As a business technique, vertical integration first emerged in the 19th century. It was a term coined by Andrew Carnegie to describe the structure of his company, U.S. Steel. He had purchased almost every aspect of the supply and distribution chain his company relied on. The primary reason for this was to ensure consistent delivery of materials and distribution and an overall lower cost of doing business. These motives remain attractive to companies embarking on vertical integration today, and one of the primary reasons a company will vertically integrate with a supplier is to manage transaction costs.

Balance of Power Between Buyer and Seller

Microeconomists have noted that simple supply and demand market forces are not the sole factor influencing transaction prices. Just as important as market forces is the balance of power between buyers and sellers. This balance of power is constantly in flux, leading to unpredictability in pricing. This is particularly the case when there is a high volume of transactions between two companies. These frequent transactions provide more opportunity for negotiation and exploitation. If one company is exploiting the other and raising transaction costs as a result, vertical integration could eliminate the problem and reduce transaction costs. With both companies acting as a single entity, the prices will be set at an agreed-upon, non-negotiable rate.

Effect of Having One Buyer, One Seller

Another instance where the balance of power between buyer and seller may have a considerable impact on transaction costs is one in which there are only one buyer and one seller in a particular market. In such a case, the companies are mutually dependent, which may lead to excessive negotiation and therefore to higher transaction costs. Again, vertical integration would reduce this unpredictability and lower transaction costs. This is often the case with automotive companies, which are particularly prone to vertical integration with suppliers.

Alternatives to Vertical Integration

Despite the benefits of vertical integration, some buyers and sellers choose instead to form close-knit relationships and devise long-term contracts. This strategy, especially popular in Japan, eliminates uncertainty in transaction costs and avoids the problems associated with vertical integration. However, some companies still view vertical integration as a better option because vague wording or gaps in stipulations within a contract can lead to the exploitation of one party. This is particularly common in fast-moving industries such as technology. In such instances, vertical integration may be the only certain method of ensuring consistent and low transaction costs.

Vertical integration is a way of ensuring reduced transaction costs, but this choice may also result in other financial costs. For example, managerial costs will inevitably rise as a company becomes more complicated. Therefore, it is important to weigh the reduction of transaction costs against other financial implications before choosing the option of vertical integration. (For related reading, see "When Is Outsourcing Preferable to Vertical Integration?")