Chapter Five

Diversification, Vertical Integration and Merger

• Diversification, Vertical Integration and Merger are three important elements of
market structure. All the three are no doubt different but closely interlinked
5.1 Integration
• It refers to the operations by a firm in two or more industries representing
successive stages in the flow of materials or products from an earlier to later
stage of production or vice versa.
Integration can take three different forms.
 Horizontal integration: It is the amalgamation of two or more firms by
merger or acquisition that follow similar stages of production to produce
similar products.
 Vertical integration: It is the amalgamation of two or more firms by merger
or acquisition that lie at different and sequential level of processing.
A firm that participates in more than one successive stage of the
production or distribution of goods or services is vertically
integrated. No vertically integrated firms buy the inputs or services
they need for their production or distribution processes from other
firms.

 Conglomerate integration: It is the amalgamation of firms

through merger or acquisition that product areas. Conglomerate
integration refers to the process of merging or acquiring
companies that operate in different industries or markets. This can
involve integrating the operations, management, and culture of the
newly acquired companies with those of the parent company.
• Horizontal integration occurs when a business merges with or
acquires another business. It is the acquisition of additional business
activities at the same level of the value chain.
• Vertical integration is the process in which several steps in the
production and/or distribution of a product or service are controlled
by a single company or entity, in order to increase that company's or
entity's power in the market place.
• Vertical integration involves joining together under common
ownership a series of separate but linked production
processes. Such a strategy is used by many enterprises to
widen the boundaries of the firm and to enlarge its size.
• Vertical integration refers to a situation where a single firm has
ownership and control over production at successive stages of a
production process.
• Activities located at the initial stages of a production process are known
as upstream activities, and those located closer to the market for the
final product are known as downstream activities.
• Upstream (or backward) vertical integration refers to a situation where a firm
gains control over the production of inputs necessary for its own operation;
• and downstream (or forward) vertical integration refers to a situation where a
firm gains control over an activity that utilizes its outputs.

• Theories tended to focus on issues such as the desire to secure enhanced market

power; the technological benefits of linking successive stages of production; the

reduction in risk and uncertainty associated with the supply of inputs or the

distribution of a firm’s finished product; and the avoidance of taxes or price

• As an alternative to vertical integration, some firms may
decide to develop vertical relationships of a looser nature than
full-scale vertical integration.
• Advantages include the preservation of some (or all) of both
parties’ independence, and the avoidance of costs that might
be associated with vertical integration. Examples of agency or
vertical relationships that stop short of full-scale integration
include franchising, involving a specific contractual
agreement between a franchisor and franchisee; and networks
of independent firms that are linked vertically, and establish
nonexclusive contracts or other relationships with one another.
• Some firms may find vertical integration or other types of
vertical relationship too costly to organize and monitor.
 5.2 Merger

• The term merger refers to amalgamation or integration of two or

more firms. The firms under different ownership and
management controls come under a unified one through merger.

• The terms 'acquisition' and 'takeover' are also used for merger,
which implies that a firm acquires assets or stocks in part or full,
of other firm or firms to get operational control over them.

• The important feature of merger is the transfer of control of

business activity from one firm or firms to another.
• The words ‘‘merger’’ and ‘‘acquisition’’ are used
interchangeably. If the two terms are to be distinguished, then
a merger occurs when two or more firms are voluntarily
combined under common ownership, while an acquisition, or
takeover, occurs when one firm acquires or buys the assets of
another without the agreement of the controllers of the target
company.
• There are three broad merger categories. These are: horizontal, Vertical and
conglomerate.

• Horizontal mergers involve firms that are direct competitors. The firms must
compete in both the same product market and the same geographic market. Whose
products are viewed by buyers as identical that is their products have high cross
elasticity of demand and supply. Horizontal merger: When companies that sell
similar products merge together.

• Vertical merger: Occurs between companies at different stages in the production

process (between companies where one buys or sells something from or to the
company).

• Vertical mergers involve firms that produce at different stages of production in the
same industry. For example steel producing industry. There may be such
integration between a producing and a marketing firm for the same commodity or
• Conglomerate mergers involve companies that operate in
either different product markets or the same product market
but different geographic markets.
• Products which are not substitutes for each other (zero
cross elasticity of demand and supply) such as merging of a
cloth making firm and a drug manufacturing one.
• Conglomerate mergers are usually subdivided in to three types:

product extension mergers between companies that produce different but related
products (e.g., laundry detergent and liquid bleach);

geographic extension mergers between companies that produce the same product
in different location (e.g. a Midwestern beer producer purchases a north eastern
beer producer); and

pure conglomerate mergers between firms operating in entirely separate markets

(e.g., a telephone company purchases a rental car company.

• One conglomerate merger example is Amazon and Whole Foods. Amazon is an

online retailer, while Whole Foods is a supermarket. The merger allowed
Amazon to expand its grocery offerings and increased the benefits provided to
its Prime members.
 Motives for merger

1. Consolidate market power:

• Vertical integration may be used as a strategy for restricting

competition, and either using or abusing market power.
• One of the arguments for vertical integration is related to the problem of double marginalization, which arises
when successive stages of a production process are under the control of independent (non-integrated) firms.

For example, if a producer and retailer are both monopolists or have strong market power, and both add their
own mark-ups to the price, the outcomes are a higher price and lower output than in the case where the two
firms are vertically integrated. Both producer and consumer surplus are higher if the production and retail stages
are vertically integrated.

• Horizontal integration between or among firms producing similar items

may be used as a strategy to increase market share and consolidate
market share. It is a more successful weapon to win competition than
any other mechanism including price war.
2. Cost saving or efficiency gain

• Vertical integration may lead to efficiency gain or cost saving because of the
following reasons.
 Technological conditions: Vertical integration may lead to the reduction of
production costs. This may occur if one or both firms may own a resource
that cannot be fully utilized, and integration will enable to optimally use it by
the two firms.

For instance, there may not be a need to double the management staff and a staff
that was deployed in one firm would be used for others as well. Some activities
can be complementary and are best completed together, which in effect reduces
costs.
• Uncertainty: The relationship between firms in successive stages of
production is subject to uncertainty arising from incomplete information.
 Assured supply: Firms may be concerned about the risks of being let down by a
Backward vertical integration may help ensure a steady supply
supplier.
of inputs.
 Externalities: arise when a firm incurs additional costs
brought about by the actions of its suppliers or distributors.
Vertical integration may help eliminate these costs.
 Complexity: Vertical relationships may be characterized by complex technical and
legal relations. The resulting difficulties may be reduced through vertical integration.
 Moral hazard: A firm’s independent suppliers or retailers may have
insufficient incentive to act in the firm’s own best interests; within an
integrated organization these disincentives may be eliminated.
 Elimination of transaction costs: A merger can reduce transaction costs
that would otherwise have existed by replacing market transaction
between firms by rather planning and coordination within one
management of the integrated firms. The transaction cost prior to
 Merger may reduce the investment cost that would have otherwise
been required to establish a firm that supplies inputs or uses the inputs
of the firm in question. Sometimes, possible existence of entry
barriers as one firm wants to establish another firm would be avoided
as the firm integrates with another firm. Merger requires relatively
shorter time than establishing a new investment venture.

 Economies of scale in the use of R&D, advertisement and

promotion and also obtaining finance arise as firms integrate.
Instead of each one of them invest in these areas, they can economize
the resource as they integrate and the risk would be would be minimal
as the firm becomes large.
 Smaller firms may have higher transaction costs and also may
not be easy to acquire capital as against larger firms.

• Bypassing government regulations: Vertical integration

sometimes helps to reduce or avoid tax or price control
regulations in the different levels of the production process or in
different countries or regions if the input supplier is in one
country or region and the input user is in another country and
now both the input supplier and final good producer are
integrated in one larger firm.
 5.3 Diversification

• If the firm produces a totally different product which is not a

substitute for the existing products in the market, then it is
called diversification. Diversification is thus "the spreading
of its operations by a business over dissimilar econo­mic
activities". Diversification occurs when a single-product firm
changes itself into a multi-product or multi-market firm.

• Diversification takes three different forms.

 Diversification by product extension, where a firm supplies

 Diversification by market extension, where a firm moves into a new
geographic market;

Generally diversification thus cannot be conceived of changes in the products

only; it implies the other two aspects of the change also, i.e. changes in the
technological base and market areas.

• Pure diversification or conglomerate diversification where a firm moves

into a completely unrelated field of activity.

• Conglomerate diversification arises through merger, acquisition, or internal

expansion.

• Internal diversification arises when a firm is involved in different economic

sectors or produce different items so as to use the available overhead cost in
terms of management, office facilities, and marketing and research facilities.
 Motives of diversification
• Enhancement of market power: The diversified firm may be in a strong
position to compete against a specialized rival by drawing on cash flows or
profits earned elsewhere within the organization, effectively cross-subsidizing
the costs of engaging the rival in either price or non-price forms of competition.

Reciprocity( refers to the possibility that a large conglomerate can encourage

its suppliers to purchase inputs from another of the conglomerate’s
divisions) and tying may be attractive strategies for a diversified firm that is
seeking to generate sales across several distinct product lines.
• Cost savings: Diversification can result in cost savings in three ways.
First, economies of scope are realized when the costs of indivisibilities are spread
over the production of several goods or services, or when the diversified producer
is able to realize other types of average cost saving.
Second, diversification reduces the firm’s exposure to adverse

fluctuations in demand in any one of its product markets. The ability to

manage risk through diversification may reduce the firm’s cost of

raising finance.

Third, by offsetting profits earned from one activity against losses in

another, a diversified firm may be able to reduce its tax exposure.

• Reduction of transaction costs: If investors are unable to access

reliable information in order to judge the performance of managers,

the efficient allocation of investment funds may be impeded.

• Within a diversified firm or conglomerate, central managers at head
office undertake the task of allocating funds between the divisions of
the conglomerate. Effectively, the conglomerate acts as a miniature
capital market, but enjoys better access to information and is able to
monitor performance more effectively.

• Most firms possess specific assets that are of value if

exploited in other markets. If the transaction costs incurred
in trading specific assets through the market are high, it
may be better for the firm to exploit the assets itself by
implementing a diversification strategy.
• Managerial motives for diversification. According to several of the
early managerial theories of the firm, diversification is the principal
method by which growth in demand is achieved in the long run.
Managers might target growth rather than profit because their
compensation and prestige are related to the size or growth of the
organization.

• Diversification might increase the managers’ value to the

organization, and it might enhance their job security by reducing risk.
 Implication for Public Policies

• Diversification and integration, whether vertical, horizontal or

conglomerate, are important market strategies which affect the
competitive envi­ronment of an industry and economy as a whole.
When a firm diversifies, it has certain well-defined motives for
that. Its actions will not be unnoticed by its rivals.

• They will also have countermoves in order to maintain their

market shares particularly when the products are closely related.
Thus, we expect an increase in the competitive climate in the
industry by diversifica­tion. The firms as well as their products
compete for scarce resources and markets under such situation.
• The question now arises whether such com­petition involves all firms in
the industry or only a few of them. Common observation is that such
competition will be between large firms only.

• They find diversification a way to maintain their growth and market

power with­out being charged for monopolizing in the market. But when
only few large firms control the market and put barriers to entry for new
competitors, it leads to an increase in market concentration so that we
may say that diversification explicitly or implicitly causes market
concentration.

• Under such situation there is a direct implication of diversification for

public policy as no welfare state will allow concentrating market for a
commodity or commodities in the hands of few firms.
• Similar situation arises in the case of vertical and horizontal
integration among the firms. It is generally agreed that vertical
integration does have the potential to increase market power
either by reducing the com­petition or through economies of
scale. But there is a counter-argument for this according to
which vertical integration does not harm competition.
• In fact, it helps in increasing competition by bypassing
monopolistic suppliers. There is thus a controversy about the
effect of vertical integration on competition but from policy
point of view there is again a strong need to regulate such
phenomenon.
• For horizontal and conglomerate mergers, there is greater
probability of their causing market concentration, so, they are
strictly regulated through-public laws. A public policy is
designed to achieve some chosen objectives or goals.
These may be, say, for example:

(1) To diffuse economic power;

(2) To have efficient allocation of scarce resources; and

(3) To ensure economic freedom of mass participation in the economy.

• All mergers and diversification poli­cies of the individual firms in the market are

to be evaluated in the light of such social goals.

• If the policies are in conflict with such goals they are to be checked and

controlled effectively. Most of the governments appoint Antitrust or Monopoly

and Restrictive Trade Practices Commissions for this purpose.

• There will be a set of rules or guidelines which will be imple­mented by such

commissions to regulate mergers and diversification strategies of the firms by

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