STRATEGIC MANAGEMENT
AND COMPETITIVE
ADVANTAGE
J. BARNEY & W. HESTERLY | 6TH EDITION
SUMMARY OF CHAPTERS 8 - 12
,H8 VERTICAL INTEGRATION
8.1 WHAT IS CORPORATE STRATEGY?
Business strategy is a firm’s theory of how to gain competitive advantage in a single business or
industry. The four business strategies are cost leadership, product differentiation, flexibility, and
collusion. Corporate strategy is a firm’s theory of how to gain competitive advantage by operating in
several businesses simultaneously. Decisions about whether to vertically integrate often determine
whether a firm is operating in a single business or industry or in multiple businesses or industries.
Other corporate strategies include diversification, strategic alliances, and mergers and acquisitions.
8.2 WHAT IS VERTICAL INTEGRATION?
The value chain is the set of activities that must be accomplished to bring a product or service from
raw materials to the point that it can be sold to a final customer. The level of vertical integration is the
number of steps in this value chain that a firm accomplishes within its boundaries. A firm engages in
backward vertical integration when it incorporates more stages of the value chain within its
boundaries and those stages bring it closer to the beginning of the chain, so closer to gaining access to
raw materials. A firm engages in forward vertical integration when it incorporates more stages of the
value chain within its boundaries and those stages bring it closer to the end of the chain, so closer to
interacting directly with final customers.
THE VALUE OF VERTICAL INTEGRATION
Coase (1937) asked a simple question: “Given how efficiently markets can be used to organize
economic exchanges among thousands, even hundreds of thousands, of separate individuals, why
would markets, as a method for managing economic exchanges, ever be replaced by firms?”
He observed that sometimes the cost of using a market to manage an economic exchange is higher
than the cost of using vertical integration. Situations where vertical integration can either increase a
firm’s revenues or decrease its costs compared with not vertically integrating, are:
▪ To reduce the threat of opportunism
Opportunism exists when a firm is unfairly exploited in an exchange. For example, a party expects
a service at a particular point in time and that service is delivered late. When one of the exchange
partners behaves opportunistically, this reduces the economic value of the firm. One way to
reduce the threat of opportunism is to bring an exchange within the boundary of a firm, that is, to
vertically integrate into this exchange. This way, managers in a firm can monitor and control this
exchange instead of relying on the market to manage it.
Firms should only bring market exchanges within their boundaries when the cost of vertical
integration is less than the cost of opportunism.
The threat of opportunism is greatest when a party to an exchange has made transaction-specific
investments. A transaction-specific investment is any investment in an exchange that has
significantly more value in the current exchange than it does in alternative exchanges. An example
is an investment in a pipeline that can only be used by one company. This one company knows
this, and will act opportunistically by asking higher prices for example. If the pipeline company
integrates vertically, this will not occur. So, these investments make parties vulnerable to
opportunism, and vertical integration solves this vulnerability problem. High levels of such
investments suggest the need for vertical integration.
,▪ Firm Capabilities
This approach focuses on a firm’s capabilities and its ability to generate sustained competitive
advantages. It suggests that firms should vertically integrate into those business activities, where
they possess valuable, rare, and costly-to-imitate resources and capabilities. This approach also
suggests that firms should not vertically integrate into business activities where they do not
possess the resources necessary to gain competitive advantages. Such vertical integration
decisions would not be a source of profits to a firm. To the extent that some other firms have
competitive advantages in these business activities, vertically integrating into them could put a
firm at a competitive disadvantage.
So, if a firm possesses valuable, rare, and costly-to-imitate resources in a business activity, it
should vertically integrate into that activity; otherwise no vertical integration.
▪ Flexibility
Flexibility refers to how costly it is for a firm to alter its strategic and organizational decisions.
Flexibility is high when the cost of changing strategic choices is low; flexibility is low when the cost
of changing strategic choices is high.
In general, vertically integrating is less flexible than not vertically integrating. This is because once
a firm has vertically integrated, it has committed its organizational structure, its management
controls, and its compensation policies to a particular vertically integrated way of doing business.
Undoing this often means changing these aspects of an organization. A non-vertically integrated
business does not have this problem.
Flexibility is only valuable when the decision-making setting a firm is facing is uncertain. A
decision-making setting is uncertain when both the possible outcomes of a decision and their
probability cannot be known when a decision is being made. In such settings, less vertical
integration is better than more vertical integration, because vertically integrating into an exchange
is less flexible than not vertically integrating into an exchange. If an exchange turns out not to be
valuable, it is usually costlier for firms that have vertically integrated into an exchange to exit that
those that have not.
This suggests that firms should form a strategic alliance to manage an exchange, because it is
more flexible than vertical integration and still gives a firm enough information about an exchange
to estimate its value over time.
Sometimes, these theories of vertical integration can contradict each other. However, more often
these are complementary. Each approach generally leads to the same conclusion about how a firm
should vertically integrate. You choose the approach that is most likely to be a source of value.
Having multiple explanations can highlight the trade-offs that a firm must make when choosing its
vertical integration strategy. For example, if opportunism-based explanations suggest that vertical
integration is necessary because of high transaction-specific investments, capabilities-based
explanations caution about the cost of developing the resources and capabilities necessary to
vertically integrate and flexibility concerns caution about the risks that committing to vertical
integration imply, and the costs and benefits of whatever decision is ultimately made can be
understood very clearly.
,8.3 VERTICAL INTEGRATION AND SUSTAINED COMPETITIVE ADVANTAGE
For vertical integration to be a source of sustained competitive advantage, not only must it be
valuable (because it responds to threats of opportunism, enables a firm to exploit its own or other
firms’ valuable, rare, and costly-to-imitate resources, or gives a firm flexibility), it must also be rare and
costly to imitate, and a firm must be organized to implement it correctly.
RARITY OF VERTICAL INTEGRATION
A firm’s vertical integration strategy is rare when few competing firms can create value by vertically
integrating in the same way. A firm can create value through vertical integration for three reasons:
1. Rare Transaction-Specific Investment
A firm may have developed a new technology or a new approach to doing business that requires
its business partners to make substantial transaction-specific investments. Firms that engage in
these activities will find it in their self-interest to vertically integrate, whereas firms that have not
engaged in these activities will not find it in their self-interest to vertically integrate. If these
activities are rare and costly to imitate, they can be a source of competitive advantage.
2. Rare capabilities
If a firm has capabilities that are valuable and rare, then vertically integrating into businesses that
exploit these capabilities can enable a firm to gain at least a temporary competitive advantage.
3. Rare uncertainty
A firm may be able to gain a competitive advantage from vertically integrating when it resolves
some uncertainty it faces sooner than its competition. Whereas the competition is still focusing on
flexibility in the face of uncertainty, this firm gets to focus on production efficiency in meeting
customers’ product demands, which can be a source of competitive advantage.
Firms can also gain competitive advantages through their decisions to vertically dis-integrate, that is,
through the decision to outsource an activity that used to be within the boundaries of the firm.
Whenever a firm is among the first in its industry to conclude that the level of specific investment
required to manage an economic exchange is no longer high, or that a particular exchange is no longer
rare or costly to imitate, or that the level of uncertainty about the value of an exchange has increased,
it may be among the first in its industry to vertically dis-integrate this exchange. Such activities, to the
extent they are valuable, will be rare and, thus, a source of at least a temporary competitive
advantage.
IMITABILITY OF VERTICAL INTEGRATION
The extent to which rare vertical integration decisions can be sources of sustained competitive
advantage, depend on the imitability of the decision. Both direct duplication and substitution can be
used to imitate another firm’s valuable and rare vertical integration choices.
Direct Duplication
Direct duplication occurs when competitors develop or obtain the resources and capabilities that
enable another firm to implement a valuable and rare vertical integration strategy. To the extent that
these resources and capabilities are path dependent, socially complex, or causally ambiguous, they
may be immune from direct duplication and, thus, a source of sustained competitive advantage.
Substitution
The major substitute for vertical integration are strategic alliances. See Chapter 11.
, 8.4 ORGANIZING TO IMPLEMENT VERTICAL INTEGRATION
Organizing to implement vertical integration involves the same organizing tools as implementing any
business or corporate strategy: organizational structure, management controls, and compensation
policies.
ORGANIZATIONAL STRUCTURE
The functional (U-form) structure is used to implement a vertical integration strategy. Each of the
exchanges included within the boundaries of a firm because vertical integration decisions are
incorporated into one of the functions in a functional organizational structure. Decisions about which
activities to vertically integrate into determine the range and responsibilities of the
manufacturing/marketing/etc. function within a functionally organized firm. Thus, vertical integration
decisions made by a firm determine the structure of a functionally organized firm.
The CEO of this firm is responsible for the strategy formulation and implementation. His job is also to
help resolve conflicts in ways that facilitate the implementation of the firm’s strategy.
MANAGEMENT CONTROLS
The organizational structure must be supported by a variety of management control processes. The
most important of these processes are the budgeting process and the management committee
oversight process.
Budgeting process
Budgeting is an important control mechanism available to CEO’s in vertically integrated U-form
organizations. Budgets are developed for costs, revenues, and a variety of other activities performed
by a firm’s functional managers. Often, managerial compensation and promotion opportunities
depend on the ability of a manager to meet budget expectations. However, the use of budgets can
also lead functional managers to overemphasize short-term behavior that is easy to measure and
underemphasize longer-term behavior that is more difficult to measure. For the CEO, evaluating a
functional manager’s performance relative to budgets can be an effective control device.
Adopting an open and participative process for setting budgets helps ensure that budget targets are
realistic and that functional managers understand and accept them. Including qualitative criteria for
evaluation reduces the chances that functional managers will engage in behaviors that are very
harmful in the long run but enable them to make budget in the short run.
Management committee
Vertically integrated U-form organizations can use various internal management committees as
management control devices. Two particularly common internal management committees are the
executive committee and the operations committee. The executive committee consists of the CEO
and two or three key functional senior managers, and reviews the performance of the firm on a short-
term basis. The fundamental purpose of the executive committee is to track the short-term
performance of the firm, to note and correct any budget variances for functional managers, and to
respond to any crises that might emerge. The operations committee consists of the CEO and each of
the heads of the functional areas of the firm, and tracks the firm performance over time intervals and
monitors longer-term strategic investments and activities.
COMPENSATION POLICIES
A firm’s compensation policy is also important for the firm’s ability to implement its vertical
integration strategy. The three explanations of vertical integration presented in this chapter have
important compensation implications:
