Vertical Integration
What is Vertical Integration?
Vertical integration is one firm owning two or more stages of the same supply chain, such as a manufacturer that also owns its parts supplier or its stores.
Integration can run backward, toward inputs, as when a coffee chain buys the farms and the roastery, or forward, toward customers, as when a manufacturer opens its own retail outlets. Firms do it to secure supply, cut the cost of writing and policing contracts, protect investments that would be worthless outside the relationship, and remove the second markup that appears when a supplier with market power sells to a producer with market power. The costs are lost specialization and a larger organization to manage. The competition worry is foreclosure, meaning the integrated firm shuts rivals out of the input or the route to customers. It differs from horizontal integration, which combines direct competitors at the same stage and so removes a seller from a market, while a vertical deal does not.
Vertical Integration: a worked example
A parts maker with a marginal cost of $20 sells to an assembler facing final demand P = 100 - Q. Each marks up once: the parts maker charges $60, the assembler sells 20 units at $80, and profits are (60 - 20) × 20 = $800 upstream and (80 - 60) × 20 = $400 downstream, or $1,200 combined. If the two merge, the part moves internally at its $20 cost and the merged firm marks up only once, selling 40 units at $60 for (60 - 20) × 40 = $1,600. Buyers pay less and the firm earns more, which is the double markup problem integration solves.
The mistake students make with vertical integration
Students treat a vertical merger like a horizontal one and assume it must reduce competition. It removes no seller from either market, and by eliminating a double markup it can lower the final price, which is why many vertical deals clear review. The real objection is foreclosure: an integrated firm can starve rivals of an input or block their route to customers, and that harm has to be shown rather than assumed.
Vertical Integration questions
What is the difference between vertical and horizontal integration?
Vertical integration combines firms at different stages of the same supply chain, while horizontal integration combines firms that compete at the same stage. Only the horizontal version directly reduces the number of sellers competing for the same customers.
What is backward vertical integration?
Backward vertical integration is acquiring or building a stage closer to raw materials, such as a bakery buying a flour mill. Forward integration is the opposite move, toward the customer, such as that same bakery opening its own cafes.
Why do firms vertically integrate?
Firms vertically integrate to guarantee that inputs arrive on time and at a predictable price, to avoid the expense of negotiating and enforcing outside contracts, and to keep the margin the other stage had been charging them. The trade-off is losing the specialization and the competitive pressure an outside supplier provides.
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