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The concept of horizontal and vertical integration

World experience of economic development shows that the following processes are sources of concentration of production:

1) integration of industries and enterprises;

2) diversification of production;

3) the merger of individual small and medium-sized organizations into one large.

Integration - as a source of concentration, involves the acquisition or inclusion in the enterprise of sources of raw materials, sales channels and other areas related to the core business - production of components, transport, etc.

Integration is the concentration of economic activity within a company. The company borders both with competing companies in its industry and with companies from related industries, from where it buys the necessary raw materials and equipment and where it supplies finished products. She has both horizontal and vertical borders. Accordingly, horizontal and vertical integration are distinguished.

In the case of horizontal integration, the boundaries of the company are expanded in breadth: it incorporates an ever-increasing production volume of any one kind. In case of vertical integration, the company distributes

their activities "up" or "down" to the neighboring links of the production process. Accordingly, vertical integration can be upward (from the final to the initial stages of the technological cycle) and downward (from the initial stages to the final).

If we imagine all the way to the consumer of a product, such as gasoline, in the form of a vertical line, as is done in Fig. 6, then the upward integration will correspond to the connection of oil production to the oil refining company, the downward - organization by it

own network of petrol stations.

Fig. 6.

Upward and downward vertical integration

There are three ways leading to the formation of a vertically integrated company: 1) it can initially be created as covering several successive production stages; 2) it can be formed due to the expansion of a non-integrated company into adjacent to the industry; 3) it may be the result of the merger of two firms located at the adjacent steps of the production process.

Integration processes depend on the industry life cycle. In young, newly emerged industries, vertically integrated firms usually predominate, as the volume of demand is too small to specialize in any one stage of a new product release. When the industry reaches the maturity phase, the trend towards disintegration begins to take effect, large, highly specialized firms are formed.

In old industries that are declining, there is a return to the vertical

but integrated organizational forms.

There are several approaches to the analysis of the integration problem.

1. Firm as a production function. This approach can be called technological. The company appears in it as a "black box" with input costs and output output. The entire internal content of the company is reduced to a technological process that is not related to the subject of economic analysis. The technological approach reduces the explanation of larger or smaller firms to the economies of scale and economies of diversity.

The simplest example is two workers lifting a heavy stone, the weight of which is greater than the total they can lift, acting alone. The increase in the size of the "enterprise" from one to two people provides an output that exceeds the total product of two "single" enterprises.

The sources of economies of scale vary. The expansion of production allows the use of more powerful and efficient equipment, deepening specialization. For example, it might be more profitable for a company to have machine repair not carried out by the personnel who work for them, but by a specialized repair unit, but its creation is justified only with sufficiently large production volumes. Economies of scale reduce average costs per unit of output.

Technological savings can give impetus to vertical integration. The combination of a continuous casting and steel rolling process saves heat: the metal does not need to be reheated.

The technological approach is also characterized by savings from diversity.

It takes place when a combination of several different types of production under one roof achieves cost reduction. Its source can be the use of the same resource or the same technology simultaneously in several production processes, as well as the complementary nature of demand. Let’s say, at a gas station, it makes sense to establish current repairs of cars, organize small-scale trade, and so on.

Usually, economies of scale and diversity come up against inevitable limitations. The expansion of production begins at a certain point not to reduce, but to increase average costs. The benefits associated with the use of more powerful equipment and the deepening of specialization are exhausted, and managers can hardly cope with the increased load.
The explanation of the size of the company by factors of technological economy is difficult to recognize as sufficient.

2. A firm as a long-term contract. Central to this approach is the introduction of the concept of transaction costs.

Transaction costs - the costs of the establishment and functioning of institutions (compliance and enforcement of rules and regulations). Transaction costs are usually linked to actions in the process of preparation, conclusion and execution of a transaction, namely: information retrieval; negotiating and concluding contracts; measuring the attributes of the good; specification and protection of rights; etc.

A firm is seen as a coalition of resources owned by various agents. Its members may include shareholders, creditors, suppliers, managers, employees, consumers. In this sense, the company is a special long-term contract linking together its component parts.

In this case, we are talking about saving not technological, but transaction costs. Production factors will be integrated by establishing long-term contractual relations only if, as a result, their interaction begins to be carried out with lower transaction costs.

Long-term contracts vary in density

emerging economic relations. The lowest level is a long-term contract in which the parties remain completely independent. The next step is long-term contracts with vertical restrictions.

An example is the franchise system (franchising), widely used in retail.

Franchising - or a comprehensive entrepreneurial license, as a form of joint activity of well-known large enterprises with beginners, has established itself well and has become widespread in many countries. With the help of franchising, companies such as McDonald's, Kodak, Fuji, Pizza Hut and others have expanded the network of their representative offices many times.

Under franchising, it is understood that a large company provides another company (in particular, a small one) with the right to sell its products or services under the trademark of a large company. Positive aspects of franchising: Firstly, this is the easiest and most painless way to establish a new enterprise. Secondly, for large enterprises this is a solution to the problems of expanding the market for sales of products, attracting additional capital, as well as saving on the development of their own sales network, etc. Partially shifting responsibility to small entrepreneurs, large firms are less at risk with their "base" capital. Thirdly, when franchising, the human factor, personal interest (own business, rather than self-employment) are more actively used, which significantly increases production efficiency.

Although the dealer (franchisee firm) does not lose the status of an independent firm, he is at the same time forced to comply with a number of restrictions imposed by the supplier (the franchisor firm) and obey his control. As a result of such not full, but partial vertical integration, a quasi-firm is formed.

The highest level is a long-term contract uniting production factors into a single organizational structure, in other words, the establishment of a company. It guarantees the maximum degree of continuity of economic relations.

The main disadvantage of long-term contracts is their inflexibility. It is necessary to observe them even when, due to the appearance of new opportunities, this is no longer profitable: from a certain moment, the costs associated with them may begin to outweigh the benefits.

3. The company as an incomplete contract. In this approach, as in the previous one, the contractual nature of firms is recognized, the concept of transaction costs, which are “prohibitively high” when concluding full contracts, is supportive.

As a rule, the contract includes some of the most important “special conditions” and does not foresee the behavior of the parties in the event of new circumstances in the future (it is impossible to foresee all future possible changes in the contracts). The renegotiation of contracts whenever a new unforeseen circumstance arises requires transaction costs.

A sufficiently effective substitute for incomplete contracts is a company which, by mutual agreement of the parties, is vested with rights upon the occurrence of events not specified in the contract.

As a rule, “residual rights” to make decisions are granted to owners of the most long-term and specific assets. These are the assets that have the greatest value within the firm. The minimum set of rights of such a central agent includes three elements: 1) the right to determine the production program of the company; 2) the right to control all other members of the company; 3) the right to receive residual income, i.e., profit remaining after payment of all involved factors of production.
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