Consumers feel their wallets bleeding with every new purchase, from cars to prescription drugs. Buzzwords such as “affordability” make for good political ads, but they don’t explain much, let alone prescribe a solution. To best serve consumers and their budgets, businesses must look to economize production through the often demonized phenomenon of vertical integration.
This term refers to a company internalizing more stages of the production process instead of (or in addition to) working with outside partners. It’s often conflated with a monopoly, where no competition results in one player skimping on quality and naming the price.
Monopoly fears need to be set aside, though, because unlike a monopoly, vertical integration benefits both companies and consumers.
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In one sense, this is as simple as human nature. Nobel Prize-winning economist Ronald Coase, in his 1937 paper “The Nature of the Firm,” established that firms expand (or integrate) right up until their internal costs exceed their transaction costs — that is, the cost of using the market. Transaction costs include inconveniences such as negotiating contracts, coordinating across companies, and enforcing patent or IP rights.
The opposite applies, too: The higher the transaction costs, the more it’s in a company’s best interest to vertically integrate. And that’s what we’re seeing today, across industries. Apple wants to control the design and manufacture of its chips. Amazon built an internal logistics system to ship its products without FedEx or USPS. Streaming platforms such as Disney and Netflix want to minimize licensing burdens by owning and distributing their content. These are all examples of vertical integration.
And transaction costs aren’t always implemented by the private sector. Coase’s “nature of the firm” was awakened in the health insurance industry when the Affordable Care Act’s regulations made it more attractive for insurers and related entities to acquire pharmacies and providers than contract with them.
Today, lobbyists and lawyers want the government to break this vertically integrated relationship, citing monopoly-adjacent concerns about price-fixing and shady business practices. But the irony here is that government policies laid the foundation for these relationships in the first place.
By now, it should be clear how vertical integration benefits a company: lower costs, less supply chain uncertainty, and reduced risk of fighting over contracts or lawsuits. But what about consumers? Doesn’t vertical integration lead to all the pitfalls of a monopoly?
The answer is no, and we can look to the pork industry to see why.
A recent study by the University of Nebraska’s Department of Agricultural Economics examined, in exacting detail, the ramifications of forbidding vertical integration for pork producers. The study found that when companies vertically integrate for efficiency, forcing them not to do so will result in a less efficiently produced good. Where it’s done for quality, losing it means lost quality. And so on, with the obvious implication being higher costs and lower consumer satisfaction. In short, “abolishment of vertical integration in the US pork sector will hurt pork consumers, integrated pork producers, and the hog producers involved.”
The university acknowledged that “a reduction in the market share and profits of major players in a sector tends to be viewed as a socially desirable outcome.” But we can’t let romantic fantasies about the haves and the have-nots carry us away. When companies consolidate their supply chains, society benefits, too.
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Granted, vertical integration is not a cure-all. Sometimes, like in the case of SaaS (software as a service), it makes sense to let a third party, with the infrastructure it already has (and you don’t), handle some of your operations. But even here, the future favors vertical integration: Once companies get better at building custom systems with AI, the cost savings of coming down from the cloud and retrenching will be obvious.
Whatever moral qualms or social complaints might exist, it’s impossible to deny that vertical integration benefits both companies and consumers. To squash it is to keep industry’s productivity artificially low for no good reason. Not only that, but it mainstreams customer dissatisfaction and even customer suffering for a shiny but ultimately self-defeating ideal.
Michael Feuz is a business economist with a Master’s Degree in Economics from George Mason University.