How Vertical Integration Is Reshaping Consumer Markets

For many businesses, there are lots of vulnerabilities in getting a new product to market.  Most firms have to purchase parts and materials from suppliers, do the manufacture and assembly themselves, and then hand off advertising and sales to retailers like Walmart and Target.  If suppliers have issues, the firm cannot make the product.  If retailers have issues, the firm may see reduced sales.  The struggles of dealing with suppliers, advertisers, and retailers has led some firms to pursue vertical integration, or the merging or acquiring of other firms on the pathway between resource acquisition and sales.

If a manufacturing firm that makes a product acquires a supplier, that is an example of backward vertical integration.  The firm now has better control of the stream of supplies it needs to make the product.  If the same firm later acquires a trucking company, this would be forward vertical integration because it helps the firm deliver its product to retail stores.  Large corporations may pursue both types of vertical integration to have better control of the entire process of generating revenue.

Economics Behind Vertical Integration

Basic free market economic theory says that specialization is key to economic growth by improving productivity.  Initially, this would imply that a firm should focus only on making its products and hire other firms that have specialized in areas like resource production, transportation and distribution, marketing, and retail.  While it is true that each of these firms is more efficient due to specialization, they are also each going to try to make a profit by charging clients higher prices than their costs.

Lower Costs

Vertical integration can be advantageous because it removes profit-seeking from each step to market and allows the owning firm to enjoy lower total costs.  By owning suppliers, distributors, advertisers, and retailers, a manufacturing company reduces its costs and can better position its products for more sales.  If it has excess capacity, it can even sell this to other firms and make profits from them.  For example, if a manufacturer buys a trucking company and has extra trucks available, it can rent the trucks to other firms or continue offering distribution services to them.  In the event of reduced capacity, the owning firm would simply reserve its capacity for its own goods.

Better Quality Control: The Principal-Agent Problem

In addition to being charged higher prices by profit-seeking firms, companies that rely on suppliers, distributors, advertisers, and retailers may have complaints about good and service quality.  After all, these separate firms are trying to maximize profit, often short term profit, and have reputations separate from their clients.  In economics, this is known as the principal-agent problem.  Each firm on the chain between natural resources and sales of finished goods has a separate, and sometimes competing, goal.

As a result of the competing goals, the manufacturer’s product may not end up in customers’ hands looking or performing as well as the manufacturer would like.  Consumer tastes and preferences may wane, causing market price - and the manufacturer’s revenue - to drop.  Sometimes, this may be due to the manufacturer having very specific needs that suppliers and other firms cannot easily meet, resulting in a lower-quality product.  To fix this, the manufacturer may need to acquire these other firms to calibrate their offerings.

For example, a tech company may need computer chips, glass, and wiring in grades and configurations not easily made by its current suppliers, who find making these supplies to more minute specifications too difficult to be worth it.  As a result, the quality of the tech company’s computers is lacking.  Although the expense of acquiring the suppliers is high, the tech company would benefit in the long run by being able to ensure its chips, glass, and wiring come in the needed configurations.  

Consumer Confidence

If a consumer can buy a product directly from the manufacturer, such as a Macbook laptop at an Apple store, it may increase consumer confidence, and thus demand.  The customer knows where he or she can take the product if there is a problem.  Therefore, the customer is willing to pay a premium and opt for a more expensive product, receiving additional utility (satisfaction) from confidence that the seller can right any wrong.

Manufacturers that are not vertically integrated and rely on retailers and third-party repair services may be seen as less reliable by customers.  If there is a problem with the expensive appliance, the customer worries it may be a hassle to get it fixed.  Knowing that the manufacturer owns its own stores and repair services increases customer demand.  Financially, the customer may be confident that the higher up-front cost of purchasing the appliance is worth it due to lower repair and service costs later on.

Control Over Pricing

Retailers have significant control over pricing.  Although companies can publish an MSRP, or Manufacturer Suggested Retail Price, this is suggested rather than mandatory.  Ultimately, once the retailer owns the product, it can change prices to suit its sales goals.  This can sometimes be harmful to the manufacturer by damaging its public perception.  If the retailer significantly drops the prices of a manufacturer’s product to clear shelf space, it may lead customers to believe that the product is of low quality.  Conversely, if the retailer significantly raises the prices, consumers may think that the manufacturer is responsible and over-charging.

History and Examples of Vertical Integration

One of the most famous examples of vertical integration comes from the oil industry in the early 1900s.  Oil tycoon John D. Rockefeller famously pursued both vertical and horizontal integration of Standard Oil to become a monopoly.  At its peak, before being broken up in 1911, Standard Oil controlled 90 percent of oil refining in the United States.  He began vertical integration efforts early, buying up companies that made components he needed, including barrels of oil.  By making his own barrels, he was able to make them at cost and pay no profit-seeking prices.  Eventually, the oil drilling firm controlled refining, distribution, and even gas stations - everything from oil in the ground to customers’ automobiles.

Today, despite the breakup of Standard Oil, its seven largest descendants, including ExxonMobil, are still vertically integrated.  A more modern example includes streaming video services like Netflix, which began as renters and sellers of other companies’ content but evolved to create their own content as well.  Today, streaming services like Netflix and Amazon Prime create their own shows and movies for customers, creating vertical integration between production and distribution.  Amazon, as a major online retailer, can also advertise its streaming services to all visitors who are shopping for other products, adding advertising to its vertical integration.

Another industry moving toward more vertical integration today is the auto industry, with automakers seeking to produce more of their parts and supplies in-house.  These firms now make parts, assemble the parts into cars, distribute the cars to dealerships, and create their own advertisements.  Many also have their own financing departments to cut out the need for third-party lenders.  This in-house financing allows the companies to create easier financing deals and promotions, directly adjusting the prices and interest rates paid by customers.  And, at dealerships, auto companies have direct control of the repair and maintenance process, allowing for post-purchase quality control.