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When does vertical integration make sense?

Vertical integration’s history as an industrial organization strategy clearly illustrates its hazards and benefits with a long list of bankrupt companies while other firms have flourished. It’s clear that at times it does make sense, but too often firms misjudge the market or base acquisitions on other factors, such as stock price. A misjudged acquisition can create long and costly losses with little to no gain in market share. However, vertical integration can also give a firm long-run dominance and higher profits.

When facing double marginalization, firms are losing profits due to oligopolist distributors setting price equal to marginal cost and thereby raising the costs of the firms dealing directly with the consumers. The are multiple solutions, but vertical integration allows a firm to bypass dealing with distributors and lower costs. When it controls manufacturing the firm can set marginal costs equal to the the marginal revenue from the consumers by changing output. This strategy can be applied to any scenario in which a firm faces high prices for inputs and has the capacity to integrate backwards.

A vertically integrated firm can also have larger market power, in which case it can increase profits through price discrimination. If the firm has the capacity to sell in different geographic areas to different classes of consumers it can discriminate based on the price elasticity of demand. However, this strategy will fail if those consumers purchasing at lower prices can engage in arbitrage because the firm will then be competing against its own products and lose revenue.

Vertical integration is a costly process that has a poor track record, but when done properly firms can gain market power and increase profits.

One Comment

  1. A good devil’s advocate statement, in the sense that you provide no details of theory that would indicate limits to vertical integration. Now it’s up to your classmates to tackle that in their comments.

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