Vertical integration is getting a lot of press today. Technically, it occurs when a firm in the market chain purchases and operates other forward or backwardly linked businesses in the same final product chain.
Farmers are the original vertical integrators in that they frequently own the means to produce the feed supply, the grind and mix facilities to produce feed, the animal production processes and the trucking needed to take the finished animals to market.
It is a solution sometimes employed when markets fail. What is the function of markets and why do they sometimes fail?
Markets are a means for buyers and sellers of products to come together to exchange goods or services. The principal function of markets is to determine price. When markets are working well, prices serve the function of efficiently allocating resources to different production processes in an economy.
All things being equal, higher market prices call forth more production in areas needed or valued by society, and lower prices send signals to slow production of a particular good or service.
Normally, prices should act like votes, signaling approval for correct production and investment decisions, and punishing incorrect choices by lowering payments.
Market Failure There are some classic cases when markets fail to allocate resources correctly. When this happens, other means are imposed. For instance, it is impractical at times to exclude people who don't pay from the use of certain goods and services. Think of roadways, radio waves and city parks, as well as national defense, as examples.
If a tollbooth was placed at every access to every roadway to recover the cost of the roads, the burden imposed on the public in terms of delays and the costs of collecting the money would dramatically raise the cost of roads. This in essence ruins the benefits. Therefore, most roads are simply "public goods" and no fee is normally charged for each use, rather the costs are recovered via taxes.
Technology is helping us be a bit more clever in restricting non-payers from what were previously public goods. For instance, satellite television used to be available to anyone who had a dish to receive it. About 10 or 15 years ago, "scrambling" signals and unscrambling them for payers was perfected.
Some super-highways in Canada can now "detect" your car electronically and bill you for use. This capability can transform public goods to private goods. Private goods markets are usually thought to better allocate resources than governments.
There are other reasons market-determined prices are sometimes impractical. Have you ever wondered how much money a grocery store might be able to make if it charged each customer based on his or her maximum willingness to pay instead of placing a fixed price on each item?
For instance, many affluent consumers would be quite willing to pay $3 for a loaf of bread when the actual price is $1.59. To extract that value (sometimes called the consumer surplus) would be impractical since it would require an auction at the check out stand instead of a scanner.
The store sets a price based on average willingness to pay or average perceived value and the uniformity of pricing saves them a lot of hassle (and cost) at the check out stand.
Think of another problem associated with pricing and how it can blur the function prices are supposed to perform. Consider a 2-lb. boneless pork loin sitting in the grocer's meat case on a Styrofoam base all wrapped up in clear plastic wrap. It has a "bundle" of attributes included, which the consumer cannot separately value and "vote" on in the purchase decision. The choice is simply to buy or not to buy the entire bundle of attributes.
For instance, say I would like my roast with half of the safety inspections, fed only organic feed, raised on a family farm and with twice the intramuscular fat? The pricing mechanism does not let me choose all of these things with precision. Therefore, the consumer is not able to precisely communicate their preferences for each element in a quality bundle since one price has to cover all of that information on average.
Because of this, too much may be invested in some attributes of my roast and not enough in others.
Vertical Integration When market failure reaches a significant level, people are tempted to simply remove it and impose decision-making through some other means.
Vertical integration is one of those means. It removes the blurring that the price mechanism is sometimes incapable of solving and imposes the focus of centralized decision-making over numerous functions in a chain.
Vertical integration is not automatically better than prices in allocating resources. The burden falls on the vertically integrated decision-maker to correctly perform the tremendously complex functions, which markets, when they are working well, seem to rather easily accomplish.
In addition, most publicly traded firms are under constant pressure to demonstrate a significant and increasing return on assets or shareholder equity.
One of the ways you can raise these returns is to produce the same income with fewer assets. This can often be accomplished by out-sourcing those assets that are not big contributors to the total value of the product. Out-sourcing is often accomplished through leasing or by contractual relationship so that the functions are performed without necessitating capital investments in long-term assets.
It's a delicate balance between owning the right assets and out-sourcing other functions.
Ownership brings control over quality and/or other crucial contributors to added value while out-sourcing, which ultimately surrenders some control, tends to lower cost and permit increased scale. At the same time, it frees management focus and capital to focus on adding value.
Information systems offer the possibility of creating the virtually integrated chain. It can accomplish the control sought by integration without the expense and diversion related to buying those businesses.