Long-Term Contracts and the Economics of Information

It is essential to recognize the possibility that some economies of integration could be gained by the right type of long-term or even short-term contract between independent firms. For example, proc-ess savings could conceivably be gained by locating the plants of two independent entities right next to each other. Metal container plants are sometimes located next door to major food processors and con-nected by conveyor belts to avoid transportation costs. Or selling and coordination costs could be avoided with sole-source long-term contracts specifying a fixed delivery schedule.

However, contracts do not usually allow the achievement of all the economies of integration because they expose one or both parties to substantial risks of being locked in and because independent par-ties have interests that are probably dissimilar. These risks and diver-gent interests often make it impossible for independent firms to agree on a contract, either because of negotiating costs or the risk of post-contract haggling. Hence integration becomes necessary to achieve the benefits.

Nevertheless, a firm should always consider the option of con-tracting with   an independent entity to achieve the same benefits as integration, especially when the risks and costs of integration, previously discussed, are great. One of the pitfalls in vertical inte-gration is to be beset by its costs or risks when many of the benefits could have been achieved through more clever dealing with outside parties.


Tapered integration is partial integration backward or forward, the firm purchasing the rest of its needs on the open market. It re-quires that the firm be able to more than support an efficiently sized in-house operation and still have additional requirements which are met through the marketplace. If the firm is not large enough for its in-house operations to be efficient, the disadvantage of small scale must be subtracted from the net benefits caused by tapered integra-tion.

Tapered integration can yield many of the benefits of integra-tion previously described while reducing some of the costs. It is undesirable if the foregone benefits due to incomplete integration exceed the reduction in the costs of integration brought about by taper. The choice between tapered integration and full integration will vary from industry to industry and from firm to firm in the same industry.


Tapered integration results in less elevation in fixed costs than full integration. Furthermore, the degree of taper (or the proportion of product or service purchased outside) can be adjusted to reflect the degree of risk in the market. Independent suppliers can be utilized to bear the risk of fluctuations, while in-house suppliers maintain steady production rates.7 This is the case in the automobile industry, and it is a prevalent practice in many Japanese manufac-turing industries. Taper can also be used to guard against imbalance between stages because of the problems described earlier. The op-timal degree of taper varies with the size of the expected market fluc-tuations and the extent of probable imbalances between stages created by expected technological change and other events. It should be noted, however, that tapered integration by necessity requires the firm to buy or sell to competitors. If this is a serious risk, tapered in-tegration is unwise.

Tapered integration reduces the risk of locked-in relationships to the extent of the degree of taper. It also gives the firm some access to outside R&D activities and can provide a partial solution to the problem of internal incentives. The juxtaposition of the in-house supplier or customer with independent suppliers or customers creates a form of competition among them that may improve their work.


Tapered integration allows the firm to prove that a threat of full integration is credible, which provides a strong discipline on sup-pliers or customers and may avoid the necessity of full integration to offset bargaining power. Furthermore, tapered integration gives the firm a detailed knowledge of the cost of operating in the adjacent in-dustry and a source of emergency supply. These factors yield additional bargaining advantages. Such a strong bargaining position is characteristic of the major automobile companies and the interna-tional oil companies (who purchase tanker shipping services to com-plement their own fleets). Maintaining a pilot plant, short of full fledged in-house production, can in some cases provide many of the same effects as tapered integration with even less required investment.8

Tapered integration also gives the firm many of the informa-tional benefits of integration. However, some other benefits of verti-cal integration discussed earlier are reduced, in some cases more than proportionately to the amount of taper. Taper may actually in-crease coordination costs in situations in which products produced by outside suppliers and the internal unit must match exactly.


Quasiintegration is the establishment of a relationship between vertically related businesses that is somewhere in between long-term contracts and full ownership. Common forms of quasi-integration are as follows:

  • minority equity investment;
  • loans or loan guarantees;
  • prepurchase credits;
  • exclusive dealing agreements;
  • specialized logistical facilities;
  • cooperative R&D.

In some circumstances, quasiintegration achieves some or many of the benefits of vertical integration without incurring all the costs. It can create a greater community of interest between buyer and seller, which facilitates specialized arrangements (like logistical facilities) that lower unit costs, reduce the risk of supply and demand interruptions, mitigate against bargaining power, and so on. This community of interest stems from goodwill, sharing of information, more frequent and informal contacts between managements, and the direct financial stake each side has in the other. Quasiintegration can also reduce costs that may be present with full integration, and it eliminates the necessity to commit to the full supply and demand of the adjacent business. It also avoids the need to make the full capital investment required for integration and eliminates the necessity of managing the adjacent business, among other factors.9

Quasiintegration should be considered as an alternative to full integration. The key is whether the community of interest estab-lished through quasiintegration is sufficient to achieve enough of the benefits of integration to justify the reduction in the costs (and risks) over full integration. Some benefits of integration, such as in-creasing return on investment, raising product differentiation, or en-hancing mobility barriers, may be quite difficult to achieve with quasiintegration. An analysis of each benefit and cost of vertical in-tegration in the particular business with the alternative of quasi-inte-gration in mind will be necessary to evaluate its desirability as a strategy.

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

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