Vertical integration refers to a firms ownership of vertically related activities.

The greater a firms ownership extends over successive stages of the value chain for its product, the greater its degree of vertical integration. When to integrate vertically: Markets are not costless: making a purchase or sale involves search costs, the costs of negotiating and drawing up a contract, the costs of monitoring to ensure that the other partys side of the contract is being fulfilled and the enforcement costs of arbitration or litigation should a dispute arise. All these costs are types of transaction costs. If the transaction costs associated with organizing across markets are greater than the administrative costs of organizing within firms, we can expect the coordination of productive activity will be internalized within firms. Types of VI : Vertical integration can be either backward, where the firm takes over ownership and control of producing its own components or other inputs, or forward, where the firm takes over ownership and control of activities previously undertaken by its customers. Benefits of Vertical Integration VI eliminates hold-up problems ( the hold-up problem is a situation where two parties (such as a supplier and a manufacturer or the owner of capital and workers) may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits.) New capabilities: Where one capability builds on capabilities in adjacent activities, vertical integration may help develop distinctive capabilities. For example: IBMs halfcentury of success in mainframe computers owes much to its technological leadership in semiconductors and software. The efficiency of Wal-Marts retailing operations depends critically on specialized IT and logistics from its in-house departments. Extension of market power: Vertical integration can be used to extend a monopoly position at one stage of an industrys value chain to adjacent stages. Double edge sword since customer might be reluctant to buy from competitor. Disneys acquisition of the ABC TV network adversely affected Disneys relationships with other TV networks and made other studios (for example, Dreamworks) more reluctant to collaborate with ABC in developing new TV productions. Flexibility (System-Wide): Where system-wide flexibility is required, vertical integration may allow for speed and coordination in achieving simultaneous adjustment throughout the vertical chain. For example, Zara is another fashion clothing business that has cut cycle times and maximized market responsiveness through a vertically integrated strategy that challenges the industrys dominant model of contract manufacture Costs of Vertical Integration Optimal Scale Suppose that Federal Express requires delivery vans that are designed and manufactured to meet its particular needs. The transaction costs avoided by Federal Express are likely to be trivial compared with the inefficiencies incurred in manufacturing its own vans. Federal Express purchases over 40 000 trucks and vans each year, well below the 200 000 minimum efficient scale of an assembly plant. Difficult to manage strategically different business: These strategic dissimilarities are a key factor in the trend to vertical disintegration. Marriotts split into two separate companies, Marriott International and Host Marriott, was influenced by the belief that owning hotels is a strategically different business from operating hotels.

Manage Cyclic demands: Where the required flexibility is rapid responsiveness to uncertain demand, there may be advantages in market transactions. VI has larger fixed costs and lower variable costs, firing employees and reducing capacity is more costly than not renewing an outsourcing contract.