Growth by Vertical Integration: The Importance of the Market

Technology of production was certainly the critical determinant in the growth of the firm. Nine out of 10 large manufacturing companies listed in Appendix A used capital-intensive, energy-consuming processes. But the use of such production methods did not in itself bring size to a firm or concentration of production to an industry. Enterprises in a number of fabricated metal, chemical, food, glass, paper, and rubber industries that used such processes remained relatively small and their industries relatively competitive.

Except in the production of primary metals, a manufacturing enterprise rarely became and remained large until it had built its own extensive marketing organization. Its owners took this step when the maintenance of high-volume output required precise and detailed scheduling of the flows of finished products to mass markets or the maintenance of specialized distributing facilities and marketing services. The creation of distributing and marketing networks to provide such coordination, facilities, and services caused the mass producers to internalize several processes of production and distribution and the market transactions between them within a single enterprise. Such internalization permitted the visible hand of administrative coordination to make more intensive use of the resources invested in these processes of production and distribution than could the invisible hand of market coordination.

Such administrative coordination in turn created formidable barriers to entry. High-volume throughput and stock-turn reduced unit costs. Advertising and the provision of services maintained customer loyalty. Rival firms were rarely able to compete until they had built comparable marketing organizations of their own.

The creation of a nationwide or global distribution marketing network further encouraged, indeed often forced, the integrated enterprise to build an extensive purchasing organization. The increasing volume of production intensified the need for assured supplies and for more careful scheduling of the flow of supplies into the processing plants. When the raw materials came from a large number of farmers, small processors, and suppliers, the purchasing organization grew as large as the marketing one. Its many buyers maintained contact with suppliers and dealers, and, in the manner of the comparable buying units of the mass retailers, set specifications for and price of materials purchased and scheduled flows to warehouses and factories. Like the mass marketers, they reduced costs by more efficient administrative coordination. When, on the other hand, the number of suppliers were few, the purchasing organization remained small. Where the manufacturer’s motives for backward integration into control over raw and semifinished materials were defensive, where they were to assure an availability of supply rather than to reduce costs, they were somewhat similar to those of the builders of railroad systems. Like the railroad managers, the manufacturers wanted to be self-sustaining. In some industries defensive integration by  manufacturers, in turn, forced producers of raw and semifinished materials to integrate forward into manufacturing and marketing. Again, the parallels to railroad system-building are obvious.

Source: Chandler Alfred D. Jr. (1977), The Visible Hand: The Managerial Revolution in American Business, Harvard University Press.

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