Question

You are the owner of a chain of tea shop in Thailand, brewing and selling the latest types of teas internally but buying all necessary factors from the market. Your 50 or so shops located around the city can seat around 20 patrons each and currently only sell caffeinated drinks. At this stage of growing your business you are considering vertical and horizontal integration. Using the theory of the optimal boundary of the firm, discuss the make-or-buy decision as well as the scope for horizontal integration and diversification of your business. What stages of the vertical chain should you consider conducting inhouse? What other horizontal markets may you integrate into?

Answer 1

Firms or business organisations are those that use inputs or resources to produce a certain output to be sold at a profit in the market. Firms differ in size, market share and so on. The size of the firm may be small scale or large scale— some firms prefer to remain small scale because of the size of the market that they cater and the lack of growth opportunities or even in some cases due to the exclusivity of the consumers—firms catering to a few segment of consumers- for example, designer clothing. Some other firms take advantage of the market situation, the availability of suppliers and so and undertake integration policies—wherein they merge in with other firms.

A firm’s size is influenced by its age—date of inception, the availability of financial capital and the type of business organisation—whether it is a sole proprietor, a partnership or a large public corporation or a equity sharing public limited company.

In the given case study , the firm is a small scale firm with 50 odd tea shops operating on the chain store basis. The basic ideas of growth through integration are focussed on reaching the ideal limits of production up to which it is possible to produce. This depends upon the economies ( or diseconomies of scale)—which mean the per unit costs of production. The larger the size of the market , the more are the possibilities to grow—the firm may enjoy the economies of large scale production -both internal and external.

The tea firm is brewing and selling the latest type of tea internally –which implies that it is enjoying internal economies like technical , research and development as well as expertise of its staff who are involved in tea making and selling. These internal economies make it possible that the firm is able to make in roads into the ‘fashion of the day’ tea flavours and is able to cater to the ever demanding and ever changing tastes and preferences of its tea consumers. The firm may be enjoying lower costs of tea production due to its internal economies or cost advantages. This may allow it to sell tea at lower or competitive rates. The fact that it has grown to 50 shops is evidence that the firm has a good market share and is on the onward profitable growth path, given the fact that ‘tea making’ is a highly competitive market where there are more and more competing firms , differing in size , volume of output and market share.

A firm will have an objective -this may vary from the basic objective of profit motive to sales maximisation, growth, profit maximisation, risk and survival and so on.

The tea firm is considering growth as its objective. It can be a natural growth path—the growth of the firm in its scale of production, whereby it focuses on producing more tea and more innovative tea flavours to the market, thereby making more profits and making inroads to more and more market segments. This internal growth will help it to gain economies of scale like buying economies—where it can buy raw materials at lower costs and place large orders for equipment needed for tea brewing . It will usually be able to obtain such orders at a rate that is lower than the market rate. The suppliers may also benefit from the regularity of orders from this tea firm and hence may give them preference over the other firms.

The tea firm may benefit from ‘integrating’ or ‘uniting’ with ‘tea estates’ that supply tea leaves to the firm to brew tea. Such an merger is called vertical integration backward. The real objectives of such an integration could be that it will reduce the prices of raw materials procured and even restricts the competitors access to the tea leaves form the estate since it is now owned by the firm.

The tea firm will also enjoy the advantages of selling economies –in the form of lower costs of packaging, storing, transportation, storage and so on. If the tea firm acquires storage outlets or even buys its own vehicles for transporting tea to different outlets then it is called vertical integration forward. It can more and more outlets and, hence will be able to enjoy the benefits of marketing economies as well.

Since the tea firm operates as chain stores pricing of tea would be uniform with ownership being centralised. This will help in further efficiency in controlling and administration , even when mergers are happening since mergers can take place smoothly due to the standardised practices that are followed regularly in all the other chain stores.

The tea firm will enjoy managerial and financial economies, especially if it decides to opt for a horizontal integration or merging with another tea firm. This will give the tea firm greater advantages in the form of lower costs of production, bigger dimension of production since the new firm is bigger in size. This will give it the necessary financial boost—in the form of higher resources. The merger will also ,mean that expert and skilled staff of the other firm will now be working in coordination with the staff of the existing firm giving rise to higher labour productivity.

Such an integration may also enable firm to sell off its unnecessary assets that have been lying ‘ in state’ and having no productivity, and have been a burden to the firm. However, care must be taken regarding management of the firm since integration would be more employees and greater control is needed especially in case of important aspects like selling , inventory and so on.

Horizontal integration leads to elimination of a competing tea firm. This may be beneficial in the form of greater market share leading to advantages of selling economies ( like lower promotional costs), risk bearing economies, since two firms merge into one single firm the risks of a competing firm is reduced and the firm’s market share will grow. The higher the market share the greater will be the firm’s control over price and output of tea in the market.

The tea firm can horizontally merge with other firms that are similarly placed in tea production. For example, the firm could consider market expansion and could collaborate with firms in other areas. This will lead to establishment of its ‘chain stores’ in other areas and will lead to brand building by the firm. This could further strengthen the finances of the firm .

The firm may collaborate with research and development agencies and laboratories and may innovate further leading to technological economies.

The consumers may benefit from higher quality products and a wider variety. This will be a boost for the firm to add on to their existing patrons, since there could be a rise in the number of tea patrons.

However, higher prices, reduced choice of risk , lesser control and delays in decision making may be the hurdles in integration.