Using Vertical Integration to prevent

Market Failures

Market Failures
Why do deals between two parties not come through?

TRANSACTION COSTS

Contracts
Long term relationships in a dynamic setting

Relationship-specific investments
Unclear property rights Captive power plants

Enforcing contracts and property rights

Information disparity between buyer and seller True Value, First Choice

One party Why do deals between two parties not come through?

Vertical Integration
The degree to which a firm owns its upstream suppliers and its downstream buyers is referred to as vertical integration.

Types of Vertical Integration

Raw Materials Raw Materials Raw Materials

Intermediate Manufacturing

Intermediate Manufacturing

Intermediate Manufacturing

Assembly

Assembly

Assembly

Distribution

Distribution

Distribution

End Customer

End Customer

End Customer

No Integration

Forward Integration

Backward Integration

Why Vertical Integration?

Relationshipspecific assets

Transaction Costs

Property rights

Information flows

 American Apparel an Industrial Revolution 2005 - World's fastest growing company in US, 440% 3-year growth 2005 - Marketer of the Year 2008 - Retailer of the Year 2008 - Top 2nd trendsetting brand after Nike Retail sales of $341 million in 2008, a 62% increase over 2007 One of the few companies to export "Made in USA goods Sweatshop Free" goods

Fabric Storage

Designing

 1990 Wholesale -> Retail 1997 Acquiring sub-contractors 2000 Single 800,000 sq. feet building in Los Angeles, California 2008 Took over US Dyeing and Finishing Inc. 2009 200 self-operated stores across the world, no franchise Owns subsidiary in US to replenish stores

Other Benefits
Synchronization of supply and demand along the chain of products Provide more opportunities to differentiate by means of increased control over inputs Capture upstream or downstream profit margins Gain access to downstream distribution channels that otherwise would be inaccessible Facilitate investment in highly specialized assets in which upstream or downstream players may be reluctant to invest Lead to expansion of core competencies Ability to monopolize market throughout the chain by market foreclosure Increase entry barriers to potential competitors, for example, if the firm can gain sole access to a scarce resource

I s s u e s w i t h Ve r t i c a l I n te g ra t i o n
Capacity balancing issues. For example, the firm may need to build excess upstream capacity to ensure that its downstream operations have sufficient supply under all demand conditions Potentially higher costs due to low efficiencies resulting from lack of supplier competition Decreased ability to increase product variety if significant inhouse development is required Developing new core competencies may compromise existing competencies. Increased bureaucratic costs

When to vertically integrate?

I N T E G R AT E YES YES Related core competencies VERY HIGH DONT I N T E G R AT E

Can derive benefits from economies of scale Strategic similarity between vertically related activities Regulations /Tax on market transactions, other obstacles Investments by other firms towards the activities Create unnecessary competition with partners

NO NO Different core competencies MANAGEABLE

RELUCTANCE

WILLINGNESS

NO

YES

Summary
Deals between two parties in a market fail because of various transaction costs Vertical integration minimizes the number of deals between two separate parties hence reduces/removes transaction costs However, vertical integration can be applied only after looking at suitable factors