More on Vertical Relationships

The Make or Buy Decision Firms should internalize those activities that can be conducted within the firm more profitably than they can be purchased in the market and should purchase the others. Three basic drivers of vertical integration: technological economies, transactional economies, and market imperfections.

Technological economies Economies of scope or scale: Side-by-side production, common inputs, level of production. Firms that can achieve the minimum efficient scale may want to make their own inputs so as to save on other costs such as transportation costs. Firms that do not use a sufficient quantity to achieve efficient scale of operations should buy the input from a large supplier that is producing at the most efficient scale.

Transactional economies Market exchanges involve costs: transportation, contracts, negotiations, etc. Also less direct costs in cases of asset specificity and incomplete contracts. –If one party must make sunk investments during a transaction because assets are specialized, then there is the potential for opportunistic behavior for both parties. –The lack of a complete contract (either because such contracts are too costly or are not enforceable) implies that one of the parties might be able to “hold up” the other and extract quasi-rents. Because VI implies control, opportunistic behavior should not occur under vertical integration.

Market Imperfections Vertical integration can serve to raise entry barriers and thus create an imperfectly competitive market. Vertical integration can also result from uncertainty or private information. –Firms with relatively constant input requirements may integrate backward to avoid paying high prices for inputs that are driven by erratic demands of other buyers. –By acquiring information about the costs of a successive production process, a vertically integrated firm is able to make more efficient quantity decisions.

Why Buy? Internal organization and management is not costless. –Amount and cost of monitoring required to run a firm efficiently increase as the size of the firm increases. –Firm must balance any benefits it receives from VI against the increasing costs of control associated with internal transactions. Also, as firms vertically integrate away from their core businesses, they may not have sufficient knowledge or experience to manage these additional activities effectively.

Market Foreclosure Firms may vertically integrate (or impose vertical restraints) to facilitate market foreclosure, i.e. to deny competitors the products from an upstream industry or make prices so high as to put the competitors at a disadvantage. Assume that there are both integrated and non- integrated firms in a market. –Integrated firm gets inputs at cost, non integrated firm pays a markup over the cost.

Market Foreclosure, con’t Assume N U firms in the upstream market and N D firms in the downstream market. Demand for the downstream product is P = a-bQ  D = (P D - P U - c D ) if the firm is non integrated  D = (P D - c D - c U ) if the firm is integrated At most, the upstream firm can charge P D - c D so it will net P D - c D - c U. (At a higher price, demand would be zero since costs for the downstream firm would exceed price.) By "selling" this unit to itself -- total output of the market does not change and it gets P D - c D - c U