A vertically integrated company is one of the most effective methods of running your own business. The formation of large structures with vertical integration is one of the most significant trends present in the modern Russian economy. Moreover, the ambiguity that distinguishes any vertically integrated company is a pretty good reason to comprehensively consider its main advantages and incentives.
Incentives
Modern large integrated organizations constantly dictate the vector of development of the modern economy and constitute the basis for maintaining stability in the production of any developed country. A vertically integrated company is a fairly popular option for doing business, and in the Russian economy, various integration processes are becoming more and more significant. One of the most important reasons for the formation of such structures in the current sector of the domestic economy can be called the fact that favorable conditions were created for conducting economic activity, mutual barriers were removed, and it was also possible to strengthen their competitive positions and exercise control over the market situation.
An analysis of the market in which the integrated participants operate provides for an active consideration of various specific incentives for different integration options.
What are they like?
There are two types of incentives that distinguish a vertically integrated company - internal and external. The latter represent various requirements that are imposed by some special characteristics of the structure of a particular industry market to potential or existing participants, as well as all sorts of actions performed by the firms working on it.
The concept of vertical integration also provides for the division of external incentives into two categories - non-strategic and strategic. Non-strategic are determined depending on the characteristics of the industry, which are not directly dependent on the activities of the company. At the same time, strategic incentives are characteristics of the market structure and are combined due to the work of the organizations themselves.
The determining non-strategic characteristics of the market are:
- capacity and saturation;
- economies of scale ;
- concentration of buyers and sellers, prevailing at the moment;
- demand elasticity;
- degree of infrastructure development;
- foreign competition;
- administrative barriers;
- general economic conditions;
- transaction costs.
If we talk about the most important strategic characteristics of the market, then this already includes:
- price and other types of discrimination;
- nature and degree of integration;
- coordinated actions of companies;
- the presence of potential competitors;
- actions of companies aimed at restricting market entry.
Internal incentives are any potential and real benefits that a company receives after using a certain type of integration. The internal integration advantages that Gazprom and other organizations with such a structure have gained may result from the effective interaction of several group members, and at the same time they can be expressed in various structural market changes that are favorable for the organization.
Benefits and motives
The Russian economy, dominated by such large organizations as Rosneft and others, is characterized by a tendency towards vertical integration, which in fact is one of the most controversial forms. Vertically integrated companies differ not only in all the advantages and disadvantages of large enterprises, but also have their own laws of development.
By combining enterprises (OOO Lukoil and others), a completely different level of management is provided, opening up opportunities for the use of a wide variety of options for coordinating the interests, actions and managerial motivations of various members of the association, thus opening up real prospects for an active increase in production efficiency.
In particular, it becomes possible to exchange various strategic information, and the introduction of innovations in any of the sectors ultimately leads to a positive result for the whole structure.
The vertical integration used by Lukoil LLC and other concerns makes the company much less dependent on distributors or suppliers. The need for continuous growth of the organization’s independence from its external environment is especially relevant in dynamic markets, where there are a large number of sellers and buyers, as well as in the presence of a shortage of certain resources.
Such methods that allow protection against arbitrariness on the part of suppliers, such as increasing stocks, the use of substitute products, working with a variety of different partners and others, can not always be called not only cost-effective, but generally realistic in terms of implementation. Various companies that are not integrated with the supplier of the necessary production factors often face the need to stop their activities whenever the demand for such factors exceeds the supply or the supplier is interested in changing the terms of the contract. In this regard, large organizations, including Gazprom, use a vertical integration structure.
In addition, the decision-making by sales companies that were not previously integrated and are not interested in selling various products of a certain enterprise always creates a certain risk of overstocking and active underloading of the used production capacities, as a result of which the production ultimately simply becomes unstable.
The vertical association of organizations used by Rosneft and other companies makes it possible to use much more efficient schemes for conducting domestic commodity circulation, as well as ensuring optimal management of inventories, which completely overcomes the sales crisis along the technological chain. The accelerated turnover of funds allows you to reduce the need for loans needed to replenish working capital, and also helps to achieve savings on interest paid.
What are the risks here?
Compared to the standard market relations that are formed between independent partners, the concept of vertical integration provides for a reduction in transaction costs, which applies not only to market coordination of companies, but also to the risk of opportunism, asymmetric data and a certain specificity of assets.
The risk of opportunistic behavior of various counterparties appears in the production process for which there is no clear definition of future demand, or when it is not possible to foresee any negative changes in the internal and external economic environment in the process of drawing up the contract.
Specific assets
Specific assets are the result of specialized investments: such assets cannot be reassigned for the purpose of further use for other purposes or by some other users, without causing losses in production potential. Their presence contributes to the emergence of bilateral dependence, which leads to some complication of contractual relations. At the same time, one must correctly understand that the specificity of assets can have several forms, among which, as the main ones, various location features, human capital, technological characteristics and targeted investments can be distinguished.
The specifics of such a structure
The specificity of the location occurs when the buyer of various factors of production and his supplier are located quite close to each other, thereby significantly reducing the costs required for storage and transportation, as a result of this leads to the extreme immobility of assets. An example is the steel industry, where the integration of various smelting and rolling operations significantly reduces transport costs, and also eliminates the need for additional heating of steel. In the same way, the placement of power plants in close proximity to the place of coal mining significantly increases the degree of economy of the enterprise on transportation costs.
The specificity of various technological characteristics is manifested in the case when one or several parties to the transaction invest in tangible assets that have unusual technological and structural characteristics. Ultimately, due to such investments, the alternative possibilities of using material resources are significantly reduced.
The specificity of human capital is the result of investing in the active development of personnel. For example, managing a vertically integrated company may include regular training in industry specifics, teamwork skills, and understanding of new technologies.
The supplier makes targeted investments if he sees the real prospect that a significant volume of products will be sold to a specific consumer. In the event of a preliminary termination of the contract, accordingly, the supplier will have idle production capacity.
Possible risks
The work of companies that produce or use all kinds of assets in the course of their activities is notable for certain risks that apply to the sale of special products, but it also has risks that are caused by uncertainty in the supply of these products, as well as the lack of the possibility of reprofiling any production facilities so that they can be used for some alternative purposes.
Even if the risks of asymmetric data and uncertainty are completely absent, vertically integrated companies of Russia and other developed countries are distinguished by the presence of reduced transaction costs, which is associated with market coordination of organizations. In any competitive market, the buyer of various factors of production and their seller are forced to spend a lot of money searching for each other, as well as the subsequent conclusion and control over the implementation of a number of relevant contracts. Subsequently, the buyer of some factors of production turns into a seller of the final product, and now he will need to allocate funds for its implementation. If the companies in question are combined, as the vertically integrated oil companies and many others do, ultimately only transactions remain that relate to the search and maintenance of the contract with respect to the buyer of the final product.
Possible result
After the introduction of vertical integration, the total cost of the final product is also significantly reduced, since the costs of intermediate factors are reduced by solving the problems associated with the so-called double marginization and double premium. Saving on costs, which differs in the sale of gasoline and other products in the form of vertical integration, allows the company to significantly expand its form of presence in the market. First of all, she achieves reduced prices for her own products, and also makes big profits at the current market price. That is why Rosneft (gas stations) and other similar structures are notable for their increased market power compared to the one they would differ only in based on their market share.
Company Benefits
Competitors' access to various markets for intermediate products is limited due to the fact that there is no possibility or there are unfavorable conditions for concluding contracts with companies united in an integrated structure. In the final product market, Rosneft (gas stations) and other structures that use vertical integration are distinguished by a host of advantages, which are determined by the presence of a specific solution to the “double mark-up” problem, lower transaction costs and many other factors. Lower costs increase the competitive position of this organization, and at the same time also raise barriers to entry in this industry for any new company.
In addition, the specific features of vertical integration make it possible to combine a fairly low level of concentration of final products in the markets with a rather high degree of monopolization of power and, accordingly, a reduction in pressure from various executive bodies in the field of antitrust regulation.
Disadvantages for the market
In connection with all this, it can be said that the consequences that vertical integration entails are ambiguous. The same company, Rosneft, can be taken as an example, which, on the one hand, sets the tendency to lower production costs and, consequently, prices, but on the other, it has significant market power and strengthens monopolization.