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Monday, March 07, 2005

Monopsony and vertical integration

For the last week or so, I've been teaching about the history of vertical and horizontal integration and their many ramifications in the late 19th century. Vertical integration was the new strategy of the period, developed by men such as Andrew Carnegie (iron and steel) and Philip Armour (meatpacking) who strove singlemindedly to drive costs out of the production process (to put it in today's parlance). The way that Wal-Mart, its core business focused on retailing, uses its great market power vis à vis its suppliers (see earlier post) to drive costs out of the supply chain seems like the functional equivalent of vertical integration in this respect.

Which is the "better" strategy--outright control or preponderant market power? There's no universal answer; it depends on the context, says the historian (an economist may answer differently). Carnegie's markets in the late 19th century were sufficiently large and stable that the risks of investing in control of supplies, labor, and distribution facilities were minimal and the reductions in unit costs that could be achieved by controlling all aspects of the process were substantial. Market conditions since the 1960s have become much more volatile for a variety of reasons, so investing in dedicated facilities/capabilities carries a much higher risk that market conditions will shift and render those facilities/capabilities useless. In this context, it makes more sense to retain the flexibility of contract relationships, using market power instead of outright control to force cost reductions.

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