Involves combination of technologically distinct phases of the production, sale, distribution, or other processes in a single enterprise. Company uses internal and administrative transactions, rather than market transactions, in order to achieve the objectives.
Vertical integration is one of the three directions of development of the company. It affects the competitive force of the company. Strategic opportunities for the company's activities are linked to relations with customers and suppliers. They are as follows:
- selling to and buying from independent companies,
- long-term contracts with independent buyers and suppliers
- quasi-vertical integration,
- total vertical integration.
Strategic benefits of vertical integration
- Access to technology can provide company basic knowledge of technology used below and over in value chain,
- Provide supply or demand - vertical integration ensures access to supplies during periods when the company has difficulties or helps in selling its products in periods when demand is low.
- Balancing tender distortions and the cost of the operations - when a business works with customers and suppliers, who have significant bargaining power integration brings benefits even if it does not follows other savings. Countering the bargaining power can reduce supply cost and make processes more efficient as a result of reducing unnecessary processes when dealing with customers or suppliers.
- Improving ability to stand out - managers by vertical integration, can increase company's value adding capabilities providing better conditions to stand out in the market,
- Countering barriers to entry and mobility - integration contribute to the achievement of these benefits and it also raises mobility barriers for other companies. It provides a competitive advantage over companies that are not integrated in the form of lower costs, higher prices and lower risk.
- Entering field with a higher profit rate - by this action company can sometimes raise its rate of return. The company must have advantages over other newly forming enterprises.
- Avoiding cutting off - if the integration does not bring benefits, it may be useful for defence against cutting off access to customers or suppliers by integrated competitors. They can take a lot of sources of supply, customers or retail.
Strategic costs of vertical integration
- Multiplying effects in operations - it increases the share of fixed costs. Vertical integration multiplies the products of the company's operations that expose it to greater cyclical fluctuations in revenue. By this, it Increases the risk.
- Decreasing efficiency when changing partners - vertical integration increases the costs of changing supplier or customer in comparison when it is an agreement with independent companies.
- Greater exit barriers - integration, specialization of resources, closer relations between companies can increase barriers to entry as well as barrier to exit.
- Capital needs - integration requires significant capital expenditure, which result in the high opportunity costs.
- Maintaining balance - companies must keep the balance in the production capacity of the integrated companies, otherwise they may encounter problems.
- Lower effectiveness of stimuli integration means that the purchase and sale system can be combined, it makes the incentives for companies higher in the chain can be lowered. They will prefer to sell inside the integrated enterprise, rather than compete on the market.
- Klein, B., Crawford, R. G., & Alchian, A. A. (1978). Vertical integration, appropriable rents, and the competitive contracting process. The Journal of law & economics, 21(2), 297-326.