Use Industrial Economic Theory to Assess the Extent to Which the Benefits Associated with Upstream and Downstream Vertical Integration Are Likely to Be Asymmetric. Give Real World Examples to Illustrate Your Answer.

Topics: Economics, The New Palgrave Dictionary of Economics, Monopoly Pages: 5 (1741 words) Published: March 28, 2013
Vertical integration is the process of combining firms, usually under a single ownership, that are different parts of a larger production scale. This could be anything from two firms to all of the firms that make up the supply chain. Due to combining multiple smaller firms, this form of integration has an effect on the market power that the firm(s) has (Riordan, 2008). This differs to horizontal integration which is the combination of firms or expansion of a single firm at one particular point of the production process (Black, Hashimzade, & Myles, 2009, p. 206-7). Vertical integration is usually carried out in one of two ways. Upstream, which can be referred to as backwards, and downstream, or forward, and the definition is linked to the ownership or controlling party. Upstream is to your suppliers and downstream is to your buyers (Enz, 2009, p. 214). Although vertical integration is usually upstream or downstream it can also be balanced which is where ownership or control is shared between the firms in the supply chain. There are multiple benefits associated with vertical integration but some of the benefits may differ between upstream and downstream. Some benefits that may arise are improved coordination between firms throughout the supply chain, cost savings through internalized transactions and an increased market share (Fairburn, & Kay, 1989, p. 10). There are many examples of both upstream and downstream integration in industry throughout history. In the 1970’s and 80’s many crude petroleum extracting companies acquired downstream firms such as refineries and distribution networks (“Idea: Vertical Integration”, 2009). This is mirrored today with many oil companies such as Shell and BP owning all parts of the supply chain from extraction to the petrol stations supplying the consumers. Smithfield Industries are a meat producing firm that has benefitted from upstream vertical integration. They have integrated with a variety of farms, slaughterhouses as well as other firms that make up the entire supply chain. They now have ownership or decision making power, such as changes to production levels to match changes in demand for the final products, in all the firms that supply them. As a result they now have 26% of the meat and poultry market (Pepall, Richards, & Norman, 2008, p. 449) as well as receiving other benefits such as maintaining a sustainable supply for larger numbers, having control over product quality (such as the leanness of the meat) and they have designed warehouses and barns for their subsidiaries to improve their operational efficiency. Most of these benefits are predominantly in favour of the retailer Smithfield as much of these benefits are associated with lowering costs across the supply chain which lowers their final input costs. These benifits, that are associated with lowering input costs, all indicate that Smithfeild do not suffer from double marginisation as a result of thier vertical integration. Double marginalisation is when all the integrated firms set a price above the marginal cost (MC) which then creates two sets of surpluses that are incurred, also reducing consumer surplus to make all parties worse off. Pepall, Richards & Newman state that this is not possible if there is competition either upstream or downstream in the chain (2008, p. 438). This is because competition can cause the wholesale price of inputs to be at the MC to either keep the upstream firm competing or the downstream firms final price competitive. Competition upstream that causes production at the MC can help the downstream firm, in this case Smithfield, achieve abnormal profits if they have monopoly power and the ability to descriminate thier prices. Although most of the benefits are for Smithfield, the subsidiaries will benefit from having more efficient processes and economies of scale that may be gained from the integration due to investment received from the parent firm. The profitability of the integration is...
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