Dunbar, John O.

English

Research Papers in Economics

Approach  I
VERTICAL  INTEGRATION
John 0.  Dunbar, Extension Economist*
Purdue University
What Vertical  Integration Is
IT  IS  ONE  OF  THE ALTERNATIVE  METHODS  OF  COORDINATING  MANAGE-
MENT  AND  CONTROL  OF  FARM  PRODUCTION  FROM  FARM  SUPPLIER
TO  ULTIMATE  CONSUMER.  The alternatives are:
1.  Self-sufficient  type  farms  buying  few  supplies  and  selling direct  to
consumers.  These  are mostly individually owned and operated.
2.  Independently organized separate firms for each supply, production,
and marketing function buying from and selling to each other. These
are growing  larger  and contract  in advance  for many supplies  and
sales.  They  may  be  individually,  corporately,  or  cooperatively
owned.
3.  Vertically integrated firms each in control of performance of two or
more  functions  in the  chain of  farm supply,  production,  and mar-
keting of a specific farm commodity.  Managerial control may be by
individuals,  partnerships,  corporations,  or  cooperatives.  Vertical
integration  has  taken  place  more  rapidly  in  recent  years  in  agri-
culture.
4.  Government  action  such  as federal  milk marketing  orders.
5.  Some combination of  1 through 4.
VERTICAL  VS.  HORIZONTAL  INTEGRATION
Vertical  integration  is  tying  together  the  control  or  management
of two  or more stages  in production  of a  single  commodity  anywhere
between  the farm  supplier  and  the final  retailer,  inclusive.  Example:
A packing  company with cattle  feeding  operations.  In contrast,  hori-
zontal integration  is using two  or more plants of a firm to perform the
same stage in the "production"  process.
*The  other  members  of the  work  group  who  reviewed  the  preliminary  draft  and
assisted  in the development  of the final  report were:  Lawrence  D.  Rhoades  (Chairman),
Ronald  Bauman,  Thomas  Brown,  A.  J.  Cagle,  Lewis  Clark,  Carl  Frischknecht,  and
Robert W. Rudd.
81THE  ESSENCE  OF  VERTICAL  INTEGRATION
The integrator furnishes additional capital and assumes added man-
agement responsibility  and control ranging all the way from specifying
type  of breeding stock to deciding how much and in what way to pro-
duce  a  product,  supervising day-to-day  operations,  and taking  all pro-
duction and  price risks.  His reward,  if any,  is  increased  return for his
capital and  management.
The  integratee  gives  up part of his management  and control  in re-
turn for additional  capital or know-how  and price,  income, or market
guarantee.
MANY  ARRANGEMENTS  ARE  NOT  VERTICAL  INTEGRATION
Such arrangements  include:  (1)  standard  loan  arrangements,  (2)
open  account  credit,  (3)  contracts  to buy  this  year's  fertilizer,  or sell
products  (hogs)  to a given dealer at a price specified  in advance.  Why?
Management  or  control  is  retained  by each  of the  parties  concerned.
How  Vertical  Integration Takes  Place
1.  By  outright  purchase  by  the  integrator  of  facilities  for  additional
stages  of supply,  production,  or marketing;  or
2.  By various  contractual  arrangements  through which  the integrator
achieves  a  degree  of control  of  additional  stages  of "production."
Who  Can  Be  an Integrator?
Any individual,  partnership,  company,  corporation,  or  cooperative
can be an integrator,  e.g., farm supplier,  farmer,  assembler,  processor,
or  retailer.
Why  Vertical Integration Takes  Place
CIRCUMSTANCES  HAVE  MADE  POSSIBLE  INCREASED  MANAGERIAL
PROFIT,  THROUGH  VERTICAL  INTEGRATION,  IN  RECENT  YEARS.  These
include:
1. New  technology  which has made  profitable  the application  of more
know-how  and  increased  capital  to  the  "production"  processes.
2.  Economies  associated with size of enterprise.
3.  Increasing  numbers and changing  location of consumers.
4.  Change  in  demand  for  uniform  supply  of  standardized  products
brought about by change in size and number of retail operations.
825.  Development  of  market  power  (includes  labor  market).
6.  Substantial  capital  accumulation  in  some  segments  of  the  food
industry.
7.  Reduced  income  of small  individual  operators.
CONDITIONS  WHICH  ENHANCE  THE  CHANCES  OF  MANAGERIAL  PROFITS
1. Where  increased  control  over  a  larger  share  of the  supply can  im-
prove  price  (bargaining  power).  For  example,  closer  control  of
supply  may  result  in  price  advantages,  through opportunity  either
to  buy  the  supply  cheaper  from  farmer-producers  or  to  sell  it  at
higher  prices  to  consumers.
2.  Where  a  special  market  opportunity  exists  for  a  new  or  different
product.  A farmer  assumes  many  risks  in  producing  on his  own  a
large output of a product new to his area (feeder pigs, for example).
If a merchandiser can see profit opportunity in guaranteeing  a mar-
ket for the farmer,  he may enter into a contract with him to the ad-
vantage  of  both.
3.  Where  marketing  costs  or risks  can  be  reduced  by maintaining  a
uniform  volume  of operation.  For example,  closer  control over  an
enterprise  may  give  the  feed  dealer  or  farm  product  processor  a
larger,  more  certain  volume  of  business  and  enable  him  to  cut
processing  costs  per unit  of product.
4.  Where the firm  (farm or nonfarm)  faces a major change in "produc-
tion"  technology.  For  example,  integrators  might  see  opportunity
for profit by helping speed up adoption of new developments  to cap-
ture  the  benefits  of  such  new  developments.  The integratee  would
also be quite receptive  since he recognizes that better ways are avail-
able  but lacks necessary  ability or resources  to put them into effect.
5.  Where  increased  use  of capital and  management  resource  per unit
of  labor  or  land  would  be  profitable.  For example,  new  develop-
ments  frequently  require  substantial  additional  capital  investment
in more  efficient machinery  and  equipment  or supplies  to  cut pro-
duction  costs.
6.  Where  standarized  and  specialized  production  procedures  can  be
substituted  for  the  arts  of production.  For example,  scientific  ad-
vances  tend  to  make  production  more  of  a  science,  less  an  art.
Standardization  in  work  routines  makes  possible  specialization  of
tasks.  Much  management  planning  then  is amenable  to centraliza-
tion and  specialization.
837.  Where  producing  in  a  specified  form  and quality  and/or on  a pre-
determined  schedule  would  effect  a  real  saving  in  production  or
processing  costs.  For  example,  many  farm  products  are  currently
variable  in quality and uncertain in supply. If by applying  new tech-
nology  through  prescribed  management  practices  these  products
can be standardized  in form, package,  quality, and time and amount
of  delivery,  mass  processors  and  merchandisers  (supermarkets)
would find such changes  advantageous.
8.  Where  sufficient capital and know-how can be acquired  to combine
two or more stages of production,  retain efficiency  in each,  and cut
costs  by  eliminating  certain  market  operators  in  the "production"
process.  For example,  a farmer may produce corn  and hogs on the
same  farm,  thereby  eliminating  the  marketing  charge  of  getting
the corn from where it is grown to where hogs are finished.
Factors Which  Limit the Possibilities  for Profits
from  Vertical Integration
1.  Success in many stages of production  still depends largely upon the
arts  and skills of the operator  (e.g.,  raising baby pigs  to weaning);
hence, possibilities for the integrator to gain through use of scientific
management  are  limited.  In  other  instances,  returns  to  superior
management  are not great  enough  to cover  added  costs.
2.  For some  large firms,  public relations  would  suffer.  Public opinion
might  demand  anti-trust  action  against them.
3.  Given present  levels  of management,  additional capital will  not be
available for some firms to expand into integrated set-ups.
4.  Many non-integrated  firms  or farms are large enough,  well enough
financed,  and  well  enough managed  to have adopted  latest equip-
ment, scale economies,  and technology; hence, integration offers no
economic  gain.
5.  Many  individuals  who might be taken  into the integrated firm pre-
fer to operate and manage their own business,  even though their net
income  may  be  less.
6.  Market  organization  for  many products  is  already  well  developed
and  is  "carrying  signals"  fairly  efficiently  from  consumer  to  pro-
ducer.
7.  Increasing  scale  may  result in  diseconomies.
84Consequences  of  Vertical Integration
This  list of consequences  applies  to those segments  of the agricul-
tural industry where the advantages  of the vertical integration outweigh
its  disadvantages.  As  indicated  previously,  numerous  limitations  to
this method of organizing  production  may be expected  to preclude  its
wholesale  adoption  throughout  the entire agricultural  system.  This  is
not a forecast  of how much vertical integration  will  take place.
EFFECTS  OF  VERTICAL  INTEGRATION  ON  PRODUCTION  AND  DISTRIBU-
TION  OF  PRODUCTION  (including  farm supply  and marketing  service)
1. More  rapid  adoption  of  new  technology,  greater  specialization  of
labor, more capital per man,  increasing output per man, etc.
2.  Reduction in number  of firms with an increase in the  size and busi-
ness power of the  remainder.
3.  Concentration  of  management  of  the  several  stages  of  food  pro-
duction  and marketing  into  the hands  of  fewer  and  fewer  people,
which should result  in more efficient  use of other resources.
4.  More  rapid  shifts  in  areas  of production,  resulting  in more highly
specialized  areas  of production.
5.  More uniform flow  of products  to market as:  (a)  fixed costs are in-
vested  in production facilities  at various stages which must be used
year-round to maximize  profits and  (b)  profits and losses are trans-
ferred from one stage to the other at various  times.
6.  More uniform quality of products  as a few well-informed  managers
controlling  quality  in  larger  and  larger  areas  of  production  are
substituted  for a multitude of less well-informed  managers.
EFFECTS  ON  CONSUMPTION  AND  THE  DISTRIBUTION  OF  CONSUMPTION
1.  Cost of food  products  to the consumer  will be  lower as  a result of
cost  reduction  achieved  by integration.
2.  Consumers  will  receive  a  more  even  flow  of  uniform,  quality
products.
3.  Consumer tastes will be reflected more quickly through the market-
ing  system.
EFFECTS  ON  THE  MARKET  SYSTEM
1. Integration well developed in certain areas  will tend to reduce facil-
ities  that  serve  independent  producers,  i.e.,  producers  who  choose
85to remain independent will have increasing difficulty in obtaining the
services of suppliers  or market agencies  locally  at favorable  prices.
2.  Less of the total supply of farm production will flow through terminal
markets,  thus more pricing will be done  by negotiation.
3.  Inefficiency  and waste  in  the marketing  system  will be  reduced.
4.  Marketing power will be increased. Even though a firm may increase
its market power,  freedom of entry for other firms  will be retained.
5.  Control  points  in the marketing  system  will be shifted  to fewer  key
decision  makers.
EFFECTS  ON  INCOME  AND  DISTRIBUTION  OF  INCOME
1. For  some  small  producers  who have the  basic abilities  for  efficient
production,  but have been  handicapped  by lack  of financing,  etc.,
integration  will offer  a way to operate larger, more profitable  enter-
prises.  For  others,  integration  will simply  speed  the day when  they
will be forced  to  seek more advantageous  employment.  Some  indi-
viduals may look to integration  as a chance for survival. However,  if
they cannot grow  in  efficiency  and  business  volume,  they may  sus-
tain  a  loss in  the  effort.
2.  In some  instances,  integration  will  shift  the areas  in  which job op-
portunities  are  available.
3.  Potential  for  unionization  of  agricultural  labor  will  be  greater  as
more  of the  labor  for farm  production  becomes  hired.
4.  The income  of many  farmers and others will fluctuate  less annually
due  to  guaranteed  fixed  payments  for  services.  Many will  become
employees.
5.  Profit margins  per unit at all stages of the production and marketing
process  will tend to be reduced.
6.  In the short run, to the extent that integration speeds up the applica-
tion  of  new  technology  in agricultural  production,  it will  increase
farm production,  reduce  prices of farm products,  and aggravate the
income problem in agriculture. It does  not provide for governmental
control of agricultural production,  hence,  is not a public policy solu-
tion  to the  general  price and income  problem in  agriculture.
7.  In  the  longer  run,  the  change  in  cost structure  of  agriculture  as  a
whole  tends to  result  in quicker  adjustment  to changing  price con-
ditions.8.  As  farm  labor  becomes  more  "industrial"  in  character,  a  higher
percentage  of farm producers  will come  under unemployment  com-
pensation  laws.
9.  Greater  income  premiums  will  be paid for special  skills.
SOCIAL  AND  POLITICAL  IMPLICATIONS
1.  Pressure  will  increase  against  the combination  of owner-manager-
laborer in one man as the typical institutional pattern of farm opera-
tion.  We  have  departed  from  this  pattern in  the  majority  of other
major  business  sectors  of  America.  When  such  changes  have  oc-
curred,  opportunities  for profit have increased for owners, for man-
agers,  and  for  workers.  Some  individuals  were  injured  in  the  ad-
justment,  but  on the  whole,  society  gained.
2.  Vertical integration  in agriculture will be resisted.  Political pressure
for maintenance  of small  family  farms  will  continue,  even  though
modern  technology  dictates  strongly  that  family  farms  become
larger.
3.  Our typical system  of fee simple ownership  by individual  operators
will be  under increasing pressure.  More  farms will be under family
ownership  managed  by professional  managers.  More will  be oper-
ated on  a multiple  tract basis.  Problems  of transfer  will increase  as
the  size  of unit  grows,  as  financing  becomes  more difficult.
4.  Fewer farmers  inevitably means decreased  political  power for agri-
culture.  Chances are, however, that farmers remaining in agriculture
will be better organized. And some political support for farm orient-
ed  measures  will  always  come  from  communities  and  businesses
closely allied with  agricultural production.
5.  Governmental  aid,  perhaps  through  the Extension  Service,  will be-
come  available  for producers  to organize  bargaining  units  to deal
with  processors  on matters affecting  price and production  arrange-
ments.
6.  The  amount  of regulation  over the entire  marketing  structure  will
increase.  This  growing  maze  of  market  regulation  will  move  us
further  and  further  away from  the traditional  concept  of  the  free
competitive  market.
7.  Governmental  discrimination  will  grow  against  the larger  proces-
sors  and  marketing  agencies  who attempt  to initiate  integrated ar-
rangements.  Larger concerns  which attempt  integration,  especially
under  direct  arrangement  with  producers,  will  face  continuing
harassing  action from  the Federal  Trade Commission,  the Depart-
ment of  Justice,  and  Congress  itself.
87BIBLIOGRAPHY
Abrahamsen,  Martin A.,  and Engberg,  Russell  C.,  "Integrated and Related  Opera-
tions,"  Central  Carolina  Farmers  Exchange,  General  Rpt.  44,  U.  S.  Department
of  Agriculture,  June  1958.
Bailey,  John  M.,  and  Engberg,  Russell  C.,  "A  Study  in  Economic  Integration,"
General  Rpt.  45,  U.  S.  Department  of Agriculture,  June  1958.
"Contract  Farming and  Vertical  Integration  in Agriculture,"  Agr. Information  Bul.
198,  U.  S. Department  of Agriculture.
Engelman,  Gerald,  'Integration  in  the  Livestock  Industry,"  Agricultural  Market-
ing Service,  U.  S.  Department  of Agriculture,  April  4,  1958.
"The  Impact  of  Integration  on  Animal  Agriculture,"  Proceedings,  Eighth  Annual
Meeting  of the  National  Institute  of Animal  Agriculture,  Purdue  University,  April
20-22,  1958.
Kohls,  R.  L.,  "Decision-Making  in  Integrated  Production  and Marketing  Systems,"
Paper  delivered  at  the  American  Farm  Economic  Association  meeting,  August
1958.
Larson,  Nellie G.,  "Contract  Farming  and Vertical Integration-A  Selected  List of
References,"  Library  List  64, Agricultural  Research  Service,  U.  S.  Department  of
Agriculture,  1958.
Mueller,  Willard  F.,  "The  Economics  of  Vertical  Integration,"  Speech  given  at
Thirtieth Annual Meeting  of the American  Institute of Cooperation.
Report  of Subcommittee  No.  6  of  the  Select  Committee  on  Small  Business  of the
House  of  Representatives,  Hearings  held  in  1957  on  Integration  in  the  Broiler
Industry.
Saunders,  Richard  F.,  "Contract  Broiler  Growing  in  Maine,"  Maine  Agr.  Expt.
Sta.  Bul.  571, May  1958.
88PART  II
Major Problems and Trends
in Farm Policy

APPROACH I: VERTICAL INTEGRATION

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