Summary : Strategic Management and Competitive Advantage (H8-12)
Chapter 8 – Vertical Integration
Business strategy = a firm’s theory of how to gain competitive advantage in a single business or
industry
-> four business strategies discussed in this book:
1. Cost leadership
2. Product differentiation
3. Flexibility
4. Collusion
Corporate strategy = a firm’s theory of how to gain competitive advantage by operating in
several businesses simultaneously
-> four corporate strategies discussed in this book:
1. Vertical integration
2. Diversification
3. Strategic alliances
4. Mergers and acquisitions
Value chain = a set of activities that must be accomplished to bring a product or service from
raw materials to the point that it can be sold to a final customer
-> a firm’s level of vertical integration is simply the number of steps in this value chain that a firm
accomplishes within its boundaries
Backward vertical integration = when it incorporates more stages of the value chain within its
boundaries and those stages bring it closer to the beginning of the value chain (raw materials)
Forward vertical integration = when it incorporates more stages of the value chain within its
boundaries and those stages bring it closer to the end of the value chain (customers)
Adam Smith’s ‘invisible hand’ states that markets can coordinate and organize themselves so
why would firms ever be better off by vertically integrating the value chain within their
boundaries?
-> three explanations
1. Using vertical integration to reduce the threat of opportunism
Opportunism = when a firm is unfairly exploited in an exchange
-> of course, firms should only do this when the cost of integration is less than the perceived
cost of opportunism, this is often the case with transaction-specific investments
Transaction-specific investments = any investment in an exchange that has significantly more
value in the current exchange than it does in alternative exchanges
2. Using a firm’s capabilities and its ability to generate sustained competitive advantages
-> firms should vertically integrate in those business activities where they possess valuable, rare,
and costly-to-imitate resources and capabilities. Otherwise, they shouldn’t vertically integrate
those activities since they are unlikely to generate a profit
3. Using flexibility to guide vertical integration
Flexibility = how costly is it for a firm to alter its strategic and organizational decisions
-> vertical integration is less flexible since you are committing your firm to other business
activities which you cannot simply leave
So this approach actually does not recommend vertical integration at all but instead
, recommends strategic alliances
-> the cost of strategic alliances is known beforehand, the risk is lower, and a firm can easily
leave a strategic alliance
These three approaches will be applied to the most outsourced part of firms: call centres
1. Using vertical integration to reduce the threat of opportunism
-> at the beginning, call centres required some very high transaction-specific investments so it
made sense for companies to vertically integrate a call centre into their firm. As technology
developed, the transactions-specific costs decreased which means a lot of firms these days
outsource their call centres
2. Using a firm’s capabilities and its ability to generate sustained competitive advantages
-> at the beginning, firms could generate competitive advantage by having high-quality customer
service within their call centres. As technology developed, firms could no longer differentiate
themselves noticeably with having high-quality customer service. Nowadays, some firms are
actually re-integrating call centres into their value chain because they want to offer specialized
service to their customers
3. Using flexibility to guide vertical integration
-> biggest uncertainty in providing customer service through call centres is whether the
employees are able to solve the customers’ problems, especially if a firm has very complex
products. This approach recommends a firm to maintain relationships with multiple call centre
companies who are each specialized in various technological solutions. They can maintain
these relationships until they are certain they have found the best solutions for their firm’s
products, after which they can vertically integrate the call centre into their firm in the way they
deem best
A firm may be able to create value through vertical integration, when most of its competitors are
not able to, for at least three reasons:
1. Rare transaction-specific investment and vertical integration
-> a firm may have developed a new technology or a new approach to doing business that
requires its business partners to make substantial transaction-specific investments
2. Rare capabilities and vertical integration
-> a firm may conclude that it has unusual skills, either in operating a call centre or providing the
training that is needed to staff certain kinds of call centres
3. Rare uncertainty and vertical integration
-> a firm may be able to gain an advantage from vertically integrating when it resolves some
uncertainty it faces sooner than its competition
Firms can also gain a competitive advantage when they realize sooner than their competitors
that it may be beneficial to vertically dis-integrate because of certain developments causing
transaction-specific investments to be lowered or that the level of uncertainty about the value of
an exchange has increased
Two ways to imitate a firm’s vertical integration approach:
1. Direct duplication of vertical integration
-> occurs when competitors develop or obtain the resources and capabilities that enable
another firm to implement a valuable and rare vertical integration strategy
2. Substitutes for vertical integration
-> strategic alliances (will be discussed in chapter 11)
Chapter 8 – Vertical Integration
Business strategy = a firm’s theory of how to gain competitive advantage in a single business or
industry
-> four business strategies discussed in this book:
1. Cost leadership
2. Product differentiation
3. Flexibility
4. Collusion
Corporate strategy = a firm’s theory of how to gain competitive advantage by operating in
several businesses simultaneously
-> four corporate strategies discussed in this book:
1. Vertical integration
2. Diversification
3. Strategic alliances
4. Mergers and acquisitions
Value chain = a set of activities that must be accomplished to bring a product or service from
raw materials to the point that it can be sold to a final customer
-> a firm’s level of vertical integration is simply the number of steps in this value chain that a firm
accomplishes within its boundaries
Backward vertical integration = when it incorporates more stages of the value chain within its
boundaries and those stages bring it closer to the beginning of the value chain (raw materials)
Forward vertical integration = when it incorporates more stages of the value chain within its
boundaries and those stages bring it closer to the end of the value chain (customers)
Adam Smith’s ‘invisible hand’ states that markets can coordinate and organize themselves so
why would firms ever be better off by vertically integrating the value chain within their
boundaries?
-> three explanations
1. Using vertical integration to reduce the threat of opportunism
Opportunism = when a firm is unfairly exploited in an exchange
-> of course, firms should only do this when the cost of integration is less than the perceived
cost of opportunism, this is often the case with transaction-specific investments
Transaction-specific investments = any investment in an exchange that has significantly more
value in the current exchange than it does in alternative exchanges
2. Using a firm’s capabilities and its ability to generate sustained competitive advantages
-> firms should vertically integrate in those business activities where they possess valuable, rare,
and costly-to-imitate resources and capabilities. Otherwise, they shouldn’t vertically integrate
those activities since they are unlikely to generate a profit
3. Using flexibility to guide vertical integration
Flexibility = how costly is it for a firm to alter its strategic and organizational decisions
-> vertical integration is less flexible since you are committing your firm to other business
activities which you cannot simply leave
So this approach actually does not recommend vertical integration at all but instead
, recommends strategic alliances
-> the cost of strategic alliances is known beforehand, the risk is lower, and a firm can easily
leave a strategic alliance
These three approaches will be applied to the most outsourced part of firms: call centres
1. Using vertical integration to reduce the threat of opportunism
-> at the beginning, call centres required some very high transaction-specific investments so it
made sense for companies to vertically integrate a call centre into their firm. As technology
developed, the transactions-specific costs decreased which means a lot of firms these days
outsource their call centres
2. Using a firm’s capabilities and its ability to generate sustained competitive advantages
-> at the beginning, firms could generate competitive advantage by having high-quality customer
service within their call centres. As technology developed, firms could no longer differentiate
themselves noticeably with having high-quality customer service. Nowadays, some firms are
actually re-integrating call centres into their value chain because they want to offer specialized
service to their customers
3. Using flexibility to guide vertical integration
-> biggest uncertainty in providing customer service through call centres is whether the
employees are able to solve the customers’ problems, especially if a firm has very complex
products. This approach recommends a firm to maintain relationships with multiple call centre
companies who are each specialized in various technological solutions. They can maintain
these relationships until they are certain they have found the best solutions for their firm’s
products, after which they can vertically integrate the call centre into their firm in the way they
deem best
A firm may be able to create value through vertical integration, when most of its competitors are
not able to, for at least three reasons:
1. Rare transaction-specific investment and vertical integration
-> a firm may have developed a new technology or a new approach to doing business that
requires its business partners to make substantial transaction-specific investments
2. Rare capabilities and vertical integration
-> a firm may conclude that it has unusual skills, either in operating a call centre or providing the
training that is needed to staff certain kinds of call centres
3. Rare uncertainty and vertical integration
-> a firm may be able to gain an advantage from vertically integrating when it resolves some
uncertainty it faces sooner than its competition
Firms can also gain a competitive advantage when they realize sooner than their competitors
that it may be beneficial to vertically dis-integrate because of certain developments causing
transaction-specific investments to be lowered or that the level of uncertainty about the value of
an exchange has increased
Two ways to imitate a firm’s vertical integration approach:
1. Direct duplication of vertical integration
-> occurs when competitors develop or obtain the resources and capabilities that enable
another firm to implement a valuable and rare vertical integration strategy
2. Substitutes for vertical integration
-> strategic alliances (will be discussed in chapter 11)
