Vertical Integration
Vertical integration requires performing your customer’s role(upmarket) or your supplier’s (downmarket) role. Upmarket vertical integration can be considered by big businesses who already have customers or by startups with no customers. For both big businesses and startups, it allows the business to potentially move into a new market, which would be more desirable with properties such as higher margin, better defensibly, or easier to sell to customers. For startups, upstream vertical integration can be appealing when customers are reluctant to buy the product or when different customers have varying needs and building a product that satisfies all of them is difficult. Finally, if the business is able to successfully disrupt and gain market share of the upstream market, then its advantages compound. The scale and business of suppliers will start to suffer, which gives the vertically integrated company even more of an advantage. Consequently, the business may be able to eventually eliminate competitive suppliers. This creates a bigger barrier to entry as the new competitors must now perform the upmarket and downmarket role. This strategy only works if the competitive suppliers primarily supply the specific upstream vertical and do not supply other verticals.
Although upstream vertical integration has its advantages, it also has its disadvantages. The upstream product must be better than the upstream competitors or the business dies. It must deal with all the challenges of entering a new market. The only initial advantage the business has on its competition that is has exclusive supply to its product that can be tailored it to its specific needs and no leaked margins/overhead of having to deal with suppliers. The upstream business may be in fact disadvantaged because it must use its own downstream business and not any other supplier. Different suppliers may experiment with different technologies and thus continually being the best supplier may be difficult. Furthermore, the overall system and required inputs for the startup have grown; thus, startup will have to divide its resources and will be bottle necked by the slowest part and will . Vertical integration creates cyclical dependencies between the downstream service and the upstream service. If the downstream business declines, the upstream business will be disadvantaged and consequently the downstream business might get less resources and have less demand, reducing its economy of scale and its quality. Finally, the whole company is bigger and less flexible for strategic changes.
Big businesses already have initial customers who are using their product. They can either stop selling their product or continue to offer their product while competing with them. Continuing to offer the product to everyone eliminates the advantage of exclusive access to the product but at the same time allows the company to not sacrifice existing business and lessens risk and dependencies. Amazon is following this strategy by still allowing suppliers to use the marketplace and its warehouses but at the same time offering Amazon Basics. Startups can frequently vertically integrate at a small scale to understand their customers better and demonstrate value to the rest of the market. After these small number of pilots, the startup can return to being a supplier.
Downstream vertical integration is another strategy that companies such as Apple are using by making their own custom asics. This strategy derisks the company from suppliers, who can be unreliable and low quality. Furthermore, suppliers might capture super high margins and integrating downstream will help reduce them. Downstream integration allows customization of that supply for the specific business and can lead to better product. Similar to upstream integration, the company can use this combination of upstream and downstream integration to eliminate suppliers and increase barriers to entry. However, downstream integration suffers from most of the disadvantages of upstream vertical integration including having to compete in a new market, locking into a specific supplier even if a better one emerges, being bottlenecked as there are more inputs, increased risk, and limited flexibility. Although the downstream business will get sales from the upstream business, it can not sell to others and thus may suffer from limited economies of scale.
