Vertical Integration and Economic Welfare
Jeffrey S. Royer
Firms may integrate forward by undertaking additional manufacturing, processing, or marketing activities involved in transforming their products into final products purchased by consumers, or they may integrate backward to produce raw materials or other inputs they otherwise would purchase from independent suppliers. According to economists who study vertical integration, incentives for firms to integrate may arise from technological economies, transactional economies, or market imperfections.
Technological economies of integration are based on physical interdependencies in the production process. The usual example is the heating and handling economies that lead to integration in the production of iron and steel. Transactional economies are associated with the process of exchange instead of production. In some situations, the market may fail as an efficient means of coordinating economic activity. Consequently, a firm may be able to reduce its transaction costs by integrating. For example, in the case of a bilateral monopoly, where there is one seller and one buyer, either firm may be able to eliminate the costs of negotiating and enforcing a contract with the other through integration.
The market imperfections that may provide incentives for vertical integration include market structures such as successive monopoly, successive oligopoly, and monopsony where there is less than perfect competition among buyers or sellers. Although vertical integration because of technological or transactional economies can generally be expected to improve economic welfare, welfare is not necessarily increased by integration in response to the existence of an imperfect market. Thus the relationships between market structure and vertical integration have important public policy implications and analyzing the effects of integration on output, prices, and economic welfare has been a major focus of economic research.
A model of successive monopoly is used frequently to illustrate the potential benefits of vertical integration. In a successive monopoly, one firm is the only producer of an intermediate product that is sold to a second firm, which is the only producer of a final product sold to consumers. If it is assumed that the second firm employs the output of the first firm in fixed proportion to its own output, it can be demonstrated that the firms will increase their profits by integrating and that integration will expand output, decrease the final product price, and improve economic welfare. Similar results hold for a bilateral monopoly.
These results may not apply to situations where the possibility exists for substitution between the monopolized input and other inputs at the second, or downstream, stage. On one hand, forward integration by the upstream monopolist may result in more efficient input use at the downstream stage, resulting in expanded output and improved economic welfare. On the other hand, by gaining control over input use at the downstream stage, the upstream monopolist may be able to expand its monopoly power, resulting in further restriction of output and a reduction of welfare. Economists have determined that the net effects will depend on several factors at the downstream stage, including the importance of the monopolized input in the production process, the substitutability of inputs, the market structure, and the final product demand.
Analysis of successive oligopoly structures, in which there are several firms at both the upstream and downstream stages, indicates that vertical integration by a subset of firms can be expected to increase industry output and decrease the final product price. Although the profits of the integrated firms increase, overall industry profits decrease. Nevertheless, vertical integration is socially desirable from the perspective of increased total economic welfare.
Research also suggests that backward integration by a monopsonist, or single buyer, through the acquisition of production capacity in an input industry will increase employment of the input, resulting in increased output and a lower final product price. Although economic welfare is enhanced, the price received by the remaining independent suppliers will decrease. This latter result has important implications for agricultural raw product markets.
Two University of Nebraska agricultural economists, Azzeddine Azzam and Allen Wellman, have simulated the effects of increasing the degree of vertical integration by a monopsonistic packer on hog slaughter and variables related to independent producers for range of elasticities of demand and supply. Their results demonstrate that increased integration can be expected to increase overall pork production and lower consumer prices while decreasing hog production by independent producers and lowering both the price they receive for hogs and their net earnings.
From Cornhusker Economics, June 21, 1995.