Gasoline Price Changes - Federal Trade Commission

THE DYNAMIC OF SUPPLY, DEMAND, AND COMPETITION
A. Vertical Integration May Be Cost-Effective for a Firm.
As a general matter, firms may integrate vertically – that is, own assets to perform more
than one step in the production, distribution, and marketing of a good – because integration can
lower costs. In certain circumstances, vertical integration can (1) reduce transaction costs; (2)
prevent contractual partners from taking advantage of a firm; (3) eliminate double markups and
thereby increase overall demand for a product; and (4) eliminate distortions of input choices
when a supplier has market power. 54
1. Reduce transactions costs.
When two separate firms enter into a supply relationship, they must negotiate the terms
of that supply relationship. For example, the two firms must agree on and enforce prices,
quantities, and other terms of trade. Such contract negotiations cost money in terms of personnel
time, legal advice, and other matters. Vertical integration can reduce such transactions costs, if it
is easier to establish these terms through direct managerial control of two business units than
through either (1) long-term contracts, or (2) repeated, arm’s-length transactions with firms
selling in spot markets. 55 If the mutually beneficial terms of the trade between two vertically
related business units are complex, and it is difficult to specify all future contingencies within a
contract, using direct managerial control is likely to reduce transactions costs below those
associated with contractual relationships.
2. Prevent opportunism by contractual partners.
To prevent contractual opportunism means to eliminate the risk that one party to a
contract will take advantage of the other. This can happen if a contract is “incomplete” – that is,
the contract fails to specify the rights and obligations of the parties in all possible circumstances.
When a contract is incomplete, unforeseen circumstances may allow one of the firms to benefit
unduly from the terms of the contract. This type of risk tends to be more significant when
potential contract partners need to invest in specialized assets to create the value resulting from
the proposed contract. For example, a very heavy grade of crude oil might require special, longlived
investments in refinery-processing equipment to produce high-value refined products.
These special investments, however, may have relatively little value in processing other types of
crude oil. Therefore, to make such investments worthwhile, a refiner would need a reliable
source of heavy crude oil. To rely on a long-term supply contract with a producer of heavy
crude oil, a refiner typically would require the contract to be sufficiently complete. To negotiate
a sufficiently complete contract may be very costly, however. If a sufficiently complete contract
could not be negotiated, vertical integration between the very heavy crude oil producer and the
refiner might be required to achieve the transaction.
CHAPTER 5: STATE & LOCAL POLICIES, & VERTICAL INTEGRATION 119