Incentives to Vertical Integration

Vertical integration is defined as the replacement of a market transaction with an internal accounting transfer.

Ford's acquisition of Autolite meant it decided to make sparkplugs rather than buy them on the open market.

AT&T's affiliation with Western Electric meant that its telephone switching equipment would be manufactured "in-house" by a subsidiary.

The international petroleum "majors" (e.g., SOCAL, BP, and EXXON) are "fully integrated"--i.e., they are engaged in exploration and extraction of crude petroleum, pipeline or water transportation, refining, and wholesale and retail distribution.

Issue: Why do firms choose to vertically integrate (by way of merger or internal expansion) instead of "outsource"?

By vertically integrating to another stage of production, firms can avoid costs associated with using the market. These include the costs of search, negotiation, contracting, and contract compliance. Ronald Coase argued that reduction in transactions costs is the primary incentive to vertical integration [For a first hand explanation of the "Coase Theorem," see Ronald H. Coase, "The Nature of the Firm," Economica, Nov. 1937:368-405].

Technological economies can be achieved by vertical integration. For example, the integration of iron-making and steel-making eliminates the cost that would be incurred to reheat the iron if the two stages were non-integrated. Just-in-time inventory (JIT) management can economize on firms' inventory carrying costs--but only when units operating at different stages of production are tightly coordinated.

The elimination of successive monopoly.

The Successive Monopoly Model

Consider the case of an upstream manufacturer of motors and a downstream boat manufacturer (both monopolists). The model is based on the following assumptions:

  1. Manufacturing one boat requires one motor plus C dollars worth of other inputs, where C = $100. Since there is one motor per boat, Q measures motor and boat production.
  2. The boat monopolist is a price-taker in the market for motors--i.e., there is no monopsony power.
  3. The marginal cost of manufacturing a motor is equal to (a constant) $100.

Let PM denote the price of a motor. Thus the marginal cost function for the boat maker is given by:

MC = PM + C [1]

Recall that to maximize profits, MR should be equal to MC. Thus:

MR = PM + C [2]

Thus the derived demand function (D'D') for motors is given by:

PM = MR - C [3]

Click here to see the graph. Notice the following:
If the manufacture of motors and boats remains non-integrated, then PM = $400; hence PM + C = $500; hence the price of boats will be equal to $650.

However, if the two monopolists merge, then the marginal cost of manufacturing a boat declines from $400 to $200. The profit maximizing price of boats decreases from $650 to $500.The quantity produced of boats increases from 140 to 300. Hence vertical integration is welfare-enhancing.

Notice that profit increases by the shaded area.

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