| What is a vertical M&A? | A vertical merger is the merger of two or more companies that provide different supply chain functions (in the same chain) for a common good or service. Most often, the merger is effected to increase synergies, gain more control of the supply chain process, and ramp up business. A vertical merger often results in reduced costs and increased productivity and efficiency. |
| What are the two types of vertical M&A? | 1. Upstream: Ownership of production of the inputs it uses (backward integration)
2. Downstream: Ownership of production units that use, distribute, sell the company’s output (forward integration) |
| What are the vertical M&A motives? | See pic |
| The motives for vertical mergers can be seen in the pic. What does the "market power - Double marginalisation" regard? | Consider an industry with two production stages:
1. Production stage (upstream)
2. Retail stage (downstream)
Consider two cases:
1. Each stage is served by a single monopolist (two separate firms). In each stage monopolists set the monopoly price mark-up = P-MC>0. But the mark-up of the producer means that the input is more expensive for the retailer, hence mark-up producer = additional marginal cost for the retailer. On top of this the retailer also charges a mark-up over the (higher) MC Double mark-up.
2. Both stages served by a single firm (vertical integration). Cares only about marginal cost of production. Charges the mark-up only once!! Produces higher output at lower price, increase producer surplus (i.e. Abnormal profits ) by avoiding the double mark-up.
In case 2 output is potentially higher and price lower than in case 1! Single monopolisits distributes resources more efficiently across stages.
By avoiding the double mark-up a vertically integrated firm can be better off than two non-integrated firms one of the strongest arguments in favor of vertical integration
NB: double marginalization only occurs if in both stages monopoly (or oligopoly or cartel i.e. some market power) |
| A motive for vertical integration is forward vertical integration. How does Vertical integration avoid double marginalization? | • Single integrated firm is facing a market demand curve, D, an achieves maximum profit by putting MC = MR where MC are the actual production costs
• The vertically integrated company has marginal costs MC1 and has a marginal revenue curve corresponding to MR2, so sets MC1 = MR2
• The merged company chooses to sell the amount Q2 price P2
• Which (by definition) provides the highest profit, which are thus higher profit than the total profit that existed prior to vertical integration
• Note that the total consumer surplus is also greater for the vertical integration. Overall increases 'total welfare'. (This emphasis is also placed on merger control)
(See pic)
By integrating with supplier A, producer of X can get input A at MC as well and does not have to pay the mark-up!
This means can use input substitution to go from point D to E: buy more of A cheaper and therefore reduce input B.
The result is that X producer can achieve the same output of X at a lower cost!
C3 < C1 is the costs savings by vertically integrating, which – everything else equal - raises X‘s profits! |
| Market power to use price discrimination is seen as a motive for vertical intergration (See pic). How so? | Price discrimination: Charge different prices in different markets (e.g., Because your input is used for different varieties of a good)
Price discrimination require 3 things to work:
1. Producer has some monopoly power (in more than one market)
2. Different price elasticities of demand in the different markets
3. No side-trading possible, i.e. byuers cannot by-pass the monopolist
Price discrimination is easier for the monopolist to implement by making sure that downstream firms do not sell your input with each other bypassing you.
Example: Price discimination and forward integration of aluminium producer (See pic) |
| The motives for vertical mergers can be seen in the pic. What does the "Cost saving transaction cost paradigm" regard? | There are multiple costs associated with transactions in the market:
1. Monitoring the market
2. Negotiation costs.
3. Search costs, finding the right dealer.
4. Implement contractual obligations
5. File lawsuits (costly) if necessary to complete transactions
If TC in market are high, vertical integration might be the better option rather than buying inputs/services on the market. As that provides lower ATC. |
| Arguments for vertical integration | • Incentives: The company avoids direct costs of using the market such costly negotiations, cf. previous slide
• Controls: The management is easier by internal control over intra-firm operations as opposed to inter-firm activities. Conflicts are cheaper to solve internally than across suppliers or customers.
• “Structural advantages“: firm has some comparative advantages relative to the market. Williamson focuses here on the quality of 'communication' experience 'code of conduct' - this is easier to achieve in an integrated company.
• Uncertainty:
- VI can eliminate uncertainty from both upstream or downstream operation
- Lower uncertainty = lower cost (it is better to know for sure what will happen)
• Vertical integration may be preferable due to:
- Uncertainty regarding inputs quality (upstream)
- Uncertainty regarding the aggregate conditions like business cycle: with VI it is easier to ensure a smooth supply of inputs
- Uncertainty regarding customers' efficiency, such as sales efforts (downstream)
• Conversely, companies that have expertise in risk management might prefer to purchase inputs on the market (for them TC lower on market, so less likely to do VI)
• Possibly combining own production input with purchase of corresponding input (this is also pressure the market for input) |
| Arguments against vertical integration | • Rapid technological development (=lots of uncertainty with whom to integrate) against upstream vertical integration. It is perhaps better to buy inputs from market to ensure that you get the newest stuff
• When there is (fluctuating) limited capacity within firm. Can do a quasi integration, using its own limited capacity in the input stage and buy the rest of the input from market uncertainty in the company's ‘internal’ market can cause outsourcing of parts of production to put the risk on other companies
Example: Within the Wind industry, it is common that producers both make inputs themselves and buy the same inputs on the market. |
| What are some cost saving motives for vertical integration? And what has asset specificity to do with anything? | Companies can choose to secure supplies of inputs through backward integration - the purchase of suppliers.
Asset specificity occurs when firms are interdependent due to investments in specific assets
Especially interesting for bilateral monopoly: upstream firm invested capital to supply the downstream business, and downstream firm is dependent on the upstream product.
Production takes place therefore at lowest marginal costs, but there might be dispute of how to share the profits; the price will then lie between monopoly price and competitive market.
A vertical integration between these companies can optimize output and increase profits. The optimal point is where marginal revenue at the retail level corresponding to marginal costs at producer level - effectively double marginalization again.
Asset specificity may be symmetric; but also unilateral, so that only one party has invested in specific assets connection.
This may lead to a so called 'hold-up' problem: one party is dependent on the other; but the reverse is not true.
If a manufacturer of hospital equipment 'forcing' a hospital to invest in infrastructure and equipment that can be used only when the company is a supplier, there is a hold-up problem. |
| What are Williamsons 4 types of asset specificity? | 1. Site specificity: You have invested in production facilities located close to each other
2. Physical asset specificity: Investing in assets that can be used only if the supplier / customer relationship is maintained
3. Human asset specificity: Investing in human capital that can be used only if the supplier / customer relationship is maintained
4. Dedicated assets specificity: Investing in sufficiently large plants to utilize cost advantages. Only profitable as long as the customer relationship is maintained. |
| What is Vertical disintegration ? | Is the market large enough for the company to buy input effectively? Maybe better to specialize and buy inputs from the “front” suppliers.
Conversely (Chen (2005)). Whether a company can produce its own input also depends on the horizontal competition in the downstream stage. If the competitors are also going to buy inputs the vertically integrated company can realize economies of scale in the production of inputs cost savings by increasing size.
Consider for example the automotive industry. For example, Porsche, which outsourced the 1990s large parts of processes to subcontractors. Approximately 80% of Porches added value created today by subcontractors.
Another example is the Iphone: Naturally, an American product? Much of the production of components takes place in China. |
