Why would a firm choose vertical integration?


American Apparel has long bragged that they’re completely vertically integrated. Their strategy seems to stem more from ideologically avoiding sweatshop labor than serious fundamental analysis,

Our average factory worker makes $12 to $14 dollars an hour—the highest pay worldwide for the manufacturing of apparel basics, and significantly more than California’s minimum wage. For us, higher pay means heightened efficiency, a better and more consistent quality of work, stronger employee morale, and ultimately, retention rates of skilled operators. For them, higher pay is often a path to the American Dream for their families.

We don’t have to do things this way, we just believe it’s the right way.

Avoiding sweatshop labor might be effective marketing for their progressive hipster clientele, but not effective enough to avoid the brink of bankruptcy. The positive sentiment for the brand doesn’t seem to translate into enough of an increase in sales to offset the increased labor cost.

So, even though American Apparel might be the most famous example of vertical integration, it doesn’t seem to be a good example of vertical integration undertaken for profit maximization.

Why would a profit-maximizing firm choose vertical integration? Recall from Coase that firms exist to minimize transaction costs. If transaction costs between lessors and lessees are high enough, vertical integration is attractive. According to the widely cited 1978 paper by Benjamin Klein, Robert G. Crawford, and Armen A. Alchian, we might see vertical integration from a specific kind of transaction cost: post-contractual opportunistic behavior. A production technology with high fixed costs that cannot be recovered by being scrapped into alternative uses will tend to be vertically integrated into the rest of the product’s production process. What are some implications of this? The paper explains:

  •  Fisher Body once supplied specialized metal dies that would stamp entire automobile bodies for General Motors. Fisher repeatedly tried to extract monopoly rents from GM, but eventually, in 1926, the companies merged.
  • Oil refineries are usually vertically integrated with oil pipelines, but not with oil tankers. An independent oil refinery would be hostage to a monopsonistic pipeline lessor, but an oil tanker has a potential appropriable rent near zero, because an oil tanker could easily be repurposed for shipping other goods.
  • Owners of highly perishable crops are quite vulnerable to collective demands by their laborers. Slavery was a form of vertical integration, but now, absent slavery, long-term labor contracts with unions consist of rigid wages with layoff provisions so that employers can’t opportunistically claim false reductions in demand.
  • Franchise relationships mimic vertical integration because, although a franchisee is technically an independent firm, the franchisee is essentially renting a brand, and is subject to certain controls by the franchisor.
  • Specific capital investments that have high fixed costs and can’t be easily repurposed could be subject to opportunistic behavior by workers, so the owners of firms tend to own specialized capital investments. Owners of firms use detailed employment contracts to prevent the appropriation of specialized capital by their employees. Such detailed employment contracts mimic the function of vertical integration.

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  1. Pingback: Why vertically integrate? | Knowledge Problem

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