Vertical integration

In microeconomics, management and international political economy, vertical integration, also referred to as vertical consolidation, is an arrangement in which the supply chain of a company is integrated and owned by that company. Usually each member of the supply chain produces a different product or (market-specific) service, and the products combine to satisfy a common need. It contrasts with horizontal integration, wherein a company produces several items that are related to one another. Vertical integration has also described management styles that bring large portions of the supply chain not only under a common ownership but also into one corporation (as in the 1920s when the Ford River Rouge complex began making much of its own steel rather than buying it from suppliers).

Vertical integration can be desirable because it secures supplies needed by the firm to produce its product and the market needed to sell the product, but it can become undesirable when a firm's actions become anti-competitive and impede free competition in an open marketplace. Vertical integration is one method of avoiding the hold-up problem. A monopoly produced through vertical integration is called a vertical monopoly: vertical in a supply chain measures a firm's distance from the final consumers; for example, a firm that sells directly to the consumers has a vertical position of 0, a firm that supplies to this firm has a vertical position of 1, and so on.

The vertical integration of a company can be measured using the Real net output ratio:

${\displaystyle 0<{\text{Real net output ratio}}={\frac {\text{Added Value}}{\text{Total Production Value}}}<1}$

Added value is the difference between a company's turnover and externally purchased services, such as profit, gross wages, or other non-wage labor costs.

In essence, the less a company outsources, the higher the degree of vertical integration - or the degree of integration tends towards one, representing a high degree of vertical integration.

This also means that the lower the vertical integration - the higher the proportion of purchased components and services - the lower the real net output ratio, as this reduces value creation.

Vertical integration is often closely associated with vertical expansion which, in economics, is the growth of a business enterprise through the acquisition of companies that produce the intermediate goods needed by the business or help market and distribute its product. A firm may desire such expansion to secure the supplies needed by the firm to produce its product and the market needed to sell the product. Such expansion can become undesirable from a system-wide perspective when it becomes anti-competitive and impede free competition in an open marketplace.