Vertical and horizontal integration vertical integration, horizontal integration. Vink - vertically integrated oil companies Examples of vertical integration of production

One of the effective ways to run your own business is to create a vertically integrated company.

Currently, such organizations comprise the basis of the Russian and world economy.

Despite the popularity of this method of organizing an enterprise, it still has certain disadvantages and features that you should definitely pay attention to in order to understand how to deal with them.

Availability of incentives

Large vertically integrated companies constantly dictate their terms world economy. They represent the basis for supporting the stability of almost any state.

In Russia, integration processes have become increasingly significant over the past few years. This is due to the fact that for them there are currently very favorable development conditions, which is expressed in the gradual removal by the state of various barriers to the development of companies.

Owners of large enterprises can constantly strengthen their competitive positions, influencing control over the country's market environment.

The market analysis showed that different integration processes are determined by with your specific incentives.

Types of incentives

Today there are two main types of incentives, that characterize vertically integrated organizations, such as:

1. Internal. This includes the perceived and actual benefits that an organization may receive from implementing a particular integration. Typically, this requires the effective interaction of several group members to change certain market structures to improve conditions, making them more favorable to the firm.
2. External. They represent requirements that arise in relation to organizations based on the characteristics of the structure of a certain industry, the segment of which the company belongs. External incentives also include the actions of the firms themselves.

External incentives can be both strategic and non-strategic. The latter are determined by based on industry market characteristics, which in fact do not directly affect the activities of the organization. These include factors such as:

• market capacity and saturation;
• effect of scale of production;
• the concentration of buyers and sellers that has developed in specific conditions;
• the degree of elasticity of demand for goods and services;
• infrastructure development;
• presence of foreign competition;
• administrative barriers;
• general economic conditions;
• costs associated with carrying out transactions.

Strategic incentives, in turn, directly characterize the market structure itself. They are combined with each other depending on how different companies interact.

Strategic incentives There are such types as:

• discrimination against the company's activities (for example, price);
• the nature of integration processes;
• degree of enterprise integration;
• coordination of the actions of various companies on the market;
• the presence and influence of competitive organizations;
• actions of other market participants aimed at limiting entry into it.

Thus, on the basis of all the above incentives, the organization of vertically integrated corporations occurs.

Advantages of vertically integrated companies

The Russian economy is dominated by such vertically integrated corporations as OJSC Rosneft. This is due to the following advantages of this way of doing business:

1. Providing absolutely new level of management. It opens up the opportunity to coordinate the interests, processes and management techniques of all participants in the association. This in turn translates into a real increase in productivity.
2. Enabling the exchange of strategically important data. The introduction of any innovative ideas in one area provokes the spread of the corresponding positive effect to other parts of the structure.
3. Reduced dependence on distributors and suppliers. This is due to the constant increase in the independence of the organization’s activities from the influence of external factors on its activities. This is extremely important in dynamic markets with a large number of participants or limited resources.

Vertical integration, which was used by companies such as Rosneft OJSC and Lukoil LLC, made it possible to introduce one of the most effective methods for maintaining internal turnover of goods, while ensuring a good level of production inventory management. As a result, in many cases crisis phenomena associated with problems of marketing products along the technological chain are overcome.

A vertically integrated company is one of the effective methods of running your own business. The emergence of large structures with vertical integration represents one of the most significant trends present in the modern Russian economy. At the same time, the ambiguity that characterizes any vertically integrated company is a pretty good reason to take a comprehensive look at its main advantages and incentives.

Incentives

Modern large integrated organizations constantly dictate the vector of development of the modern economy and represent the basis for maintaining stability in the field of production of any developed country. A vertically integrated company is a fairly popular option for doing business, and in the Russian economy, various ones are becoming more and more significant. One of the most important reasons for the formation of such structures in the existing sector of the domestic economy is that favorable conditions were created for economic activity, mutual barriers were removed, and the opportunity arose to strengthen their competitive positions and exercise control over the market environment.

Analysis of the market in which integrated participants operate involves active consideration of the various specific incentives for different integration options.

What are they?

There are two types of incentives that distinguish a vertically integrated company - internal and external. The latter represent various requirements that are imposed by some special characteristics of the structure of a certain industry market on potential or existing participants, as well as all kinds of actions performed by firms operating in it.

The concept of vertical integration also provides for the division of external incentives into two more categories - non-strategic and strategic. Non-strategic are determined depending on the characteristics of the industry that do not directly depend on the company's activities. At the same time, strategic incentives are characteristics and are combined due to the work of the organizations themselves.

The defining non-strategic characteristics of the market are:

• capacity and saturation;
• current concentration of buyers and sellers;
• elasticity of demand;
• degree of infrastructure development;
• foreign competition;
• administrative barriers;
• general economic situation;
• transaction costs.

If we talk about the most important strategic characteristics of the market, then this already includes:

• price and other types of discrimination;
• the nature and degree of integration;
• concerted actions of companies;
• presence of potential competitors;
• actions of companies aimed at limiting entry into the market.

Intrinsic incentives represent any potential and actual benefits that a company receives after using a particular type of integration. The internal integration advantages that OAO Gazprom and other organizations with such a structure received may be the result of effective interaction between several group members, and at the same time can be expressed in various structural market changes that are favorable for the organization's work.

Benefits and Motives

The Russian economy, dominated by large organizations such as OJSC Rosneft and others, is characterized by a tendency towards vertical integration, which in fact represents one of the most controversial forms. Vertically integrated companies are distinguished not only by all the advantages and disadvantages of large enterprises, but also have their own patterns of development.

Disadvantages for the market

In connection with all this, it can be said that the consequences that vertical integration entails are ambiguous. As an example, we can take the same company “Rosneft”, which, on the one hand, sets a trend towards reducing production costs and, accordingly, prices, but on the other hand, it has significant market power and strengthens monopolization.

Vertical integration- production and organizational association, merger, cooperation, interaction of enterprises connected by common participation in the production, sale, consumption of a single final product: suppliers of materials, manufacturers of components and parts, assemblers of the final product, sellers and consumers of the final product.

Vertical integration refers to that part of the added value that is produced under joint ownership. The price of the product sold will likely include the costs of materials, components and systems. The high purchase price of these investments means a low level of integration. If the majority of total sales value is generated within a single organization, the level of integration will be high. The concept of horizontal integration is used much less frequently these days and refers to the use of a wide range of products in order to maximize customer satisfaction.

Vertical integration is the process of replacing market transactions with intra-corporate transactions, which leads to a planned economy in which suppliers enjoy a monopoly position and consumers simply have no other choice. Vertical integration, like diversification, was once very popular in the management of commercial organizations, but the peak of this popularity passed several decades ago. A classic example is Singer, an American sewing machine company that at one point integrated all of its operations from primary sources of raw materials (forests and iron mines) to finished sewing machines.

Vertical integration in a company is closely related to outsourcing and make-versus-buy analysis and touches on philosophical questions such as “did Ronald Coase win the Nobel Prize in 1992?” or “where does the company begin and end and why?”

Experience shows that a low level of competition leads to a high level of integration, that is, diversification. Those countries of the world where competition was at a low level were too strongly influenced by the planned economy to be competitive in the modern world with its globalization. This led to a thorough review of the entire business chain and, as a result, consideration of outsourcing opportunities. As a result, traditional value chains were broken and new companies were created. At the same time, the productivity of older companies was declining. The production of components and the supply of support systems in the telecommunications industry was left to specialized companies whose main activity was the production of electronics.

Most industries are now in a phase of reduced integration where they produce fewer end products themselves and source more components from third party suppliers.

In theory, all functions can be performed by separate companies. We can highlight the computer department, factory, sales company and other parts of the management apparatus. The decision to vertically integrate essentially involves a choice between producing goods and/or services in-house and purchasing them from someone else.

Gradually, the disadvantages of advanced vertical integration emerged. The high level of vertical integration became a problem and an object of struggle for Mikhail Gorbachev in the Soviet Union, a similar problem faced by all traditional airlines. The largest European companies have always been relatively free from the stress of competition, and accordingly they have been characterized by a high level of vertical integration. In the competitive battle with newcomers such as Ryanair and Easy.Jet, older companies have faced challenges not only with their cost structures, but also with advanced vertical integration. These companies handled their own engine maintenance, cleaned their own aircraft, ran their own ground support and cargo handling operations, etc., which of course led to a whole series of intermediary deals.

Centralized organizations are characterized by excessive faith in their own abilities, which is expressed in the desire to do everything on their own. Organizations that are more entrepreneurial, on the other hand, have a different tendency: they make the entire chain more efficient by purchasing the goods and services they need from other companies. The following are the negative features of advanced vertical integration:

• 1. It eliminates market forces, and with them the possibility of correcting unnecessary transactions.
• 2. It makes the provision of subsidies attractive, which distorts the picture of competition and distorts the question of the meaning of the company's existence.
• 3. It creates a misleading sense of power that does not correspond to the realities of the free market.
• 4. It creates interdependence that can lead to the collapse of any of the functions involved if one of them finds itself in a difficult situation.
• 5. The closed market it organizes (guaranteed sales channels) lulls the company’s vigilance and creates a false sense of security.
• 6. A false sense of security dulls an organization's desire and ability to compete.

Many examples of vertical integration are based on misconceptions and self-deception. The most common misconception is the belief in the possibility of eliminating competition in a single link of the production chain through its control. Some of the illusions prevalent in the world of vertical integration are listed below:

Illusion 1: a strong market position at one stage of production can be transformed into a strong position at another.

This assumption often led to poor investment decisions in the activities of the Swedish Consumers Cooperative* and other conglomerates, which were subsequently exposed to the above-mentioned shortcomings.

Illusion 2: commercial transactions that do not extend beyond the boundaries of one company exclude the participation of sales agents, simplify the management process and thus make transactions cheaper.

This is nothing more than the classic credo of all adherents of a planned economy, who consider centralized control the only true path and the free market anathema.

Illusion 3: We can resurrect a strategically weak unit by buying out the unit next to it in the production chain, or the unit preceding it.

This is possible in rare cases. The logic of each industry must be judged by its own metrics. This rule applies here too, with the exception of situations of diversification for the purpose of spreading risks.

Illusion 4: Industry knowledge can be used to achieve competitive advantage in both upstream and downstream operations.

It is worth taking a closer look at the potential benefits and making sure that this logic is not misleading.

There are many examples of stunning improvements in profitability achieved by breaking down vertically integrated structures. It is perhaps for this reason that business organizations in general are moving towards less integration. Automobile manufacturers with their own supply chains do not supply their vehicles to export markets at a lower price than those using independent supply companies. They also make their own transmissions no less expensive than transmission companies.

One of the reasons why vertical integration was so popular in the technocratic era was the obvious economies of scale that were tangible and measurable, as opposed to the advantages of small scale, such as entrepreneurial spirit and competitive energy, which cannot be expressed in numbers.

In certain specific situations, vertical integration also has a positive side, especially when control of key resources allows achieving competitive advantages.

Some are listed below:

• - higher level of coordination of operations with better control capabilities
• - closer contact with end users thanks to vertical integration
• - creating stable relationships
• - access to technical know-how relevant to the industry
• - confidence in the supply of necessary goods and services.

The integration of the travel company VingrevSor into the hotel business through the creation of holiday villages in tourist resorts is an example of growth from the sale of holiday packages to holiday accommodation, a move that was seen as a likely strategic advantage.

SAS has also invested in hotels, and IKEA, with its backward integration from furniture sales to furniture design and production planning, is balanced by forward integration, leaving the final stage of production (furniture assembly) to consumers themselves.

Vertical integration is often based on narcissism or excessive pride, so it is worth carefully considering your own internal motives.

Tired of the look of the kitchen? Do you want to change something? Order kitchens to order for individual orders.

This strategy means that the company is expanding in areas of activity related to the promotion of a product to the market, its sale to the end customer (direct vertical integration) and related to the supply of raw materials or services (reverse).

Direct vertical integration protects customers or the distribution network and guarantees the purchase of products. Reverse vertical integration aims to secure suppliers who provide products at lower prices than competitors. Vertical integration also has a number of advantages and disadvantages, some of which are given below.

Advantages:

New savings opportunities arise that can be realized. These include better coordination and management, reduced handling and transportation costs, better utilization of space, capacity, easier collection of market intelligence, reduced negotiations with suppliers, lower transaction costs and benefits from stable relationships.

Vertical integration should ensure that the organization delivers within tighter deadlines and, conversely, sells its products during periods of low demand.

It can provide a company with greater scope to engage in differentiation strategy. This is because it controls more of the value chain, which can provide more opportunities for differentiation.

This path allows you to counter the significant market power of suppliers and buyers.

Vertical integration may allow a company to increase its overall return on investment if the proposed option offers a return greater than the company's opportunity cost of capital.

Vertical integration may have technological advantages due to the fact that the acquiring organization will gain a better understanding of technology, which can be fundamental to the success of the operation and competitive advantage.

Flaws:

Vertical integration tends to increase the proportion of fixed costs. This is due to the fact that the company must cover the fixed costs associated with backward or forward integration. The consequence of this increased operational dependence is that enterprise risk will be higher.

Vertical integration may lead to less flexibility in decision making due to changes in the external environment. This arises because a company's competitive advantage is related to the competitiveness of the suppliers or buyers included in the integration process.

It can also create significant barriers to exit because it increases the tie-up of the company's assets. They will be much harder to sell in a downturn.

There is a need to maintain balance between the initial and final stages of the main

The activities of modern companies take place in a rapidly changing competitive environment, which is caused by globalization processes, market liberalization, as well as technological progress. The success of a company in such a situation largely depends on the effectiveness of interaction with other companies at various stages of creating and promoting the final product or service to the final consumer, in other words, on the effectiveness of vertical integration.

The main purpose of this article is to consider the concept of vertical integration, a comprehensive analysis of theoretical approaches to explaining this phenomenon, which has not received significant attention in the literature previously, as well as the creation of a theoretical basis for explaining the processes of vertical integration in the automotive industry. The main source of information when writing the article were the works of R. Coase, O. WilliamsonM. AdelmanK. R. Harrigan, J. Stigler, V. Abernasie, K. Arrow, R. Blair, R. Basel, devoted to the consideration of issues of vertical integration, as well as a number of articles in scientific journals.

The object of study in this article is economic theories that are used to explain the vertical integration of a company. At the same time, the object of analysis, the arguments given in defense of vertical integration, the contribution to the theoretical justification of vertical integration, as well as their limitations are considered.

Vertical integration is the process of incorporating into the structure of a company firms that are connected to it by a single technological chain, or merging the production stages of a single technological chain and establishing control of one company over them. At the same time, the production stage is understood as a process as a result of which added value is added to the initial cost of the product, and the product itself moves along the chain to the final consumer.

The main difference in scholars' definitions of vertical integration is the degree of control one firm has over another that results from the integration of different stages of the value chain.

Thus, professor at the Massachusetts Institute of Technology M. Adelman believes that a company is vertically integrated when within it, from one division to another, there is a movement of goods and services that could be sold on the market without further processing. This definition reflects the opinion of most scientists that vertical integration implies 100% control of the company over several stages of production. This definition excludes the firm's flexibility in choosing the degree of vertical integration, as well as the possibility of implementing quasi-integration strategies.

Harvard University professor K.R. Harrigan gives a broader definition of vertical integration as a way of increasing added value in creating a product or service and promoting it to the end consumer. This point of view assumes a variety of forms and degrees of control over the relationships between different stages of production, including their disintegration. The latter phenomenon is observed in many industries, for example in the automotive industry.

Depending on the direction of vertical integration, there are:

• -- “forward” integration, or direct integration, which involves combining one of the stages of the value chain with subsequent stages of production and sales. An example of such integration could be the integration of the stages of car assembly and distribution;
• -- “backwards” integration, or reverse integration, in which one of the stages of the value added chain is combined with previous links in the technological process. For example, a company that assembles a car vertically integrates with a supplier of assembly materials.

Depending on the degree of integration, the following are considered:

• -- full integration;
• -- quasi-integration, requiring less capital investment and allowing companies to remain freer.

Quasi-integration can exist in the form of:

• -- long-term contracts;
• -- joint ventures and strategic alliances. In this form, firms pool certain resources to achieve a common result, while remaining independent in resolving other issues;
• -- licenses for the right to use technologies. In this case, we are talking about vertical integration, in which one of the integrated stages is technology development and R&D. Full vertical integration can be replaced by a licensing agreement if the developed technology is difficult to copy and additional assets, such as marketing specialists, are not required to sell such technologies;
• -- ownership of assets. The firm has ownership rights to certain assets at various stages of the process chain, and the management of such assets is carried out by external contractors. For example, automobile manufacturers own specialized tools, fixtures, templates, stamping and casting molds, without which the production of components is impossible. They enter into contracts with contractors for the production of such components, while remaining the owners of the means of production, thereby preventing the possibility of breach of contracts by contractors and guaranteeing supplies;
• -- franchising. The franchisor is the owner of intangible assets (for example, a trademark), controls prices, product quality, and level of service, while minimizing financial and managerial resources.

At the moment, there is no general theory of vertical integration in economic science and its existence is explained using various theories and approaches.

For a long time in neoclassical direction of economic theory Taking into account one of the assumptions about the existence of competitive markets through which efficient allocation of resources occurs, the only justified case of vertical integration was the existence of a continuous technological interconnection of the various stages of production. It is assumed that in order to achieve efficiency in sequential processes that coincide in time and space, as in steel production, for example, common ownership is necessary. According to this approach, vertical integration in the automotive industry as a discrete manufacturing business does not make sense.

This approach is unjustified, since, as various scientists subsequently proved, the market is not an ideal mechanism for allocating resources; in addition, in the history of the automotive industry there are many examples of successful vertical integration.

In economic theory there is the concept of integration. Integration is the process of developing stable relationships between neighboring states, leading to their gradual economic merger, based on the implementation by these countries of a coordinated interstate economy and policy. There are horizontal and vertical integration.

Horizontal integration involves the acquisition by one firm of others engaged in the same business. A type of horizontal integration is diversification, which means the combination of firms whose technological processes are in no way related (for example, the production of chemical fibers and aircraft).

Vertical integration is a method by which a company creates (integrates) its own input or output stages of the technological chain. Integration can be complete (combining all inputs or outputs) or narrow (a company purchasing only part of the input elements and producing the rest in-house).

A company using vertical integration is usually motivated by the desire to strengthen the competitive position of its key source business, which should be facilitated by: cost savings; departure from market value in integrated production; increasing quality control of production and management processes; protection of own technology.

However, vertical integration also has negative sides: increased costs; inevitable financial losses due to rapid changes in technology and unpredictability of demand.

Vertical integration can increase costs if a company uses its own input production when external low-cost sources of supply are available. This may also occur due to the lack of competition within the company, which does not encourage its suppliers to reduce production costs. When technology changes, there is a risk that the company may become overly tied to outdated technology. With constant demand, a higher degree of integration allows for more secure and coordinated production of products. When demand is unstable and unpredictable, such coordination under vertical integration is difficult, increasing the cost of management. In these circumstances, narrow integration may be less risky than full integration because it reduces costs compared to full integration and, under certain conditions, allows the company to expand vertical integration. Although narrow integration can reduce management costs, it cannot eliminate them completely, and this effectively limits the expansion of the limits of vertical integration.

It is all of the above that emphasizes the relevance of the chosen topic of the course work.

The purpose of this course work is to study vertical integration. The objectives of this work are to find a definition of vertical integration, study the causes of vertical integration, consider vertical restrictions and mergers, and study this topic at the present stage.

To produce any type of product, it is necessary to carry out a series of stages, each of which includes a sequence of technological stages. For example, it is necessary to explore raw materials, extract raw materials, deliver them to the processing site, process them into intermediate and then final products, distribute them and deliver them to the consumer.

Vertical integration is the combination of two or more such stages of production. Theoretically, it can include all stages - for example, from the extraction of raw materials to the distribution of the final product between manufacturers. In this case, all transformations of the product at each stage must be internal within the company. In Fig. 1 presents elements and options for vertical integration. The sequence of technological operations T 1 - T Q characterizes the completed production cycle, which includes the sequence of production stages E 1 - Um, the growth of added value goes from the initial to the final operation, and it increases towards the product output of the production process. If at each stage the product is produced by a single firm, then there is no vertical integration, and each subsequent stage is implemented through a transaction on the open market.

In reality, almost every company has several intermediate stages of integration, i.e. carries out a certain sequence of technological redistributions, combining them with the purchase of initial resources from other companies. In the product flow, they can integrate upstream (lagging) or downstream (advanced).

In non-integrated firms, products move from one stage to another through market transactions based on free market prices. In integrated firms, the internal transfer of products from stage to stage is carried out at internal (conditional) transfer prices, which do not require equivalence to market prices and are completely dependent on the internal interests and behavioral strategy of the company. In this regard, it is necessary to note the reasons for choosing the integration of stages, since:

Market transactions can provide close, efficient and controlled contacts and strict ownership;

Highly representative control in integration can be effective, authoritative and relatively inexpensive.

The question of the scope of vertical integration and its very feasibility is a complex issue of theory and practice, which is still largely debatable. In particular, the core of the debate remains the connection between integration and monopoly forces.

Economists at the Chicago UCLA School tend to argue that integration cannot transform monopoly forces from one level to another and cannot create greater market forces than exist at horizontal levels. Other opinions boil down to the fact that integration, on the contrary, generates a transaction, eliminates the market and therefore can eliminate competition among sellers for access to resources. In this regard, it is important to note the actualization of the problem of the possibility of both determining and measuring the level (magnitude) of integration, as well as the reasons for firms using this process.

From the standpoint of measuring the level of vertical integration, intuitive simplicity rests on the measurement methodology itself. It is possible to count the number of stages with broad integration, but uncertainty arises in the definition of the very concept of “stage” - it can include many individual, relatively independent stages. For example, in the electronics industry, the processes of preparing integrated circuits include 2.5-3 thousand technological stages (transitions), which are sometimes quite difficult to separate into separate stages. Alternatively, a firm's value added to its final sales revenue can be used as an index of the degree of integration of these firms. An integrated manufacturer adds value through many stages, so its rate will be high. For example, the value added of a retailer will be low. At the same time, there are examples of other polarities - brick production is single-stage and has a high added value, while multi-stage industries have a low added value. The value added indicator may be lower for industries that are ahead in the production chain (raw materials, processing).

Thus, to date there are no perfect (reliable) measures of the level of integration; conceptual approaches require clarification and improvement.

Ensuring efficiency includes the use of technical specifications and cost savings in the transaction.

Some of the technical efficiencies are physical - for example, in metallurgical production, thermal resources can be saved when smelting iron and making ingots and processing them while maintaining the heated state. (The heat can be used to heat water, heat greenhouses and farmsteads, etc.).

Savings and efficiency can also be achieved by increasing the level of organization, more precise coordination and interpenetration of technological processes, eliminating additional costs and risk, as well as compliance with clear schedules and regulatory procedures.

John Stuckey Director McKinsey, Sydney
David White former McKinsey employee
Magazine "McKinsey Bulletin" No. 3(8) for 2004

Managers of any large company sooner or later have to deal with issues of vertical integration. The authors of this article, which, although it has become a classic in the decade since its first publication, has not lost its relevance, examines in detail the four most common reasons for vertical integration. But most importantly, they urge business leaders not to pursue vertical integration when value can be created or preserved otherwise. Vertical integration is successful only in one case - if it is vitally necessary.

Vertical integration is a risky, complex, expensive and practically irreversible strategy. The list of successful cases of vertical integration is also short. Nevertheless, some companies undertake to implement it without even conducting a proper risk analysis. The purpose of this article is to help managers make smart decisions about integration. In it we consider different situations: some companies really need vertical integration, while others are better off using alternative, quasi-integration strategies. We conclude by describing a model that is appropriate to use when making such decisions.

When to integrate

Vertical integration is a way to coordinate different components of an industry chain under conditions in which bilateral trade is not beneficial. Take, for example, the production of liquid iron and steel - two stages of traditional steel production. Liquid iron is produced in blast furnaces, poured into thermally insulated ladles and transported in liquid form to a nearby steel foundry, usually half a kilometer away, where it is then poured into steelmaking units. These processes are almost always carried out by one company, although sometimes the liquid metal is bought and sold. Thus, in 1991, Weirton Steel sold liquid iron to Wheeling Pittsburgh, located almost 15 km away, for several months.

But such cases are rare. The specificity of fixed assets and the high frequency of transactions force technologically closely connected pairs of buyers and sellers to negotiate the terms of a continuous flow of transactions. Against this background, transaction costs and the risk of abuse of market power are growing. Therefore, from the point of view of efficiency, reducing costs and risks, it is better for all processes to be carried out by one owner.

Figure 1 shows the types of costs, risks, and coordination issues that need to be considered when making integration decisions. The difficulty is that these criteria often contradict each other. For example, vertical integration, although it usually reduces some risks and transaction costs, at the same time requires large start-up capital investments, and, in addition, the effectiveness of its coordination is often very questionable.

There are four valid reasons for vertical integration:

• the market is too risky and unreliable (there is a “failure” or “insolvency” of the vertical market);
• companies operating in adjacent parts of the production chain have more market power than you;
• integration will give the company market power, since the company will be able to set high barriers to entry into the industry and conduct price discrimination in different market segments;
• the market has not yet fully formed, and the company needs to vertically “integrate forward” for its development, or the market is in decline, and independent players are leaving related production units.

These reasons cannot be equated. The first prerequisite, the failure of the vertical market, is the most important.

Vertical market failure

A vertical market is considered failed when it is too risky to transact on it, and it is too expensive or impossible to write contracts that could insure against these risks and monitor their execution. A failed vertical market has three characteristics:

• limited number of sellers and buyers;
• high specificity, durability and capital intensity of assets;
• high frequency of transactions.

In addition, a failed vertical market is particularly susceptible to uncertainty, bounded rationality, and opportunism, problems that affect any market. None of these characteristics by themselves indicate the failure of a vertical market, but taken together they almost certainly warn of such danger.

Sellers and buyers. The number of buyers and sellers in the market is the most important, although most variable, variable that signals the failure of a vertical market. Problems arise when there is only one buyer and one seller in a market (bilateral monopoly) or a limited number of buyers and sellers (bilateral oligopoly). Figure 2 shows the structures of such markets.

Microeconomists believe that in such markets, the rational forces of supply and demand do not themselves set prices or determine the volume of transactions. Rather, the terms of transactions, especially the price, depend on the balance of power between sellers and buyers in the market, and this balance is unpredictable and unstable.

If there is only one buyer and one supplier in a market (especially in long-term relationships involving frequent transactions), then both have a monopoly position. As market conditions change in unpredictable ways, disagreements often arise between players and both may abuse their monopoly position, which creates additional risks and costs.

For bilateral oligopolies, the problem of coordination is especially relevant and complex. When there are, for example, three suppliers and three consumers in the market, then each player sees five others in front of him, with whom he will have to share the total surplus. If market participants act imprudently, they will transfer the surplus to consumers in the fight against each other. It would be possible to avoid such a development of events by creating a monopoly in each link of the industry chain, but antimonopoly legislation does not allow this. There remains another option - to integrate vertically. Then, instead of six players, there will be three left in the market, each competing with only two contenders for their share of the surplus and probably behaving more intelligently.

We used this concept when a company came to us for help: it could not decide whether to maintain a repair shop for its steelmaking needs. The analysis showed that the services of external contractors would be much cheaper for the company. However, the opinions of the company's managers were divided: some wanted to close the workshop, others were against it, fearing disruptions in production and dependence on few external contractors (there was only one enterprise within a radius of 100 km that repaired large equipment).

We recommended closing a repair shop if it could not compete with the competition for routine maintenance and non-machine-intensive work. The scope of this work was known in advance, it was carried out using standard equipment, and could easily be completed by several external contractors. The risk was low, as were the level of transaction costs. At the same time, we advised leaving the large parts repair department at the plant (but significantly reducing it) so that it would only perform emergency work, which requires very large lathes and rotary lathes. It is difficult to predict the need for such repairs; only one external contractor could do it, and the costs of equipment downtime would be enormous.

Assets. If problems of this kind arise only with a bilateral monopoly or a bilateral oligopoly, are we not then talking about some kind of market curiosity that has no practical significance? No. Many vertical markets, which appear to have many players on each side, actually consist of closely intertwined groups of two-sided oligopolists. These groups are formed because the specificity, durability and capital intensity of assets so increase the costs of switching to other counterparties that of the visible multitude of buyers, only a small part has real access to sellers, and vice versa.

There are three main types of asset specificity that determine the division of industries into bilateral monopolies and oligopolies.

• Location specificity. Sellers and buyers locate fixed assets, such as a coal mine and a power plant, close together, thereby reducing transportation and inventory costs.
• Technical specificity. One or both parties invest in equipment that can only be used by one or both parties and has little value in any other use.
• Specificity of human capital. The knowledge and skills of company employees are of value only to individual buyers or customers.

Asset specificity is high, for example in the vertically integrated aluminum industry. Production consists of two main stages: bauxite mining and alumina production. Mines and processing plants are usually located close to each other (location specificity) for several reasons. Firstly, the cost of transporting bauxite is incomparably higher than the cost of bauxite itself, secondly, during beneficiation, the volume of ore is reduced by 60-70%, thirdly, enrichment plants are adapted to process raw materials from a particular deposit with its unique chemical and physical properties. Finally, fourthly, changing suppliers or consumers is either impossible or associated with prohibitively high costs (technical specificity). That is why the two stages - ore mining and alumina production - are interconnected.

Such bilateral monopolies exist despite the apparent multitude of buyers and sellers. In reality, at the pre-investment phase of interaction between mining and processing enterprises, there is still no bilateral monopoly. Many mining companies and alumina producers cooperate around the world and participate in tenders every time a new deposit is proposed to be developed. However, in the post-investment stage, the market quickly turns into a two-sided monopoly. The ore miner and the ore beneficiator developing the deposit are economically tied to each other by the specificity of their assets.

Since industry players are well aware of the dangers of vertical market failure, ore mining and alumina production are usually handled by one company. Almost 90% of bauxite transactions are carried out in vertically integrated environments or quasi-vertical structures, such as joint ventures.

Auto assembly plants and component suppliers can also become highly dependent on each other, especially when certain components fit only one make and model. Given the high level of investment in component development (asset capital intensity), the combination of an independent supplier and an independent auto assembly plant is very risky: the likelihood that one of the parties will take the opportunity to renegotiate the terms of the contract is too high, especially if the model has been a great success or, conversely, has failed. Auto assembly companies, to avoid the dangers of bilateral monopolies and oligopolies, are gravitating towards “backwards integration” or, as Japanese automakers have done, creating very close contractual relationships with carefully selected suppliers. In the latter case, the reliability of relationships and agreements protects partners from abuse of market power, which often happens when companies that are technologically dependent on each other keep their distance.

Bilateral monopolies and oligopolies that arise in the post-investment stages due to the specificity of assets are the most common reason for the failure of a vertical market. The effect of asset specificity is magnified when assets are capital-intensive and have a long lifespan, and when they have high fixed costs. In a bilateral oligopoly, there is generally a high risk of disruption to delivery or sales schedules, and the high capital intensity of assets and high fixed costs especially increase losses caused by disruption of production schedules: the scale of direct losses and lost profits during downtime is too significant. In addition, the long life of assets increases the period of time over which these risks and costs may arise.

Taken together, specificity, capital intensity and long life cycles often result in high switching costs for both suppliers and customers. In many industries, this explains most decisions in favor of vertical integration.

Frequency of transactions. Another factor in the failure of a vertical market is frequent transactions with bilateral oligopolies and high specificity of assets. Frequent transactions, negotiations and bidding increase costs for the simple reason that they create more opportunities for abuse of market power.

Figure 3 shows the relevant mechanisms of vertical integration depending on the frequency of transactions and asset characteristics. If sellers and buyers interact infrequently, then, regardless of the degree of asset specificity, vertical integration is usually not necessary. If asset specificity is low, markets operate efficiently using standard contracts, such as leasing or commodity credit agreements. With high asset specificity, contracts can be quite complex, but there is still no need for integration. An example is large government contracts in construction.

Even if the frequency of transactions is high, low asset specificity mitigates its negative effects: for example, going to the grocery store does not involve a complex negotiation process. But when assets are specific, long-term, and capital-intensive, and deals occur frequently, vertical integration is likely to make sense. Otherwise, transaction costs and risks will be too high, and drawing up detailed contracts that eliminate uncertainty will be extremely difficult.

Uncertainty, bounded rationality and opportunism. Three additional factors have important, although not always obvious, influences on vertical strategies.

Uncertainty prevents companies from drawing up contracts that can guide them if circumstances change. The uncertainty in the work of the repair shop mentioned above is due to the fact that it is impossible to predict when and what kind of breakdowns will occur, how complex the repair work will be, and what will be the ratio of supply and demand in local markets for equipment repair services. In conditions of high uncertainty, it is better for the company to keep the repair service in-house: the presence of this link in the technological chain increases stability, reduces the risk and costs of repairs.

Bounded rationality also prevents companies from writing contracts that detail the details of transactions under all possible scenarios. According to this concept, formulated by economist Herbert Simon, people's ability to solve complex problems is limited. The role of bounded rationality in market failure was described by Oliver Williamson, one of Simon's students.

Williamson also introduced the concept of opportunism into economic circulation: when given the opportunity, people often violate the terms of commercial agreements in their favor if it suits their long-term interests. Uncertainty and opportunism are often driving forces in the vertical integration of markets for R&D services and markets for new products and processes resulting from R&D. These markets often fail because the main product of R&D is information about new products and processes. In a world of uncertainty, the value of a new product is unknown to the buyer until he tries it out. But the seller is also reluctant to disclose information until payment for the goods or services, so as not to give away a “company secret”. Ideal conditions for opportunism.

If specific assets are needed to develop and implement new ideas, or if a developer cannot protect its copyright by patenting the invention, companies are likely to benefit from vertical integration. For buyers, this will be the creation of their own R&D departments. For sellers - “integration forward”.

For example, EMI, the developer of the first CT scanner, would have to “forward integrate” into distribution and service, as other high-tech medical device manufacturers typically do. But at that time she did not have the appropriate assets, and creating them from scratch required a lot of time and money. General Electric and Siemens, with their integrated R&D, process engineering and marketing structures, undertook the design analysis of the tomograph, developed their own, more advanced models, provided training, technical support and customer service and captured leading positions in the market.

Although uncertainty, bounded rationality and opportunism are ubiquitous phenomena, they are not always equally pronounced. This explains some interesting features of vertical integration across countries, industries and time periods. For example, Japanese steel and automobile companies are less “backward integrated” into their supply industries (components, engineering services) than their Western counterparts. But they work with a limited number of contractors with whom they maintain strong partnerships. Probably, among other things, Japanese manufacturers are ready to trust external contractors also because opportunism is a much less characteristic phenomenon for Japanese culture than for Western culture.

Defending against market power

The failure of the vertical market is the most important argument in favor of vertical integration. But sometimes companies integrate because their partners have more advantageous market positions. If one link in the industry chain has more market power and therefore abnormally high profits, players from the weak link will strive to penetrate the strong link. In other words, this link is attractive in itself and may be of interest to players both from within the industry chain and from outside.

The industrial concrete industry in Australia is known to be fiercely competitive, with barriers to entry to the market low and demand for uniform and standardized products cyclical. Market participants often engage in price wars and have low incomes.

Mining sand and gravel for concrete producers, on the contrary, is an extremely profitable business. The number of quarries in each region is limited, and the high costs of transporting sand and gravel from other regions pose high barriers to entry for new players in this market. A few players, protecting common interests, set prices much higher than those that would prevail in a competitive market environment and receive significant excess profits. A significant share of the costs of concrete production is attributed to expensive raw materials, so concrete companies have "integrated back" into the quarrying business, mainly through acquisitions, and now three large players control almost 75% of industrial concrete production and quarrying.

It is important to remember that entering the market through an acquisition does not always bring the desired results to the acquiring party, because it can give away the capitalized equivalent of the surplus in the form of an inflated price for the acquired company. Often players from less powerful links in the industry chain pay too high a price for companies from stronger links. In the Australian concrete industry, at least a few quarry takeovers have destroyed value for the acquiring companies. Recently, a major concrete producer acquired a smaller integrated gravel and concrete producer for a price that gave the company a price-to-cash flow ratio of 20:1. When the cost of capital of the acquiring company is about 10%, it is very difficult to justify such a high overpayment.

Players from less powerful parts of the industry chain certainly have incentives to move into more powerful ones, but the question is whether they can integrate without the costs of integration outweighing the expected benefits. Unfortunately, judging by our experience, this is rarely possible.

Managers of such companies often mistakenly believe that, as industry insiders, it is easier for them to enter other parts of the industry chain than for outside applicants. However, usually the technologically different links of an industry chain are so different from each other that “outsiders” from other industries, even if they have the same knowledge and skills, are much more likely to enter a new market. (New players, by the way, can also destroy the potential of an industry link: once one company overcomes the barriers to entry, others can do the same.)

Creating and using market power

Vertical integration may make strategic sense if its goal is to create or exploit market power.

Entry barriers. When most of the competitors in an industry are vertically integrated, it tends to be difficult for non-integrated players to enter the market. To become competitive, they often have to maintain a presence throughout the industry chain. This drives up capital costs and economic minimum production levels, effectively raising barriers to entry.

The aluminum industry is one industry where vertical integration has contributed to higher barriers to entry. Until the 1970s, six large vertically integrated companies - Alcoa, Alcan, Pechiney, Reynolds, Kaiser and Alusuisse - dominated all three levels: bauxite mining, alumina production and metal smelting. The markets for intermediate raw materials, bauxite and alumina were too small for non-integrated traders. But even integrated companies were not eager to shell out the $2 billion (in 1988 prices) required to enter the market as an integrated player on a reasonable scale.

Even if the newcomer were to overcome this barrier, it would need to immediately find ready markets to sell its products - about 4% of global aluminum production by which production would increase. Not an easy task in an industry growing at about 5% per year. Not surprisingly, the industry's high barriers to entry are largely due to the vertical integration strategy pursued by large companies.

Much the same barriers to entry exist in the auto industry. Automakers are usually "forward integrated" - they have their own distribution and dealer (franchise) networks. Companies with a powerful dealer network usually own it entirely. For market newcomers, this means that they must invest more money and time in developing new and extensive dealer networks. If it weren’t for the strong dealer networks of American companies, established over many years, Japanese manufacturers would have won a much larger market share from American auto giants like General Motors at one time.

However, creating vertically integrated structures to erect barriers to entry is often very expensive. Moreover, success is not guaranteed, and if the volume of excess profits is quite large, then inventive newcomers will eventually find loopholes in the fortifications erected. Aluminum producers, for example, at some point lost control of the industry, mainly because outsiders entered through joint ventures.

Price discrimination. By “forward integration” into certain customer segments, a company can benefit further from price discrimination. Consider, for example, a supplier with market power whose customers occupy two segments with different degrees of sensitivity to price changes. The supplier would like to maximize its profit by charging a higher price in the low-sensitivity customer segment and a lower price in the high-sensitivity segment. But he cannot do this because consumers receiving the product at a low price will resell it at a higher price to consumers in the adjacent segment and ultimately undermine this strategy. By “integrating forward” into low-price customer segments, the supplier will be able to prevent overselling of its products. It is known that aluminum producers are integrating into the most price-sensitive production sectors (production of aluminum cans, cables, casting of components for auto assembly), but do not strive for sectors in which there is almost no danger of substitution of raw materials and suppliers.

Types of strategy at different stages of the industry life cycle

When an industry is just starting out, companies often “forward integrate” to develop the market. (This is a special case of vertical market failure.) In the early decades of the aluminum industry, manufacturers integrated into aluminum products and even consumer goods to push aluminum into markets that had traditionally used steel and copper. Early manufacturers of fiberglass and plastic similarly discovered that the advantages of their products over traditional materials were only appreciated through “forward integration.”

However, in our opinion, this justification for vertical integration is not enough. Integration will only be successful if the acquired company has a unique patented technology or a well-known brand that is difficult for competitors to copy. It makes no sense to acquire a new business if the acquiring company cannot generate excess profits for at least a few years. In addition, new markets will only develop successfully if the new product has clear advantages over existing or similar products that may appear in the near future.

As an industry reaches an aging stage, some companies integrate to fill the void left by the departure of independent players. As the industry ages, weak independent players withdraw from the market, leaving key players vulnerable to increasingly concentrated suppliers or customers.

For example, after the cigar business began to decline in the United States in the mid-1960s, the country's leading supplier, Culbro Corporation, had to acquire all distribution networks in key markets on the US East Coast. Its main competitor, Consolidated Cigar Company, was already involved in distribution, and Culbro distributors “lost interest” in cigars and were more willing to sell other products.

When vertical integration is not needed

Vertical integration should be dictated only by vital necessity. This strategy is too expensive, risky, and very difficult to reverse. Sometimes vertical integration is necessary, but very often companies go for excessive integration. This is explained by two reasons: firstly, integration decisions are often made on dubious grounds, and secondly, managers forget about a large number of other, quasi-integration strategies, which in fact may turn out to be much preferable to full integration in terms of costs and economic benefits.

Dubious grounds

Often decisions about vertical integration are not justified. Cases where the desire to reduce cyclicality, secure market penetration, break into segments with higher added value or become closer to the consumer could justify such a move are extremely rare.

Reduced cyclicality or volatility of earnings. This common but often weak reason for vertical integration is a variation on the old theme that corporate portfolio diversification benefits shareholders. This argument is invalid for two reasons.

Firstly, incomes in adjacent links of the industry chain are positively correlated and are influenced by the same factors, such as changes in demand for the final product. This means that combining them in one portfolio will not significantly affect the overall level of risk. For example, this is the case in the zinc ore mining and zinc smelting industry.

Secondly, even with negative earnings correlation, smoothing the cyclicality of corporate earnings is not that important for shareholders - they can diversify their own investment portfolios to reduce unsystematic risk. Vertical integration in this case is beneficial to the company's management, but not to the shareholders.

Guarantees of supply and sales. It is generally accepted that if a company has its own sources of supply and distribution channels, then the likelihood that it will be forced out of the market, fall victim to price fixing, or suffer from short-term imbalances in supply and demand that sometimes arise in intermediate commodity markets is significantly reduced.

Vertical integration may be justified when the threat of market exclusion or “unfair” pricing indicates either vertical market failure or structural market power of suppliers or customers. But where the market is functioning properly, there is no need to own sources of supply or distribution channels. Market players will always be able to sell or buy any quantity of goods at the market price, even if it seems “unfair” in comparison with costs. An integrated company operating in such a market is only deceiving itself by setting internal transfer prices that differ from market prices. Moreover, a company integrated on this basis may make incorrect decisions regarding production levels and capacity utilization.

The structural features of the selling and buying sides of the market are the same implicit, but critically important factors that determine when to take over supply and distribution. If both sides are characterized by competitive principles, then integration will not be beneficial. But if structural features create vertical market failures or persistent market position imbalances, integration may be warranted.

Several times we have witnessed an interesting situation: a group of oligopolists - suppliers of raw materials to a rather fragmented industry with weak buyer power - "integrated forward" to avoid price competition. Oligopolists understand that it is shortsighted to fight for market share through price wars, except perhaps for very short periods, but they still cannot resist the temptation to increase their market share. Therefore, they “integrate forward” and thereby secure all the major consumers of their products.

Such actions are justified when players avoid price competition and when the price that oligopolistic companies pay to acquire their industrial customers does not exceed their net present value. And “forward integration” is beneficial only if it helps maintain oligopolistic profits at the top of the industry chain, where there is a constant imbalance of power.

Providing additional value. The idea that companies should move into higher value-added parts of the industry chain is usually expressed by those who adhere to another rather outdated stereotype: being closer to the consumer. Following these tips leads to greater “forward integration” - towards the end consumer.

There may be a positive correlation between the profitability of a link in an industry chain, on the one hand, and the absolute value of its added value and proximity to the consumer, on the other, but we believe that this correlation is weak and unstable. Vertical integration strategies based on these assumptions tend to destroy shareholder value.

Surplus, not added value or proximity to the consumer, is what generates truly high profits. Surplus is the income a company receives after covering all costs of doing business. The size of the surplus and added value (which is defined as the sum of all costs and markups minus the cost of all materials and/or components purchased in an adjacent link in the industry chain) of one of the links in the industry chain can only be proportional as a result of a random combination of circumstances. However, surplus is most often created at the stages closest to the consumer, because this is where, according to economists, direct access to the consumer's wallet and, accordingly, consumer surplus opens.

Therefore, the general recommendation should be: “Integrate into those parts of the industry chain where the maximum surplus can be achieved, regardless of proximity to the consumer or the absolute value added.” However, remember that the links with consistently high surplus should be protected by barriers to entry, and the cost of overcoming these barriers for a new entrant into the sector through vertical integration should not exceed the surplus that it can obtain. Typically, one of the barriers to entry is the specialized knowledge required to run a new business, which newcomers often lack, despite the experience gained in related parts of the industry chain.

Consider, for example, the industry chain of the cement and concrete industry in Australia (see Figure 4). In each individual link, the surplus is not proportional to the added value. In fact, the sector with the highest added value, that is, transportation, does not bring a decent return, while the sector with the least added value, the production of fly ash, creates a significant surplus. In addition, the surplus is not concentrated in the sector closest to the consumer, and if it is formed, it is at the primary stages. The size of the surplus varies widely across the industry chain and must be determined on a case-by-case basis.

Quasi-integration strategies

Company management sometimes goes for excessive integration, losing sight of many alternative quasi-integration solutions. Long-term contracts, joint ventures, strategic alliances, technology licenses, asset ownership and franchising require less investment while allowing companies more freedom than vertical integration. In addition, these strategies effectively protect against vertical market failure and against suppliers or customers with greater market power.

Joint ventures and strategic alliances, for example, allow companies to exchange certain types of goods, services or information while maintaining formal business relationships for all other items, maintaining their status as independent companies and not being exposed to the risk of antitrust prosecution. Potential mutual benefits can be maximized and conflicts of interest inherent in trading relationships minimized.

This is why most plants in the aluminum industry turned into joint ventures in the 1990s. Through such structures, it is easier to exchange bauxite, alumina, know-how and local knowledge, establish oligopolistic coordination and manage relations between global corporations and the governments of the countries in which they operate.

Asset ownership is another type of quasi-integration structure. The owner retains ownership of key assets in adjacent parts of the industry chain, but outsources their management. For example, manufacturers of automobiles or steam turbines have specialized tools, fixtures, templates, stamping and casting molds, without which it is impossible to produce key components. They enter into contracts with contractors to produce these components, but remain the owners of the means of production and thus protect themselves from the possible opportunistic behavior of the contractors.

Similar agreements can be concluded with companies lower in the industry chain. Franchising agreements allow an enterprise to control distribution without diverting significant financial and management resources to this, which would be inevitable with full integration. The franchisor does not seek to own tangible assets, since they are not specific or long-term, but remains the owner of intangible assets, such as a trademark. By having the right to cancel the franchise agreement, the franchisor controls the standards. For example, McDonald's Corporation, in most countries in which it operates, strictly monitors prices, product quality, level of service and cleanliness.

When it comes to buying or selling technology, licensing agreements should be considered as an alternative to vertical integration. Technology and R&D markets are at risk of failure as inventors find it difficult to protect their copyrights. Sometimes an invention is only valuable when combined with specific complementary assets, such as experienced marketing or customer support personnel. A license agreement may be a good solution to the problem.

Diagram 5 presents a decision-making methodology for the developer of a new technology or product. We see, for example, that when a developer is protected from counterfeiting by patents or trade secrets, and additional assets are either of little value or can be found on the market, then it is necessary to enter into licensing agreements with all comers and pursue a long-term pricing policy.

This strategy is typically suitable for industries such as petrochemicals and cosmetics. When technology becomes easier to copy and complementary assets become more important, vertical integration may be necessary, as we showed with the CT scanner.

Changing vertical strategies

As market structure changes, companies must adjust their integration strategies. Among the structural factors, the number of buyers and sellers and the role of specialized assets change most often. Of course, companies should reconsider strategies, even if they simply turned out to be wrong, and this does not necessarily require any structural changes.

Sellers and buyers

In the mid-1960s, the oil market showed all the symptoms of vertical failure (see Figure 6). The four largest sellers controlled 59% of industry sales, the eight largest 84%. The situation was much the same for buyers. There were very few possible combinations of buyers and sellers adequate to each other, since oil refineries could only work with certain grades of oil. Assets were capital-intensive and long-term, transactions were very frequent, and the need to constantly modernize plants increased the level of uncertainty. Not surprisingly, there was almost no spot market for oil, most transactions were carried out within the company, and if contracts were concluded with external contractors, they were for 10 years - to avoid the transaction costs and risks associated with trading in an unstable, vertically bankrupt market.

However, over the next 20 years, the market structure underwent fundamental changes. As a result of the nationalization of oil reserves by OPEC members (replacing the Seven Sisters with a multitude of national exporters) and the increase in the number of non-OPEC exporters (such as Mexico), the concentration of sellers has decreased significantly. By 1985, the market share controlled by the four largest sellers had fallen to 26%, and by the eight largest sellers to 42%. The concentration of ownership of oil refineries has decreased significantly. Moreover, technological improvements have reduced asset specificity as modern refineries can process significantly more grades of oil and do so with lower switching costs.

All this has encouraged the development of an efficient crude oil market and has significantly reduced the need for vertical integration. It is estimated that in the early 1990s, about 50% of transactions took place on the spot market (where even large integrated players trade), and the number of non-integrated players began to grow rapidly.

Disintegration

The shift towards vertical disintegration that occurred in the 1990s was caused by three main factors. First, in the past, many companies integrated without sufficient justification and now, although no structural changes occurred, had to disintegrate. Second, the emergence of a powerful mergers and acquisitions market is increasing pressure on overintegrated companies to restructure, either voluntarily or through coercion from their shareholders. And third, many industries around the world have begun structural changes that enhance the benefits of trade and reduce the risks associated with it. The first two reasons are obvious, but the third, in our opinion, requires explanation.

In many industry chains, the increased number of buyers and sellers has reduced the costs and risks associated with trading. Industries such as telecommunications and banking have been deregulated, allowing new players to enter markets previously occupied by national monopolies or oligopolies. In addition, with the economic development of many countries, including South Korea, China, Malaysia, more and more potential suppliers are emerging in many industries, such as consumer electronics.

Also, the globalization of consumer markets and the need to become “local” in any of the countries where they operate is forcing many companies to create production facilities in regions to which they previously exported their products. This, of course, increases the number of buyers of components.

Another factor that reduces costs and increases the positive effects of trade is the increasing need for greater production flexibility and specialization. It is very difficult for a car manufacturer, for example, which uses thousands of components and assemblies in its production (at the same time they are constantly becoming more complex, and their life cycle is shortening), to maintain a leading position throughout the chain. It is much more profitable for him to focus on design and assembly, and purchase components from specialized suppliers.

It is also important that today's managers have become adept at using quasi-integration strategies, such as long-term preferential relationships with suppliers. In many industries, procurement departments are trying to establish closer relationships with suppliers. In the US auto industry, for example, companies are moving away from rigid vertical integration, reducing the number of suppliers and developing stable partnerships with only a few independent suppliers.

However, there is also an opposite trend - towards consolidation. As conglomerates break up, their components end up in the hands of companies that use them to increase their shares in certain markets. But, in our opinion, the factors that stimulate the formation of industry structures capable of competing at the global level are much stronger.

Not only industry chains are disintegrating: under the influence of the market, many companies are forced to disintegrate their own business structures. Cheaper foreign manufacturers force companies from developed countries to constantly reduce costs. Technological advances in information and communications technology are reducing the costs of bilateral trade.

While all of these factors contribute to the disintegration of industry chains and business structures, one caveat is still worth making. We suspect that some executives, in an effort to get rid of “extra assets” and “give the company more flexibility,” may end up throwing out the baby—and more than one—with the bathwater. They disintegrate some functions and activities that are vital in a failed vertical market. As a result, it turns out that some of the strategic alliances they switched to are legalized piracy, and some supplier “partners” are not averse to showing their tempers as soon as their competitors are kicked out the door.

In any case, decisions on integration or disintegration must be based on careful analysis and not made according to the dictates of fashion or on a whim. Therefore, we have developed a step-by-step methodology for vertical restructuring (see diagram 7). The basic idea is still the same: integrate only if it is vital.

Using the methodology

We have successfully applied this methodology in situations where our clients had to decide whether to keep a particular production facility in-house or purchase the required products (services) externally. Among these dilemmas are the following:

• Should the steel mill's repair shop remain as it is?
• Does a large mining company need its own legal department or is it more profitable to use the services of a law firm?
• Should the bank print checkbooks on its own or order them from specialized printing houses?
• Does a telecommunications company with 90,000 employees need to organize its own training center or is it better to attract external instructors?

We have also used our methodology to analyze strategic issues, such as:

• What parts of the business structure—product development units, branch network, ATM network, data center, etc.—should a retail bank own?
• What mechanisms should a public research organization use when it provides services and sells its knowledge to private sector clients?
• Should a mining and processing company integrate into metal production?
• What mechanisms does an agricultural company use to penetrate the Japanese imported meat market?
• Should a brewing company divest itself of its chain of beer restaurants?
• Should a gas production company buy pipelines and power plants?

Process

The process depicted in Diagram 8 speaks for itself, but a few points are still worth explaining.

First, when making a strategic decision, companies must take a serious approach to quantifying various factors. In general, it is important to know exactly the switching costs (in case the company has to change the supplier with whom it has invested in specific assets), as well as the transaction costs that are inevitable in the case of purchases or sales to third parties.

Second, in most cases, when analyzing the advantages or disadvantages of vertical integration, it is important to evaluate the behavior of small groups of sellers and buyers. A technique such as supply and demand analysis helps to see the full range of possible actions, but it cannot be used to predict behavior deterministically (although it is quite suitable for analyzing more competitive market structures). To predict the actions of competitors and choose the optimal strategy, it is often necessary to use dynamic modeling and competitive games. Problem-solving techniques like these are as much a science as they are an art, and our experience has shown that the involvement of the company's senior management is essential to ensure that they understand and acknowledge the assumptions that often have to be made about competitor behavior.

Thirdly, this process involves a lot of analytical work, and it takes a lot of time. The primary, most general analysis of the proposed steps identifies key problems, allows us to develop hypotheses and collect material for subsequent deeper analysis.

Fourth, those who use our methodology must be prepared to face serious opposition. Vertical integration is one of those last bastions of business strategy where intuition and tradition are revered above all else. It is difficult to offer a universal solution to this problem; try to give examples of other companies from your or a similar industry that will clearly illustrate your points. Another way is to attack faulty logic head-on, break it down into its component parts and find the weak links. But perhaps the best thing is to involve all stakeholders in the analysis and decision-making process.

Vertical integration is a complex, capital-intensive and long-term strategy, and therefore involves risk. And it's not surprising that sometimes leaders make mistakes - and give far-sighted strategists the opportunity to learn from the mistakes of others.

See, for example: R.P. Rumelt. Structure, and Economic Performance. Harvard University Press, 1974.

See: H.A. Simon. Models of Man: Social and Rational. New York, John Wiley, 1957, p. 198.

See: O.E. Williamson. Markets and Hierarchies: Analysis and Antitrust Implications. New York, Free Press, 1975.

See: D.J. Teece. Profiting from Technological Innovation // Research Policy, vol. 15, 1986, p. 285-305.

The concepts of “excess profit” and “seller surplus” are synonymous.

See: E.R. Corey. The Development of Markets for New Materials. Cambridge, MA, Harvard University Press, 1956.

See: K.R. Harrigan. Strategies for Declining Business. Lexington Books, 1980, chapter 8.