's or entity's power in the market place.
• The foregoing discussion focuses on vertical integration in
particular.
• Vertical integration involves joining together under
common ownership a series of separate but linked
production processes. Such a strategy is used by many
enterprises to widen the boundaries of the firm and to
enlarge its size.
• Vertical integration occurs in one of two ways.
 Forward vertical integration occurs when a business
acquires another business, which brings it closer to the
customer.
 Backward vertical integration move closer to its
sources of supply.
• Vertical integration does not necessarily imply that
 All the output of every stage is used only within the
firm. sell some output at some stages
 All inputs are produced within the firm. It may suit the
firm to buy some inputs at other stages, resulting in
partial integration.
• Vertical integration in the business sense is the
ownership by one firm of two or more vertically linked
processes. The more stages owned and controlled by
one firm the greater the degree of vertical integration.
6.2.2 Motives of Vertical Integration
• The various motivations can be categorized under four main
headings:
 Efficiency gains in terms of technological joint economies.
 The ability to avoid imperfect markets.
 Distribution cost savings.
 Security and planning and avoidance of volatile markets.
• Porter suggested examining the advantages to a firm of
pursuing a strategy of vertical integration under six headings:
cost savings, increased control, improved communications,
changed organizational climate, operations management and
competitive differentiation.
6.2.2.1. The reasons for and against Vertical Integration
There are at least three possible costs of vertical integration.
• First, the cost of supplying its own factors of production or
distributing its own product may be higher for a firm that
vertically integrates than one that depends on competitive
markets which serve these needs efficiently.
• Second, as a firm gets lager, the difficulty and cost of managing
it increase. The advantage of dealing with a competitive
market is that someone else supervises production.
• Third, the firm may face substantial legal fees to arrange to
merge with another firm. Because of these costs, firms
vertically integrate only if the benefits out-weigh the costs.
• There are at least six major advantages to integrating.
i. Integration to lower Transaction costs.
• A firm may lower its transaction costs by vertically
integrating. For example, the transaction costs of
buying from or selling to other companies are avoided.
• There are four types of transactions in which
transaction costs are likely to be substantial enough to
make vertical integration desirable. They involve
specialized assets, uncertainty that makes monitoring
difficult, information, or extensive coordination.
• A Specialized asset is tailor- made for one or a few specific
buyers. It involves
 Specific physical capital which includes buildings and
machines that can be used for only one or a few buyers;
 Specific human capital i.e. a firm may need workers
specially trained in how the firm operates (specific human
capital). Such as engineers, to produce a particular product.
If it uses outside contractors as opposed to its own
employees, opportunistic behavior is possible.
 If successive stages of a production process must be located
adjacent to each other (that is, they involve site specific
capital),
• The second transaction cost reason for vertical integration,
uncertainty, suppose that a buyer cannot determine how long a
durable machine will last. The best way to predict quality (life
expectancy) may be to observe the method by which the machine is
constructed.
• The third transaction -cost reason for vertical integration concerns
transactions involving information.
 For example, if one firm pays another firm a fixed fee to obtain
information on newly developing markets, the hired firm does not
have an incentive to work hard at the margin to uncover all the
information, and the buyer has no way of determining if the supplier
did a good job. Disputes on payments may well and be difficult to
resolve. Such problems can be avoided by vertical integration.
• Extensive coordination: The fourth transaction-cost reason to vertically integrate
is to facilitate extensive coordination, Such as in industries with networks such as
airlines and rail roads.
ii. Integration to assure supply
• A firm may vertically integrate to assure itself a steady supply of a key input. To
do so, the firm may vertically integrate backwards buying or building the capacity
to produce that input.
iii. Integration to Eliminate Externalities
• A firm may vertically integrate to correct market failures due to
externalities by internalizing those externalities.
• For example, McDonald’s by owning or controlling all its restaurants, can
ensure a uniform quality, which results in a positive reputation
(externality). Consumers, as they travel around the country, know that
they can expect a certain minimum quality at any of this chain’s
restaurants.
iv. Integration to avoid Government intervention
• A firm may be able to avoid government restrictions,
regulations, and taxes by vertically integrating. A vertically
integrating firm can avoid price controls by selling to itself.
• For example, the federal government controlled prices on
steel products on several accessions. It set a maximum
price that could be charged for steel. Under binding price
controls, a firm that buys steel is unable to purchase all
the steel that it wants at the controlled price because
producers choose to ration steel rather than supply as
much as is demanded at the controlled price.
V. Integration to increase Monopoly profits.
• A firm may vertically integrate to increase or create market
power. A firm may be able to increase its monopoly profits
in two ways by vertically integrating.
• First, a firm that is a monopoly supplier of a key input in a
production process used by a competitive industry may be
able to vertically integrate forward, monopolize the
production industry, and increase its profits or, a firm that is
a buyer may benefit from acquiring its sole supplier.
• Second, a vertically integrated monopoly supplier may be
able to price discriminate, eliminate competition, or
foreclose entry.
Vi. Vertical Integration to Monopolize another
Industry.
• A Victim of another firm’s market power may
vertically integrate to eliminate that power.
• For example, around the turn of the century, dairy
farmers contended that they faced a single process
or that bought their milk at a low, monopolistic price.
• To raise the price of milk, dairy farmers vertically
integrated forward to form their own processors.