Illusions in Vertical Integration Decisions

There are some common misperceptions about the benefits of vertical integration that must be guarded against:

  1. A strong market position in one stage can automatically be extended to the other.

It is often said that the firm with a strong position in its base business can integrate into a more competitive adjacent business and extend its position to that market. Suppose a strong manufacturer of consumer goods integrates forward into retailing, a very competitive business. Although the integrated retailer might pick up all the man-ufacturer’s business, thereby increasing share, the manufacturer might well be better served if many retailers were competing actively to sell its products.10 The manufacturer could indeed raise its prices to its captive retailer—though it would just be a bookkeeping trans-fer of profits from one unit to another—but if the captive retailer then adjusted its prices, its competitive position would be worsened. Thus the integration does not automatically allow the extension of a strong market position at all. Only if the integration per se produced some tangible benefits would integration allow the extension of mar-ket power, because under these circumstances it would improve the competitiveness of the combined entity.

  1. It is always cheaper to do things internally.

As has been discussed, there are many potential hidden costs and risks in vertical integration that may be avoided by dealing with outside firms. There is also the possibility that clever contracting can reap the benefits of integration without the costs or risks. The economies of integration are often looked at much too narrowly, and inte-gration decisions thereby ignore many of these issues.

  1. It often makes sense to integrate into a competitive The deck is stacked against the advisability of integration into a highly competitive industry. Firms in such an industry are earning low returns and are competing vigorously to improve quality and serve customers. There are many firms to choose from in buying or selling. Vertical integration can dull incentives and blunt initiative.
  1. Vertical integration can save a strategically sick business.

Although a strategy of vertical integration can bolster the stra-tegic position of a business under certain conditions already dis-cussed, it is rarely a sufficient cure for a strategically sick business. A strong market position cannot be automatically extended vertically except under particular circumstances. Each stage of a vertical chain must be strategically sound to insure the health of the enterprise as a whole. If one link is sick, the sickness is more likely to spread to the other healthy units, as the analysis presented earlier has shown, rather than vice versa.

  1. Experience in one part of the vertical chain automatically qualifies management to direct upstream or downstream units.

As has been discussed, the managerial characteristics of verti-cally related businesses are often extremely different. A false sense of security growing out of the proximity of the business can lead to the destruction of the new upstream or downstream business, simply by the process of applying historical managerial approaches.

Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.

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