Vertical integration

2.63 Vertical integration involves the combination of two or more separable stages of production or marketing under common ownership and management. It can take place via simultaneous investments in multiple, interlinked activities or through investments 'forward' or 'backward' to existing activities. Vertical integration can be complete or partial, the latter involving at least some sales or purchases of the focal intermediate products or services to or from outside parties. The economics literature stresses four major rationales for vertical integration, each being potentially relevant in the context of food commodity systems. a) Production/Logistical Economies: Vertical integration may reduce logistical costs associated with the procurement of raw materials and/or the sale of finished products. Where vertical integration involves bringing together in one location formerly distinct operating units, transport costs can be saved, particularly for bulky and perishable raw materials. Bringing under one management the suppliers and users of a raw material or other intermediate input can reduce the levels of required inventories because internal planning allows for a better match of supply and demand in terms of quantity and location. b) Transaction Cost Economies: With vertical integration information costs can be saved as the firm becomes the sole or predominant supplier to itself for certain goods and services (Coase (1937; Williamson ( 1979). Bargaining costs are saved as the firm engages in relatively few long-term employment contracts instead of many more short-term hiring and supply agreements. Streamlined information systems provide ample scope for transmitting complex non-price directives within the firm. Centralized decision-making within the firm provides scope for rapid adjustments to changing technical or market conditions. Adaptations can be made in a sequential way without having to consult, revise, or renegotiate agreements with other firms. c) Risk-bearing Advantages: Vertical integration may be a very effective institutional means of overcoming problems of risk and uncertainty (Arrow (1975). By internalizing flows of intermediate inputs, the firm may be able to eliminate certain risks such as variability of supplies, outlets, and quality, and the unauthorized use of technical information. More direct control over goods and assets can be exercised than under any arms-length or voluntary cooperation scheme. This reduced uncertainty may render the integrated firm better able to invest in highly specialized processing and marketing facilities and to take advantage of potential economies of scale. Partial integration (as with nucleus estate and outgrower schemes) may provide an even better combination of flexibility and risk-reduction or sharing (Carlton (1979)). d) Advantages in the Presence of Market Imperfections: In the early stages of market development when certain production or marketing functions remain slow in developing, vertical integration of multiple stages may be necessary to both stimulate consumer demand and guarantee the availability of the commodity (Stigler (1951). In the presence of taxes, price and exchange controls, and other regulations, the mere act of internalizing transactions may provide pecuniary gains as the firm. Governments treat market transactions differently from those which occur within firms. Vertically integrated firms may thus be able to bypass or minimize the effects of taxes and market controls." Finally, vertical integration may enable the firm to increase its market share and its leverage vis-a-vis suppliers and customers.