A:

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 that 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.

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, then 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 and non-negotiable rate.

Another instance where the balance of power between buyer and seller may have a considerable impact on transaction costs is one in which there is 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.

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 will 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.

RELATED FAQS
  1. Can Internet companies be vertically integrated?

    Find out how online businesses are beginning to take advantage of vertical integration for many of the same reasons as traditional ... Read Answer >>
  2. When does it makes sense for a company to pursue vertical integration?

    Discover how vertical integration allows firms to take more control over production costs, the quality of its products and ... Read Answer >>
  3. What is the difference between horizontal integration and vertical integration?

    Horizontal integration refers to acquiring a company in the same industry; vertical integration refers to a company acquisition ... Read Answer >>
Related Articles
  1. Investing

    Understanding Vertical Analysis

    In vertical analysis, each line item on a company’s financial statements is presented as a percentage of a larger number.
  2. Small Business

    Vertical Integration

    Vertical integration occurs when a company buys and controls other businesses along its supply chain.
  3. Managing Wealth

    Data Integrity Analyst: Job Description & Average Salary

    Learn about the average salary of a data integrity analyst and the required skills, education and previous experience needed to fill this role.
  4. Insights

    Cable Veteran Leo Hindery Jr. Casts Doubt on AT&T/Time Warner Merger (T, TWX)

    The former CEO of TCI and Liberty Media joins a growing group of skeptics who warn regulatory hurdles will doom the merger between AT&T and Time Warner.
  5. Insights

    Leo Hindery on ATT, Time Warner

    Leo Hindery spoke with Investopedia about the future of vertical integration in the telecom industry.
  6. Investing

    Arm's Length Transaction

    An arm’s length transaction describes business deals in which the buyer and seller act independently and with no interest in the other’s benefit.
  7. Managing Wealth

    The Top Reasons Why M&A Deals Fail

    A significant number of M&A transactions result in failure. Here are the top reasons why it happens.
  8. Investing

    The Ins And Outs of Seller-Financed Real Estate Deals

    There's more than one way to buy or sell a house. Seller financing presents yet another unique option.
  9. Tech

    How Much Cheaper are Bitcoin Fees than Credit Card Fees?

    Bitcoin transaction fees are starting to rise as the network gets backlogged due to more usage, but are still much lower than typical credit card fees.
RELATED TERMS
  1. Vertical Integration

    When a company expands its business into areas that are at different ...
  2. Backward Integration

    Backward integration is a form of vertical integration that involves ...
  3. Vertical Well

    A well that is not turned horizontally at depth, and which allows ...
  4. Vertical Line Charting

    A technique used by technical traders and market technicians ...
  5. Forward Integration

    A business strategy that involves a form of vertical integration ...
  6. Vertical Analysis

    A method of financial statement analysis in which each entry ...
Hot Definitions
  1. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  2. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  3. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  4. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  6. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
Trading Center