Vertical Integration

Conceptual Overview

The history of the development of the capitalist firm is in effect synonymous with integration, as documented by Chandler in 1962. It is therefore important to discuss why firms decide to integrate (vertically). It is also useful to know the reasons why firms decide to integrate vertically by setting up their own facilities or by buying out existing firms. In the space available, we will focus on the fundamental perspectives—reasons developed in the literature to explain VI. The choices between greenfield VI and VI through takeover can be similar to those discussed under the entries on mergers and acquisitions and on FDI elsewhere in this encyclopedia. Fundamentally, the considerations are similar to those pertaining to the basic decision as explained below.

VI is more common that usually thought; indeed the very act of setting up a firm involves VI. Moreover, simple day-to-day decisions by firms can involve acts of VI that are not always thought of as such. Consider, for example, a café whose owner decides to buy the café its own ice-cube-making machine instead of continuing to buy ice cubes from an ice-cube producer-distributor. This simple act internalizes the market vertically, so it is an act of VI. The theory of VI tries to explain the advantages and disadvantages of such acts by entrepreneurs or firms in a systematic way. For example, the café owner might have decided to buy the ice-cube machine simply because she is sick and tired of dealing with a grumpy sales assistant every morning. If so, economic theory suggests that the café owner undertakes VI in order to reduce market transaction costs!

There are three major perspectives on VI: the industrial organization (IO) perspective, the transaction cost perspective, and the resource-based perspective. Transaction cost theory emphasizes efficiency savings from the exchange side of the economy. The IO perspective and the resource-based view (RBV) both emphasize reasons related to power, control, and barriers to entry as well as efficiency, mainly production efficiency. There can also be some overlapping between these three perspectives. The rest of this entry provides a short account of the various arguments.

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