Part 3: CORPORATE STRATEGIES
Chapter 6: Vertical Integration
What is corporate strategy?
Corporate strategy is a firm’s theory of how to gain competitive advantages by operating in several
businesses simultaneously. Decisions about whether to vertically integrate often determine whether
a firm is operating in a single business or industry or in multiple businesses or industries. Other
corporate strategies discussed in this book are: strategic alliances, diversification and mergers and
acquisitions.
What is vertical integration?
A value chain is that 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.
Firms that are more vertically integrated accomplish more stages of the value chain within their
boundaries than firms that are less vertically integrated.
A firm engages in 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, that is, closer to gaining access to raw materials.
A firm engages in 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;
closer to interacting directly with final customers.
The value of vertical integration
The question of vertical integration ‘’Which stages of the value chain should be included within a
firm’s boundaries and why’’ has been studied by many scholars for almost 100 years. The resulting
work has described several different situations where vertical integration can either increase a firm’s
revenues or decrease its costs compared with not vertically integrating, that is, several situations
where vertical integration can be valuable.
Three of the most influential explanations of when vertical integration can create value for a firm:
1. Vertical integration and the threat of opportunism: using vertical integration to reduce the
threat of opportunism. Opportunism exists when a firm is unfairly exploited in an exchange. An
example is when a party to an exchange expects to receive a service by a particular point in time
and that service is delivered late. When one of its exchange partners behaves opportunistically,
this reduces the economic value of a firm. One way to reduce the threat of opportunism is to
bring an exchange within the boundary of a firm, that is, to vertically integrate into this
exchange. This way, managers in a firm can monitor and control this exchange of relying on the
market to manage it. Firms should only bring market exchanges within their boundaries when
the cost of vertical integration is less than the cost of opportunism. The threat of opportunism is
greatest when a party to an exchange had made transaction-specific investments. A transaction-
specific investment is any investment in an exchange that has significantly more value in the
current exchange than is does in alternative exchanges.
The essence of opportunism-based explanation of when vertical integration creates value:
transaction-specific investments make parties to an exchange vulnerable to opportunism, and
vertical integration solves this vulnerability problem. Vertical integration is valuable when it
reduces threats form a firm’s powerful suppliers or powerful buyers due to any transaction-
specific investments a firm has made.
Chapter 6: Vertical Integration
What is corporate strategy?
Corporate strategy is a firm’s theory of how to gain competitive advantages by operating in several
businesses simultaneously. Decisions about whether to vertically integrate often determine whether
a firm is operating in a single business or industry or in multiple businesses or industries. Other
corporate strategies discussed in this book are: strategic alliances, diversification and mergers and
acquisitions.
What is vertical integration?
A value chain is that 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.
Firms that are more vertically integrated accomplish more stages of the value chain within their
boundaries than firms that are less vertically integrated.
A firm engages in 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, that is, closer to gaining access to raw materials.
A firm engages in 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;
closer to interacting directly with final customers.
The value of vertical integration
The question of vertical integration ‘’Which stages of the value chain should be included within a
firm’s boundaries and why’’ has been studied by many scholars for almost 100 years. The resulting
work has described several different situations where vertical integration can either increase a firm’s
revenues or decrease its costs compared with not vertically integrating, that is, several situations
where vertical integration can be valuable.
Three of the most influential explanations of when vertical integration can create value for a firm:
1. Vertical integration and the threat of opportunism: using vertical integration to reduce the
threat of opportunism. Opportunism exists when a firm is unfairly exploited in an exchange. An
example is when a party to an exchange expects to receive a service by a particular point in time
and that service is delivered late. When one of its exchange partners behaves opportunistically,
this reduces the economic value of a firm. One way to reduce the threat of opportunism is to
bring an exchange within the boundary of a firm, that is, to vertically integrate into this
exchange. This way, managers in a firm can monitor and control this exchange of relying on the
market to manage it. Firms should only bring market exchanges within their boundaries when
the cost of vertical integration is less than the cost of opportunism. The threat of opportunism is
greatest when a party to an exchange had made transaction-specific investments. A transaction-
specific investment is any investment in an exchange that has significantly more value in the
current exchange than is does in alternative exchanges.
The essence of opportunism-based explanation of when vertical integration creates value:
transaction-specific investments make parties to an exchange vulnerable to opportunism, and
vertical integration solves this vulnerability problem. Vertical integration is valuable when it
reduces threats form a firm’s powerful suppliers or powerful buyers due to any transaction-
specific investments a firm has made.
