Question

What is vertical integration. Under what conditions can vertical integration reduce the cost of producing the final good? Why is it the case that in general vertical integration does not lower cost? (Hint: If firm A buys a factor of production firm firm B, and firm A notices that firm B produces the factor for only $1, but sells it to firm A for $10, firm A might think it can reduce its costs by purchasing firm B, since it would thereby save $9 per unit of the factor of production. But firm A would have to pay the current owners of firm B the present discounted value of the $9 per unit of the factor of production in order to get them to sell. Hence, it is a wash, the price of purchasing firm B is equal to the present discounted value of the savings. This implies that vertical integration in general does not increase profits. There must be special circumstances in order for it to increase profits.)

Answer 1

Vertical integration is a strategy whereby a firm purchases a supplier's firm. This enables the firm get control over the supplier's firm. Vertical integration can help reduce costs, which will ultimately create an efficient supply chain. It helps reduce costs when a supplier is exploiting and charging more prices for the goods supplied. This way vertical integration will help reduce the transaction costs. Vertical integration also creates value as the firm gains control on supplier which also leads to a reduction in the risk.

Inspite of this, it has to remembered that there are significant capital expenditures involved in the process. The high capital expenditures arise because the firm has to provide capital for the functioning of the supplier firm as well. Along with this, money has to be spent to the shareholders of the supplier firm when acquiring it. Though these could be significant costs, the profits that could come with the reduced prices which gives benefits of economies of scale along with market power to thr firm make integration profitable. The profitability of the vertical integration depends on the type of market and competition levels prevailing.