Vertical Integration and Motivation

Contents

1. Introduction 2

2. Vertical Integration 2

2.1 Motivation behind Vertical Integration 3

3. Appropriation of Upstream Profits 3

3.1 Relationship-Specific Assets 3

3.2 Rents and Quasi-Rent 4

3.3 Hold-up Problem 5

4. Fallacy of Vertical Integration 6

5. Conclusion 7

1. Introduction

Vertical integration has been widely used by many industries in the modern world to minimise transaction cost, lower uncertainty and most importantly to improve supply chain coordination. An excellent example on the usage of vertical integration would be oil companies, such as Exxon Mobil. These companies usually start off from the very beginning of its production which follows a simple chain of operations: locating the oil deposits, drilling and extracting the oil, transporting oil to refineries and finally exporting the refined oils to its own distribution centers (petroleum stations). Even though, these operations seem relatively simple in theory, they are in fact expensive business functions and more so if each stage were to be operated by different vendors. As such, it would be more profitable to vertical integrate and have complete control over the entire business. There are many motivations that influence firms to vertical integrate. One such possibility would be an attempt to appropriate the profits of the firm’s suppliers. Hence, this report aims to discuss the possible motivation of having backward vertical integration in a firm with regards to quasi rent and holdup problems.

2. Vertical Integration

Vertical integration is a style of management control whereby companies in a supply chain are united under one common owner. Each member in the supply chain typically produces different components or services which will be combined to serve a common need. For example, a vertical integrated automobile manufacturer will have its own production of wheels, car frames, tyres or even teams of service staff and salesperson. These assets or operations serve...