After taking this lecture, you should be able to:
1. Define vertical integration, forward vertical integration, and backward vertical integration.
2. Discuss how vertical integration can create value by reducing the threat of opportunism.
3. Discuss how vertical integration can create value by enabling a firm to exploit its valuable, rare,
and costly-to-imitate resources and capabilities.
4. Discuss how vertical integration can create value by enabling a firm to retain its flexibility.
5. Describe conditions under which vertical integration may be rare and costly to imitate.
6. Describe how the functional organization structure, management controls, and compensation
policies are used to implement vertical integration.
Vertical integration is defined as the number of stages in an industry’s value chain that a firm has
brought within its boundaries. Forward vertical integration is vertical integration that brings a firm
closer to its ultimate customer; backward vertical integration is vertical integration that brings a firm
closer to the sources of its raw materials. In making their vertical integration decisions for a particular
business activity, firms can choose to be not vertically integrated, somewhat vertically integrated, or
Vertical integration can create value in three different ways: First, by reducing opportunistic
threats from a firm’s buyers and suppliers due to any transaction-specific investments it may have
made. A transaction-specific investment is an investment that has more value in a particular exchange
than in any alternative exchanges. Second, vertical integration can create value by enabling a firm to
exploit its valuable, rare, and costly-to-imitate resources and capabilities. Firms should vertically
integrate into activities where they enjoy such advantages and should not vertically integrate into other
activities. Third, vertical integration typically only creates value under conditions of low uncertainty.
Under high uncertainty, vertical integration can commit a firm to a costly-to-reverse course of action
and the flexibility of a non–vertically integrated approach may be preferred.
Often, these three different approaches to vertical integration will generate similar conclusions.
However, even when they suggest different vertical integration strategies, they can still be helpful to
The ability of valuable vertical integration strategies to generate a sustained competitive advantage
depends on how rare and costly to imitate these strategies are. Vertical integration strategies can be rare
in two ways: (1) when a firm is vertically integrated while most competing firms are not vertically
integrated and (2) when a firm is not vertically integrated while most competing firms are. These rare
vertical integration strategies are possible when firms vary in the extent to which the strategies they
pursue require transaction-specific investments; firms vary in the resources and capabilities they
control; or firms vary in the level of uncertainty they face.
The ability to directly duplicate a firm’s vertical integration strategies depends on how costly it is
to directly duplicate the resources and capabilities that enable a firm to pursue these strategies. The
closest substitute for vertical integration—strategic alliances—is discussed in more detail in Chapter 9.
Organizing to implement vertical integration depends on a firm’s organizational structure, its
management controls, and its compensation policies. The organizational structure most commonly used
to implement vertical integration is the functional or U-form organization which involves cost
leadership and product differentiation strategies. In a vertically integrated U-form organization, the
CEO has to focus not only on deciding which functions to vertically integrate into, but also how to
resolve conflicts that inevitably arise in a functionally organized vertically integrated firm. Two
management controls that can be used to help implement vertical integration strategies and resolve
these functional conflicts are the budgeting process and management oversight committees.
Each of the three explanations of vertical integration suggests different kinds of compensation
policies that a firm looking to implement vertical integration should pursue. Opportunism-based
explanations suggest individual-based compensation—including salaries and cash bonus and stock
grants based on individual performance—while capabilities explanations suggests group-based
compensation—including cash bonuses and stock grants based on corporate or group performance—
and flexibility explanations suggest flexible compensation—including stock options based on
individual, group, or corporate performance. Because all three approaches to vertical integration are
often operating in a firm, it is not surprising that many firms employ all these devices in compensating
employees whose actions are likely to have a significant impact on firm performance.