A:

In the initial stages of a vertical integration, there are inevitable legal and administrative costs as the two companies become economic affiliates. This process tends to be complex and time-consuming. Legal costs can be high if the vertical integration is a result of a merger (rather than an internal integration), and it is subject to a legal challenge under the ambit of antitrust laws. Such legal challenges can result in lengthy court processes; three vertical integration cases have reached the United States Supreme Court.

Following a vertical integration, there is generally an increase in bureaucratic costs. While the transaction costs generally decrease following a vertical integration, it is usually the case that managerial and administrative costs increase as a result of incorporating the existing staff members and managing all of the transactions between the two integrating economic affiliates. It is not uncommon for the management and administrative systems of the two companies to become bloated and inefficient following a vertical integration, which can be costly. Furthermore, restructuring the management and administrative systems to accommodate the new state of affairs more efficiently can also result in further costs being accrued by the company.

Capacity balancing issues can mean additional costs to a company following a vertical integration. This is the case if the downstream operations (for example, the production of raw materials or factory assembly processes) are producing more in output than is required by the upstream operations (that is, distribution). In such a case, the company may need to invest more money in the upstream operations to ensure that there is always enough demand to accommodate the supply of the downstream operations. This is more typically the case if the two companies previously only dealt with one another on an infrequent basis prior to the vertical integration. This is why it is advised that companies only vertically integrate with one another if their business dealings are regular and frequent.

One of the primary advantages to pursuing a vertical integration of two companies is to reduce transaction costs in the supply chain. However, under certain circumstances, a vertical integration can have the exact opposite effect. If the level of competition is reduced to a great extent following a vertical integration, then it is more likely that the costs of transactions could actually increase within the vertically integrated company. This could result in a long-term increase in costs for the company.

Finally, if for whatever reason the vertical integration is ultimately unsuccessful – for instance, if one of the companies fails, or if the product supplied by the downstream operations becomes superfluous because of modern innovations – then disintegration is also a lengthy and costly procedure that likewise involves legal and administrative processes.

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