Vertical Integration and Demand Variability

Abstract

FLUCTUATIONS in demand, and uncertainty due to imperfect foresight regarding these fluctuations, are expensive. Short-run fluctuations force sellers to hold inventories, to adopt costly production techniques, and/or to mitigate the effects of fluctuations by adjusting prices or other terms of sale. Long-run fluctuations may lead to excess capacity that cannot be easily liquidated, and/or to the need to adjust price or other terms of sale. Vertical integration by any means-whether by ownership or long-term contractbetween suppliers and users may reduce demand variability as felt by suppliers. But, vertical integration has costs that dealing in the market may avoid. Profit maximizing firms will integrate to the point where the marginal benefits of further integration equal the costs [51. One expects, therefore, vertical integration to be relatively great where it can greatly reduce demand variability felt by suppliers, and where the costs of variability and uncertainty are high [ I I. In this paper I state three simple, but previously neglected, principles for determining the effect of vertical integration on demand variability felt by individual suppliers in a market with many suppliers.' Polar case models and a theorem show their validity and give the conditions under which integration reduces demand variability felt by individual suppliers. The determinants of the reductions, if any, are also given.2 The usefulness of the principles and theorem is shown in two ways. (i) The principles and theorem are consistent with, and make more precise, prior theory about the power of large buyers. (2) They permit plausible explanations of vertical integration movements difficult to explain on other grounds. One example discussed is a controversial vertical integration movement in the U.S. cement industry