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What are the arguments for and against vertical integration? A vertical structure consists of an upstream firm such as a manufacturer of an intermediate good, and a downstream firm such as a wholesaler or a retailer. The down stream firm may also be a manufacturer or service provider using the intermediate good as an input. An upstream firm is said to be vertically integrated if it controls (directly or indirectly) all the decisions made by the vertical structure. The vertically integrated profit therefore refers to the maximum aggregate profit of the vertical structure (manufacturer＊s plus retailer＊s). There are many cases where the firms (and possibly the consumers) will benefit from vertical integration. One such example is where the problem of double marginalisation exists. Consider the case where both the upstream and downstream firms have monopoly power. If vertical integration exists, the final price charged to the consumer would be pm and the quantity supplied (qm) would be determined by the demand function D (.). So, qm = D (pm) Pm would be chosen to maximise (p 每 c)D(p), where c represents the cost of production. In the decentralised structure the manufacturer will provide the intermediate good to the retailer at a price pw, which he will choose to maximise his profits as a monopolist. The retailer will then have a marginal cost of pw, so the final price, p, will be greater than the vertically integrated price of pm (assuming pw > c). Because the retailer does not consider the manufacturers marginal profit, there are two successive mark-ups, causing the decentralised price to be greater than the vertically integrated one. To examine this in greater detail, consider a case where there is a demand function of D(p) = 1 每 p, and c<1. Let ﹊m and ﹊r denote the manufacturer＊s and retailer＊s profits respectively. For simplicity we will assume that the retailer incurs zero costs other than the price of the intermediate good. For the non-integrated industry, the retailer will want to maximise: (p 每 pw)(1 每 p) which will give: p = 1 + pw 2 Using the demand function, the quantity to be provided will then be: q = 1 每 pw 2 Hence, the retailer makes a profit of: ﹊r = ((1 每 pw)/2)2 Now, consider the manufacturer＊s situation. He will want to maximise: (pw 每 c) ((1 每 pw)/2) Which will give: Pw = 1 + c 2 Thus giving him a profit of: ﹊m = (1 每 c)2 8 Therefore, the total profit of the decentralised industry is 3 (1 每 c)2 16 and the final price is p = 3 + c . 4 If, however vertical integration exists, the vertical structure will maximise: (p 每 c) (1 每 p) this gives a final price of: p = 1 + c 2 and a vertically integrated profit of: ﹊integrated = (1 每 c)2 4 < ﹊decentralised In this example, the total profit is higher for the vertically integrated structure and the price to the consumer is lower that it would be without integration. The quantity provided is also lower without integration. Therefore vertical integration is clearly beneficial in such cases where double marginalisation is problem. However, this problem only arises where both the firms are monopolists. If either of the firms is competitive and therefore prices at marginal cost, there is no price distortion and so the total profit will not be increased by integration.
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