Incentives to vertical integration

1
Incentives to vertical integration
Vertical integration is the replacement of a
market transaction with an internal accounting
transfer
All business enterprises are integrated to some
degree at the same time, no enterprise is fully
integrated.
2
International Petroleum Majors
Firms such as British Petroleum and Gulf-Chevron
are fully-integrated, meaning they engage in
crude extraction, transportation by ship or
pipeline, refining, and wholesale and retail
distribution.At the same time, they are NOT
integrated into manufacturing of pipelines or oil
extraction equipment. Thus, even the most
integrated firms are not perfectly integrated.
3
The make or buy decision

• Should the big food processors such as General
  Foods integrate upstream into agriculture?
• Should GM manufacture brakes for trucks at its
  Dayton, OH parts facility, or should it
  outsource.
• Should SBC communications manufacture
  telecommunications equipment in house.
• Should Amheiser-Bush get into the aluminum
  packaging business?
• Should Sears manufacture appliances?

4
Issue Why do firms choose to vertically
integrate (by way of merger or internal
expansion) instead of "outsource"?

• Economists have identified three basic incentives
  to vertical integration
• The elimination of transactions costs
• Technological economies
• Elimination of successive monopoly

5
The Coase contribution 1
Professor Coase argued that using markets can be
costly and that the systematic replacement of the
market with organization through vertical
integration could result in vast cost savings

• Transactions costs that can be avoided through
  making instead of buying include
• Search
• Negotiation
• Contracting
• Contract compliance

1 Ronald H. Coase, "The Nature of the Firm,"
Economica, Nov. 1937 368-405
6
Technological economies

• 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.

7
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
• 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.
• The boat monopolist is a price-taker in the
  market for motors--i.e., there is no monopsony or
  oligopsony power (hear audio explanation (wav)).
• 3.The marginal cost of manufacturing a motor is
  equal to (a constant) 100.

8
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')(hear audio
explanation (wav)) for motors is given by PM
MR C 3

9
Successive Monopoly Pre and Post-Merger

800
Pre-merger boat price
700
650
Post-merger boat price
PM C
500
200
MC (Motors and C)
Derived demand for motors
100
MC (Motors)
M
M
D
D
0
Q
800
300
140
700
10
Summary
Back to Lesson 7

• 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 red shaded
  area.