Vertical Integration: Making vs Buying

Why some firms own multiple stages of production while others buy from suppliers, and how integration affects competition.

Every business must decide which activities to do itself and which to buy from others. A car maker could make its own tyres, steel and batteries, or buy them. When a firm owns several stages of the production chain, it is called vertical integration.

Upstream and downstream

Backward integration means owning suppliers, like a clothing brand buying a textile mill.
Forward integration means owning distribution or retail, like a manufacturer opening its own shops.

Why integrate?

Economists, building on the work of Ronald Coase and Oliver Williamson, explain the choice with transaction costs: the costs of finding suppliers, negotiating, writing contracts and resolving disputes.

Reliable supply: owning a supplier avoids shortages or hold-ups.
Specialised investments: when a supplier must invest in equipment useful only to one buyer, both sides fear being exploited. Integration removes this problem.
Coordination: easier to coordinate design and production.
Capturing margins: owning more of the chain keeps more profit.

Why buy instead?

Specialists are more efficient: suppliers serving many customers gain scale and expertise.
Flexibility: buying lets a firm switch suppliers.
Focus: managing many different businesses is hard.

Tesla and batteries

Electric car maker Tesla has integrated heavily, building battery production facilities and designing many of its own components and software, partly to secure supplies and control a critical technology. Many other car makers buy batteries from specialist suppliers. Both approaches can work; the choice depends on how critical, specialised and scarce the input is.

Competition concerns

Vertical integration can raise concerns when an integrated firm uses its control of one stage to disadvantage rivals at another, called foreclosure. For example, a firm controlling an essential input might refuse to supply competitors. Competition authorities review vertical mergers for such risks.

Thinking vertical integration is always about monopoly

Most vertical integration aims to reduce costs and improve coordination, not to harm competitors. Concerns arise mainly when the integrated firm controls an essential input that rivals cannot get elsewhere.

Key takeaways

Vertical integration means owning several stages of production.
Firms integrate to reduce transaction costs, secure supply and coordinate better.
Buying from specialists offers efficiency, flexibility and focus.
Competition authorities watch for foreclosure of rivals.