Horizontal Integration Does Not Imply Monopolies

In conversation not too long ago, our resident Penguatroll asked me to explain how horizontal integration does or does not imply a monopoly.  First, a note on what horizontal integration is and is not.

The easiest way to explain horizontal integration is to talk about the three different kinds of mergers that firms can do, set in a concrete example.  In my example, we’ll look at a soft drink manufacturer.  Like I said, there are three different kinds of mergers that this soft drink manufacturer can perform:  horizontal, vertical, and orthogonal.  Horizontal integration occurs when our soft drink company buys out Coca-Cola and the two merge together to produce soft drinks as one company.  In other words, when two firms which produce the same (or very similar) products merge together, this is horizontal integration.  Following from that, vertical integration would occur if our soft drink company bought a company which manufactures aluminum cans, or a company which mines bauxite and transforms it into aluminum, or even a company which makes cardboard boxes.  In all of these cases, the soft drink manufacturer is buying companies along its supply chain:  these companies do not compete with the soft drink manufacturer, but are instead vendors—or, to flip the example around, it would still be vertical integration if an aluminum can manufacturer bought a soft drink company.  The important part about vertical integration is not that a firm merge “upstream” of its supply chain, but rather that two firms along a supply chain merge.  Finally, orthogonal integration contrasts with both horizontal and vertical integration in that the two firms produce completely separate products and one is not in the supply chain of the other.  Our soft drink firm might merge together with a t-shirt manufacturer and a travel agency, for example.  This style of integration was big back in the ’80s as a risk-reduction technique:  a big company would branch out and buy all kinds of companies under the notion that if some parts of the business get hit with an economic downturn, enough would still be profitable that the conglomerate could still be profitable.  What’s humorous about this is that the end result was almost the exact opposite of that theory:  because management was unable to control the various business units (often because they had no clue about the various industries), big firms which tried this technique bled money and eventually we saw a “return to your core values” business movement.

Now that we know what horizontal integration is, I need to clarify the concept of “monopoly” a little bit, specifically in regard to how difficult it is to operate a true monopoly in a free market.  First of all, if there is any form of product variation, subjective tastes could result in product differentiation and a non-monopolistic market.  Let’s go back to our example with the beverage market.  People have differing tastes and prefer different products.  There’s a lot of horizontal integration there, with two primary manufacturers (and several smaller manufacturers, like Royal Crown), and you do see what is essentially an oligopoly, but no monopoly.  Part of this is anti-trust regulation, but I’d argue that even absent that, the two big companies would not merge together due to market variance.

Even within a more uniform market, such as crude oil, you will still see competitors.  One big reason is that there are geographical and network-based costs to being a mega-company.  The more spread out your company gets, the more difficult it is to keep tabs on everything and the more space there is for other firms to use local knowledge to out-compete you in a specific area.  That’s not going to lead to the perfect competition chimera of multitudinous, equal-sized firms which mimic one another perfectly, but that isn’t truly competition (and that point is an entire topic within itself).

But even if you find a way to close out all of the other firms, by buying them out or out-competing them, there is another big question:  is this a contestable market (references here and here)?  In other words, even if you saw one company in a monopolistic situation, are there sufficient barriers to entry to prevent other firms from jumping in if the monopolist tries to obtain monopoly profits?  Classic barriers to entry tend to be government providing state monopolies, as well as extreme resource scarcity, like there being a very small number of locations in which we may find a particular rare mineral.  If there are no such barriers, other firms could jump in and produce a product, eating away at the monopolist’s share.  That is, unless the monopolist kept prices below what it would cost to overcome the fixed costs necessary for entry into the market.  Typically, this means that even a de facto monopoly cannot charge monopoly prices and must act as if there were additional competition in the market even if there are no other firms which currently exist.  So even if our soft drink manufacturer bought Coca-Cola and Pepsi and all of the other competitors, it would not necessarily act as a monopoly because some other firm could enter the market and steal away market share.

All of these factors will inhibit complete horizontal integration.  With complete horizontal integration, you do get a monopoly—but like I said above, you may not get monopolistic behavior from that monopoly—but the factors above will make it less worthwhile for a firm to try to achieve complete horizontal integration, especially given that there are costs to integration.  These costs include the obvious ones, like the money necessary to buy out competitors, but they also include non-obvious costs, like the opportunity cost of buying that firm:  now you cannot get your best alternative, which might be more profitable than to push the horizontal integration margin a little further.  In fact, the single-minded quest to become a monopolist has ruined more than one individual—I’m thinking specifically of people who tried to corner the gold and silver markets, expecting that they could drive out all of the competition and take over the entire market.  This generally does not turn out well for the enterprising soul who makes the attempt.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s