Question

1. Explain the risk reduction hypothesis for vertical integration?

Answer 1

Vertical integration is the unification of various stages of the supply chain, previously controlled by separate members, with the goal of consolidating and increasing production, improving productivity and gaining competitive advantage by means of greater cooperation, improved tracking and process management, reducing volatility and risks of errastic materials and reducing costs. However, this danger dilutes the company's core competences by investing more of its resources on the less important tasks that it finds to be too expensive and easier to manage.

The advantages are evident because it becomes more likely that the Business can guarantee the process consistency through the controls on all supply chain processes, will increase the quality on production through introducing more effective quality management, comply with the regulations, and minimize costs through minimizing the number of channels through which supply passes.

There are risks under which the organization may eventually handle its majority resources where it does not know how and, under addition, adversely affect its core forces or when control of the various steps requires so much capital so that the entire plan is ineffective. Additional problems such as lack of cultural assimilation, inherent job issues and other business factors and conditions may adversely affect the company's overall efficiency.

Vertical integration also makes strategic sense when used to create or exploit market power.

Entry obstacles. This can be difficult for unintegreen players to join because most rivals in an market are vertically integrated. Potential entrants will have to engage in all stages. This raises the cost of capital and marginal productivity and thus raises entry barriers.

The upstream aluminum industry was one sector that applied vertical integration to the entry barriers. By the 1970s, the six major vertically integrated companies – Alcoa, Alcan, Pechiney, Reynolds, Kaiser and Alusuisse – dominated the three stages – Bauxite extraction, alumina processing and metal melting. For a non-integrated trader, the markets for intermediate goods, bauxite and alumina were too small. The $2 billion price tag for productive entry in a vertically integrated competitor also rejected competitive entrants.

Even if this barrier could be raised, an entrant will have to find immediate markets for around 4% of the world's potential — not an simple task in an industry that develops at about 5% annually. Not surprisingly, the majors 'vertical integration strategies were the key cause of the substantial barriers to entry in the industry.

In the automobile industry, there are common entry barriers. Car manufacturers are typically organized into dealerships and franchisees. Those with large distributor networks are usually exclusive. New entrants must therefore create large and time-consuming dealer networks. Manufacturers like General Motors would have lost more market share than they have for Japanese without their "inherited" dealership networks.

However, it is also costly to use vertical integration to create barriers to entry. Moreover, success can not be assured when imaginative enthusiasts eventually find armor drops, if the economic surplus is sufficiently high. For example, the companies of aluminum gradually lost control of their market, largely because of new entrants using joint ventures.

Discrimination in costs. The integration of selected customer segments can lead to price discrimination in a business. Find a market driving manufacturer marketing a commodity product to two consumer groups with various cost sensitivities. The supplier tries to increase its overall profits by charging the price-insensitive market with high costs and low prices, but not because the consumer with low prices will sell to high-prices and ultimately kill the whole plan. That is not the case. The supplier can also increase its entire profit.

The retailer avoids resales by expanding into the low-price market. There is evidence that aluminum producers have integrated themselves into manufacturing segments with the highest pricing requirements (such as stockpiles, cables and automotive castings) and have avoided incorporation into segments where the substitution risk is low.

Responding to industry life cycle

Often businesses can enter into a market when an industry is new. In the early decades of the aluminum industry, manufacturers have been forced to expand into manufacture products and even manufacture of end goods to reach markets where materials, such as steel and copper, are historically used. Early fiber glass and plastic manufacturers have considered future integration critical for the idea that these products are superior to conventional materials.

Nevertheless, our experience suggests that this rationale for future incorporation is overestimated. This only works if the downstream organization has patented technologies or a clear brand image, which stops "free riders" from being imitated. No new markets can be established if the economic surplus can not be restored for at least many years. Therefore, only if the product has any clear advantages over its existing or future alternatives is market creation effective.

Often businesses merge when an sector fails to fill the holes left by the independent individuals who retire. When an industry decreases, weaker companies leave the market, which leaves core players more and more focused providers and consumers open for abuse.

As a result, Culbro Corporation, a leading American provider, had to buy distribution companies on key markets along the eastern shore following a downturn in US cigar industry during the mid-1960s. Consolidated Cigar, its biggest rival, had already been forward-integrated and the cigar dealers of Culbro were "missing" and had prioritized several product lines.