I consider how vertical integration affects the bargaining power of the integrating firms against non-integrated firms in the supply chain. Integration has costs because it limits an assembler’s flexibility in choosing the most suitable suppliers for a particular end product. However, by gaining bargaining power the assembler can appropriate a larger share of the total revenue which can make integration a profitable strategy for the assembler.
I use two examples from the PC and the cell phone industry to motivate my analysis. In the PC industry, IBM and Apple Inc. followed very different strategies. IBM only controlled the hardware of the original PC and had Microsoft provide the operating system. In contrast, Apple controlled both the operating system and the hardware of the Macintosh PC from the start. Within a few short years, Microsoft became the dominant player in the PC industry and in 2005 IBM exited the PC business by selling its remaining factories. Apple, on the other hand, was able to keep its PC business highly profitable and thriving. Apple’s decision did not come without costs because the company was often slow in updating its operating system.1 Ultimately, however, Apple’s decision to integrate software and hardware and sacrifice flexibility proved profitable. In the cell phone industry, there has been substantial disagreement about the optimal level of vertical integration and the boundary between in-house and outside procurement has shifted a number of times during the past 15 years. In the 1990s, large handset manufacturers such as Motorola, Nokia and Ericsson outsourced a lot of the design and software development to suppliers in Taiwan, Singapore and India. These suppliers gained crucial knowledge and expertise as a result which allowed some of them to become fierce competitors on their own right.2 The business press has acknowledged the importance of vertical integration for bargaining with suppliers. For example, the Financial Times stated in a special report on vertical integration that “An- other reason to integrate vertically is to affect argaining power with suppliers” (November 29, 1999).
In my model, each final product requires a continuum of inputs which are each produced by a specialized supplier. Inputs in my model are complements and each supplier has ex-ante equal ability to hold up assembly of the final product. I assume that inputs differ in their specificity, defined by the extent to which the revenue produced by each supplier is subject to hold up. The assembler of the final product has the opportunity to purchase suppliers and integrate them into a single company. The integrated company obtains bargaining power that is disproportionately larger than the share of the production process that is being integrated in the single company. In return, the assembler loses the ability to choose the most suitable companies for production of the final product.
As long as the inefficiency that is caused by integration is not too severe a well defined integrated equilibrium exists. I show that the vertically integrated company will incorporate those suppliers who are required to make the most specific investments. The intuition behind this result is that those suppliers are most vulnerable to hold-up and therefore benefit the most from an increase in bargaining power. In my basic model, integration always has negative welfare consequences because integration affects the distribution of revenue between integrated and non-integrated firms but actually decreases total available revenue (due to the flexibility loss). In an extension of the model I allow firms to vary the level of investment. I show that, under certain conditions, integration can improve welfare because firms with specific investments will invest more after integration since their investments are better shielded from expropriation.
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Supply Chain Control: A Theory of Vertical Integration
