As a business technique, was pioneered vertical integration in the 19th century. It was a term coined by Andrew Carnegie to describe the structure of his company, U.S. steel. He bought almost every aspect of the supply chain and the sale of his company relied on. The main reason for this is to ensure a stable supply of raw materials and distribution and overall lower cost of doing business. These motives remain attractive for companies, embarking on vertical integration today, and one of the main reasons the company is vertically integrated with the provider to manage transaction costs.
The balance of power between buyer and seller
Microeconomists point out that simple supply and demand market forces are not the only factor affecting the price of the transaction. As important as market forces, is the balance of power between buyers and sellers. This balance of forces is constantly changing, which leads to unpredictable prices. This is especially true when there is a high volume of transactions between the two companies. These frequent transactions provide more opportunities for negotiation and operation. If one company exploits others and increasing transaction costs, as a result, vertical integration can eliminate the problem and reduce transaction costs. With both companies operating as a single entity, prices will be set by agreement of the parties, non-negotiable rates.
The effect of one buyer, one seller
Another case where the balance of power between buyer and seller can have a significant impact on the cost of the transaction is one in which there is only one buyer and one seller in a particular market. In this case, companies are independent from each other, which can lead to excessive negotiations and therefore to higher transaction costs. Again, vertical integration will reduce this unpredictability and to reduce transaction costs. It often happens with car companies, which are particularly prone to vertical integration with suppliers.
Alternatives to vertical integration
Despite the advantages of vertical integration, some buyers and sellers, and do not choose to form close-knit relationships and develop long-term contracts. This strategy is especially popular in Japan, eliminates the uncertainty in the value of the transaction and eliminates the problems associated with vertical integration. However, some companies still view vertical integration as the best option, because the ambiguous wording and gaps in the terms of the contract can lead to exploitation on one side. This is particularly common in fast-growing industries such as technology. In such cases vertical integration can only be a certain way to ensure consistent and low transaction costs.
Vertical integration is a way to reduce transaction costs, but this choice can also lead to other financial costs. For example, management costs will inevitably rise as the company becomes more complex. Therefore, it is important to weigh the reduction of transaction costs for other financial implications before choosing the option of vertical integration. (For associated reading, see: when is outsourcing preferable to vertical integration?)