CHAPTER FIVE

CONSOLIDATION OF MARKET POWER: INTEGRATION, MERGER

& DIVERSIFICATION
❖Diversification
▪ The typical unit of analysis in microeconomic theory is a single-product, single-plant firm
serving a single market.
▪ In practice, however, many firms produce a range of products and serve or a number of
markets.
▪ Thus, such companies are described as diversified.
▪ Diversification occurs when a single-product firm changes itself into a multi-product or
multi-market firm.
▪ Mostly, in diversification firms involve themselves in products related to their initial
activity, providing a degree of coherence and economic logic that may have initially.
▪ However, where the firm diversifies into products that are unrelated, the economic benefits and
logic are not so easily identified.
➢Types of Diversification Strategies
▪The strategies of diversification can include:
✓ Internal development of new products or markets
✓ Acquisition of a firm
✓ Alliance with a complementary company
✓ Licensing of new technologies, and
✓ Distributing or importing a products line manufactured by another firm.
▪Generally, the final strategy involves a combination of these options.
▪This combination is determined in function of available opportunities and consistency with the
objectives and the resources of the company.
❖ There are three types of diversification:
1. Concentric diversification
2. Horizontal diversification
3. Conglomerate diversification
[Link] diversification; It is a growth strategy in which a company seeks to grow and
develop by adding new products to its existing product lines to attract new customers.
✓ It is also called convergent diversification.
▪Concentric diversification is a growth strategy that involves adding new products or services
that are related to the company’s existing business.
▪Under concentric diversification, a firm adds new but related products.
▪In other words, to increase the revenue and grow its business, a company adds new but similar
products to its existing product lines.
▪The similarity could be in terms of distribution, technology, customer usage, and managerial
skills.
▪By coming with similar products, a firm is able to benefit from its current infrastructure,
experience, and technical expertise.
▪Basically, the new product is a “strategic fit” to the company’s present line of business.
▪The goal of concentric diversification is to pull the company’s existing competencies and
resources to enter new markets and grow its business.
▪This means that there is a technological similarity between the industries, which means that the
firm is able to leverage its technical know-how to gain some advantage.
▪It also seems to increase its market share to launch a new product which helps the particular
company to earn profit.
▪Alternatively, Concentric diversification refers to the development of new products and services
that are similar to the ones you already sell.
▪Examples:
1.A company that manufactures industrial cements might decide to diversify into cements to be
sold via retailers.
▪The technology would be the same but the marketing effort would need to change.
[Link] orange juice brand releases a new “smooth” orange juice drink alongside it’s hero product,
the orange juice “with bits”
[Link] automobile company adds a solar-powered car to its eco-friendly auto line.
4.A manufacturer of computers who is experiencing a decline in PC sales.
✓ Thus, to boost revenue, the computer maker can start selling laptops and tablets.
5.A pizza restaurant adds pasta and calzones to its menu.
[Link] diversification: it is a growth strategy in which a company seeks to add new
products to its existing lines that will appeal to its existing customers.
❑Horizontal Diversification is a growth strategy in which a company seeks to add to its existing
product lines with improved versions of the originals or with new products that add value and
appeal for its current customers.
✓The Company adds new products or services that are technologically or commercially
unrelated (but not always) to current products, but which may appeal to current customers.
✓A Firm can adds new products to a company's lines that are meant to serve existing customers.
✓When a company decides to use horizontal diversification, they might add products to one of
their current product lines that do not relate to the other products in the line.
✓This can allow for new products to appeal to customers that already make purchases at a
business by offering new ways to meet their needs.
✓Horizontal diversification might also involve creating new product lines that offer products
that differ from previous product lines.
➢What steps should be followed?
▪Horizontal diversification works by identifying a need for a product and trying to fill that need
with a new product that does not already exist in a company's product lines.
▪To determine where they might need to engage in horizontal diversification, a company might
conduct market research by offering feedback surveys to its customers, looking into consumer
behaviour or analysing sales performance for different products that they offer.
▪Performing research about where horizontal diversification can help that company's employees
decide which products they might start manufacturing and selling to customers either within
existing product lines or in new product lines.
▪This form of diversification is desirable if the present customers are loyal to the current
products and if the new products have a good quality and are well promoted and priced.
▪Examples:
[Link] retail having a reputation for selling quality jewelry can diversified using horizontal
diversification, by start selling premium perfumes to magnify the revenues.
2.A company was making note books earlier now they are also entering into pen market through
its new product.
▪One clear benefit of horizontal diversification is the chance for a company to grow its product
lines.
▪Because horizontal diversification often involves introducing new products to existing lines in
the interest in better serving current customers, it can result in product lines being expanded and
becoming more complete and varied.
[Link] diversification (lateral/unrelated diversification): It is a growth strategy in
which a company seeks to develop or grows by adding totally unrelated products and markets
to its existing business.
▪Mainly involves offering new products or services to new customers. It is used as a strategy to
grow on the market and gain new customers, which are no interested in current offerings.
▪New products and services created during conglomerate diversification strategy, are usually
totally different than products or services currently in the offering.
▪Main goals of conglomerate diversification is to grow sales and profits in the same time
maintaining current marketing activities.
▪The company needs to market new products or services that have no technological or
commercial interactions with current products, but which may appeal to new groups of
customers.
▪ The conglomerate diversification has very little relationship with the firm's current business.
▪ Why this types diversification is needed?
▪ The main reasons of adopting such a strategy are;
✓ First to improve the profitability and the flexibility of the company, and
✓ Second to get a better acceptance or recognition in capital markets as the company gets bigger.

❖Examples
▪There is no limited example in this case:
[Link] diversification involves adding new products or services that are significantly
unrelated and with no technological or commercial similarities.
▪For example, if a computer company decides to produce notebooks, the company is pursuing a
conglomerate diversification strategy.
2. Real-life example of Amazon’s diversification strategy.
▪Amazon is a multinational company that provides various online services such as; e-commerce,
cloud computing, email delivery, online video, music streaming, e-payment, and affiliate
marketing.
▪Apart from this, Amazon also introduced a virtual assistant
▪Further, it operates brick-and-mortar stores in the United States.
❖Motives for Diversification
✓ Why firms need to engaged with diversification?
▪When a company's current goals, like profit and growth, can no longer be achieved with its
current product, diversification may become necessary.
▪Because of the threat to profitability, diversification is something to think about.
▪Nevertheless, a variety of push factors resulting from the firm's current situation may be
responsible for the adoption of a diversification plan.
❖ Push factors may include:
[Link] limited size of the existing market
[Link] existence of underutilized assets that might be used to produce new products or manage
new activities; and
[Link] investment resources that could be used to finance new activities.
❖Pull factors:
▪There may also be a number of pull factors, or incentives, for firms to adopt diversification.
▪Managers may also be pulled toward diversification where the potential rewards from investing
in new market opportunities promise greater profitability than ploughing them back into
existing activities.
▪The greater the profit potential of new activities compared with its existing activity the stronger
the pull.
▪However, any diversification will have a higher degree of uncertainty attached compared with
the more certain but limited returns in existing activity.
▪Therefore, diversification may be a high-risk strategy because it involves new products, new
markets and the commitment of financial and managerial resources for uncertain returns.
❖The treats and risks of Managers:
▪The pursuit of diversification may be strengthened by the need to make sufficient profits to
keep shareholders happy and to maintain the valuation ratio of the firm.
▪If this cannot be achieved, then shareholders may prefer to see retained earnings returned in the
form of dividends.
▪The term of the current management may be threatened by a poor stock market performance,
either as a consequence of shareholder dissatisfaction or as a result of outside interests
purchasing assets they believe to be undervalued..
▪Therefore, managers must also consider the threats and risks posed to the firm as a consequence
of diversification.
❑The following can be some of the motives of diversification.
[Link] of the firm’s resources
[Link] of scope and size
[Link] the volatility of profits and risk spreading
[Link] synergies; (Refers to the improvements in financial activities and conditions)

[Link] risks and rewards

[Link] pursuit of growth
[Link] costs (cost of using vs selling unutilized resource to the third parties)
[Link] power
[Link] of the firm’s resources
[Link] better use of the firm’s existing assets and competences could lower unit costs and
increase labour and capital productivity.
[Link] use could be made of Indivisible plant and equipment by making new products
alongside existing ones.
[Link] distribution and logistics system by distributing related goods to the same outlets.
[Link] marketing department to advertise and promote the new product using its accumulated
knowledge and expertise of particular markets and customers.
[Link] brand name to sell new products using the goodwill built up for its existing branded
products. brand names and knowledge.
[Link] earnings that are not required to develop current activities can be used for
investment in new activities rather than keeping them in the non-interest earning form of cash.
[Link] talent, in general and specific functions of the firm to extend its range of
activities.
[Link] of scope and size
▪Economies of scope arise from the nature of the production function, so that two or more
products or activities can be produced more cheaply together than separately. These benefits are
not available to single-product firms.
▪The increase in size of the firm that comes with diversification may also produce economies of
size. For example, an increase in size might mean that larger firms may be able to use its buying
power to obtain lower cost inputs. The extent to which this is possible may depend on the degree
of relatedness between the various activities of the firm.
▪Economies arising from buying power may only be achieved where common raw materials are
used in several activities.
▪Marketing benefits may only be achieved if the same methods are applicable to different
activities.
▪ Size may also allow the company to achieve lower management costs through organizational
efficiency.

▪ Diversification may be a spur to a firm adopting more cost-effective organizational forms.

✓ This structure allows the firm to add new activities and new divisions with limited
disturbance to existing activities.
[Link] the volatility of profits and risk spreading
▪A single-product, single-market firm is vulnerable to unpredictable and cyclical variations in
demand and input costs, as well as to long-term decline in demand.
▪These lead to cyclically fluctuating revenue and costs and hence profits, as well as to profits
that are potentially in secular decline.
▪Therefore, diversification is a way for the firm to reduce the dispersion and offset the decline in
profits.
▪Cyclical variations can be offset by the acquisition of products whose sales move counter-
cyclically to its existing product, while secular decline can be offset by acquiring products
exhibiting long-term growth.
▪Such diversification strategies are intended to both stabilize and prevent the firm from making
losses, because such diversification may be a strategy designed to avoid bankruptcy and the
death of the enterprise.
▪Diversification enables a firm to spread risks by offering a degree of insurance against
unexpected changes in any one market for any one product.
▪A market shock affecting a single product will have greater impact on a specialist firm’s profits
than those of a diversified one.
▪A diversified company with a portfolio of two products whose sales move counter-cyclically
can achieve a more even flow of revenues.
▪Counter-cyclical activities could involve products whose cycles are inversely related to existing
products and products whose cycles lag behind other products and reach their peak at different
times. Together, the difference between highs and lows in overall sales can be reduced.
[Link] synergies; (Refers to the improvements in financial activities and conditions)
▪Diversification may limit profit variability and, hence, variations in dividend payments to
shareholders; this may give the firm a cost of capital advantage compared with firms whose
profits are more variable.
▪The firm may find it can raise new equity capital and loans on advantageous terms that are
unavailable to firms with greater profit variability.
▪If the firm has a choice between equity and debt finance, then a more stable profit and dividend
flow will allow the firm to increase the proportion of its finance raised through debt capital.
▪The greater stability of earnings reduces the risk to debt holders of not receiving their interest
payments.
▪Equity capital is the capital that a company raises by selling equity securities or shares to
investors.
▪It represents the core funding of a business and is used to finance the growth and development
of a company.
▪Debt capital refers to the money that a company raises by borrowing from investors or lenders.
▪Debt capital is a common way for companies to raise funds for their operations or expansion.
▪The company pays interest on the borrowed amount and is required to repay the principal
amount at the end of the loan term.
▪Debt capital may also offer tax advantages to the firm, since the interest payments are treated as
a cost rather than an element of profit. Dividends in contrast are regarded as profits distributed
to shareholders.
▪Thus, if a firm wanted to raise an equal amount of capital using debt and equity, then the level
of corporation tax payable would be higher if the equity method was chosen.
▪A diversified share portfolio enables them to stabilize their incomes.
[Link] risks and rewards
▪Unlike their shareholders, senior managers of a corporation are unable to diversify their job risks
▪If the company performs poorly, the managers risk being fired by the shareholders or having the
business acquired by another company.
▪As a result, it is in the interests of senior managers to diversify the activities of the firm to reduce
the variability of overall profits, dividends and, hence, share price to reduce the risk of their own
dismissal.
▪If managerial rewards are also tied to the size of the firm, then growth by diversification satisfies
both their need to protect security of employment and the desire to see the remuneration package
increase in size.
▪However, if managers take diversification too far in pursuit of managerial security, then it may
eventually reduce profitability and bring managers into conflict with shareholders.
[Link] pursuit of growth
▪Diversifications is thought as a potential component of the company’s growth strategy.
▪Diversification can help to secure the growth of assets, sales, and earnings in a addition to
lowering risks.
▪Companies whose main goal is expansion will want to break free from the limitations of their c
urrent, slow-growing markets.
✓ This push effect will be higher the larger its market share and the greater the percentage of sales coming from
slow-growing markets, making it more challenging to grow sales and acquire competitors.

▪When a product is at an early stage of its life cycle in one market and in a late stage in another,
businesses may be drawn towards other geographical markets.
▪The goal of growth will stimulate the purchase of other companies with portfolios of potentially
lucrative new goods if the firm does not already have one.
▪The rate of growth of demand for existing products is a constraint on the growth of the firm.
▪This constraint can be overcome if the firm diversifies into new products that are being sold in
faster growing markets.
▪Diversification is a risky strategy in that all new products do not necessarily succeed in
winning profitable positions in markets. Whether they do so or not depends on the number of
consumers who switch expenditure to the new products.
▪The impact of a strategy of diversification on profits will depend on the number of
diversification projects undertaken. Initial ones might earn higher rates of profit than later
ones, because the most profitable projects are undertaken first.
[Link] costs (cost of using vs selling unutilized resource to the third parties)
▪The transaction cost framework has been used to explain the boundaries of the firm.
▪Efficiency-based arguments for diversification have to be compared with the alternative of
using the market.
▪Only if the gains from utilizing unused resources internally exceed the gains made by arranging
to sell the use of the resources to third parties can the efficiency arguments for diversification
hold.
▪For diversification to yield competitive advantage requires not only the existence of economies
of scope in common resources but also the presence of transaction costs that discourage them
from selling or renting the use of the resource to other firms.
▪It is not only efficiency gains but also the presence of transaction costs that discourage the firm
from selling or renting the resources to other firms.
▪Transaction costs are likely to be substantial when intangible assets, such as brand names and
technical knowledge, are involved.
✓ Likewise, the more tacit the knowledge and the more unique it is to the firm the lower its value outside the firm.

▪If a firm jointly produces two products, then the efficiency argument is that the combined costs
of making both goods are less than if they are made separately.
✓ The alternative to both products being produced by a single enterprise is for a contract to be agreed between the
producer of product 1 and product 2 to jointly produce the two products.

▪For example, spare printing capacity owned by a newspaper may be used to justify the launch
of a new newspaper.
▪The alternative is for the newspaper to sell its spare capacity to another company requiring
printing facilities. An alternative arrangement is to have the relationship between newspaper
firms and printing firms regulated by contract rather than ownership.
▪A contractual arrangement might be more expensive or less expensive than joint production
within the firm. Thus, if the production costs are the same for both arrangements, then the
choice between the two alternatives requires a comparison of governance and transaction costs.
▪If the transaction costs of writing and enforcing contracts are greater than the governance costs,
then the firm may find diversification the preferred option. However, the alternative to using
excess capacity to diversify is to rent the excess capacity to other potential users.
▪Therefore, the transaction cost approach calls for closer assessment to see whether the
efficiency arguments for diversification are justified.
▪The firm should always consider the alternative of seeking to sell spare resources to outside
users and, therefore, identify the core activities of a diversified firm.
▪The transactions cost approach also focuses attention on the potential failures of the market
system to organize these resources.
[Link] power
▪Diversification does not add to the market power of the firm in the sense that its market share is
increased in a single market.
▪However, it does increase its ability to adopt other anti-competitive practices.
▪The ability to do so comes from the strength of the company to finance activity in one market
with support of profits made in another.
▪The implication is that diversified firms will thrive at the expense of non-diversified firms not
because they are more efficient, but because they have access to what is termed conglomerate
power, which is derived from the sum of its market power in individual markets.
▪A diversified firm can engage in practices unavailable to single-product enterprises. It might
engage in predatory pricing to make life difficult for competitors and possibly drive them from
the market.
❑Benefits and Costs of Diversification
▪The benefits of diversification give the firm cost advantages for given ranges of output and
revenue possibilities:
✓ For example, using excess capacity to produce an additional product must have finite
possibilities.
▪Competences whose capacity expands with use would seem to have no limit to their
exploitation.
▪In practice, the firm has to combine cost advantages and disadvantages and determine the
optimal degree of diversification that aids the maximization of profits.
▪Diversification that initially leads to cost savings may later lead to cost increases; this is more
likely to happen the further the firm moves from its core activities and the larger the firm
becomes.
▪Increases in the number of products produced and markets served, particularly if they are
unrelated to the core activities of the firm, may eventually lead to there being no synergy gains,
while additional activities add more to the management costs of the enterprise.
➢ The relationship between diversification and profitability can involve four scenarios:
[Link] increases
[Link] decreases
[Link] increases initially and at some point starts to decline and
4. Profitability decreases initially but at some point starts to increase.
▪Cross-sectional studies show an inverted U-shaped relationship between profit and
diversification. Or
▪Profit initially increases, but the more diversified the company becomes so the rate of profit
declines.
▪Thus, diversification taken too far eventually brings increasing costs and reducing profitability;
this is attributed to greater administrative and managerial costs the more diversified and
complex the firm becomes, leading to information distortion and control loss.
▪Managerial assets that can initially cope with diversification may be less able to do so the more
diversified the firm becomes.
▪The competences and skills of the managerial team may become less appropriate the farther
away the new activities are from the original ones of the firm.
▪For example, techniques appropriate to managing oil refineries may not be appropriate to
managing supermarkets.
▪Organizational structures may likewise become inappropriate for a larger and more diversified
firm, leading to increases in management costs and less effective management as the span of
control increases.
▪The ending of synergy benefits will also contribute to increasing costs.
▪Therefore, a position can be envisaged where the marginal benefits of increased
diversification decrease and marginal costs increase.
▪The optimal level of diversification occurs at a point where marginal benefits equal the marginal
costs of diversification.
▪Another problem with increasing diversification is that shareholders and financial markets find
it increasingly difficult to value the firm because of the wide range of activities, the disbelief in
effective internal capital markets and the absence of appropriate valuation techniques for highly
diversified firms; this leads to a decline in its valuation ratio as shareholders sell rather than buy
shares.
▪Thus, if shareholders believe, rightly or wrongly, that the enterprise may be more valuable
broken into its component parts than as a single enterprise, then the management may be forced
to yield to shareholder pressure and split its businesses.
▪If demand for the product is growing more quickly in a geographically separated market, then
the firm may be able to increase its growth rate by selling in this new market, assuming it can
gain a position in the market and achieve a faster rate of growth.
▪However, entry into a new market incurs marketing and transport costs that are likely to be
higher than those of existing firms;
✓ This will result in lower profits unless in time the new entrant can match the cost levels of the
incumbents.
❖INTEGRATION
▪It refers to the operations by a firm in two or more industries representing successive stages in
the flow of materials or products from an earlier to later stage of production or vice versa.
▪Thus, it is a type of diversification but it may be looked as ‘vertical concentration’, and if the
process takes place by merging of two different firms then it is ‘vertical merger’.
▪However, vertical integration is a popular term for all these. Essentially, it is the integration
among intermediate products used in production of a commodity.
▪It may be initiated in either way, i.e., a firm itself starts manufacturing all of them or different
firms producing goods at different stages of the process and merge together.
➢Types of Integration
▪Integration of firms may be either horizontal or vertical in nature, or conglomerate.
[Link] integration occurs when a business merges with or acquires another business. It is
the acquisition of additional business activities at the same level of the value chain. Here,
businesses in the same industry and which operate at the same stage of the production process
are combined.
[Link] integration is the process in which several steps in the production and/or distribution
of a product or service are controlled by a single company or entity, in order to increase that
company's or entity's power in the market place.
[Link] vertical integration: This involves acquiring a business operating earlier in the
supply chain – e.g. a retailer buys a wholesaler, a brewer buys a hop farm.
[Link] vertical integration: This involves acquiring a business further up in the supply
chain – e.g. a vehicle manufacturer buys a car parts distributor
[Link] integration occurs when a business moves into a totally different area.
❑ The foregoing discussion focuses on vertical integration in particular.
➢ Vertical integration occurs in one of two ways;
▪Forward vertical integration occurs when a business acquires another business, which brings it
closer to the customer.
▪Backward vertical integration move closer to its sources of supply.
▪Vertical integration involves joining together under common ownership a series of separate but
linked production processes. Such a strategy is used by many enterprises to widen the boundaries
of the firm and to enlarge its size.
✓ A decision by a firm to integrate vertically alters both the boundaries and the size of the firm. The production
of goods and services involves a chain of linked activities from raw materials to final product. At each point
the product of the previous stage is used as input for the next stage of production.
✓ Ultimately, all the various inputs are combined to meet the demands of final consumers. Vertical integration is
the outcome of a make or buy decision. If the firm decides to make its own inputs, then it becomes vertically
integrated. If it does not, then it remains vertically unintegrated.
▪Vertical integration is often taken to mean that the firm will either supply all its requirements
for a particular input or use all the output it produces.
▪However, vertical integration does not necessarily imply that all the output of every stage is
used only within the firm. Nor does it mean that all inputs are produced within the firm. It may
suit the firm to sell some output at some stages and to buy some inputs at other stages, resulting
in partial integration.
▪Vertical integration in the business sense is the ownership by one firm of two or more vertically
linked processes. The more stages owned and controlled by one firm the greater the degree of
vertical integration.
▪Traditionally, the emphasis has been on ownership of successive stages and has generally been
understood to be an all or nothing concept. However, some writers have placed the emphasis on
control rather than ownership.
❑Motives of Vertical Integration
▪Firms may decide on a strategy of vertical integration for a multitude of reasons that do not lend
themselves to neat economic categorizations.
▪The various motivations can be categorized under four main headings:
[Link] gains in terms of technological joint economies.
[Link] ability to avoid imperfect markets.
[Link] cost savings.
[Link] and planning and avoidance of volatile markets.
▪Porter suggested examining the advantages to a firm of pursuing a strategy of vertical
integration under six headings: cost savings, increased control, improved communications,
changed organizational climate, operations management and competitive differentiation.
▪Moreover, we will examine the reasoning suggested for firms engaging in vertical integration
under two broad headings:
[Link] explanations and
[Link] explanations (associated with transaction cost economics).
▪In general terms, both sets of explanations are looking for factors that result in increasing
profits or reducing costs, as well as reducing risk, uncertainty and volatility.
▪In addition, the modern view sees vertical integration as a trade-off between technical and
agency, or managerial efficiency.
▪The traditional explanations for firms seeking to vertically integrate are:
[Link] establish a source of supply if none exists.
[Link] secure cost savings by bringing under single ownership technologically linked processes.
[Link] ensure the quality of the input.
[Link] weaken the position of a supplier who appears to be making excessive profits and hence:
[Link] secure a supply of inputs at lower prices.
[Link] control retail outlets and ensure market presence.
[Link] strengthen monopoly power and raise barriers to entry.
▪Technical efficiency and production cost savings linking the production of an input and output
through ownership produces a more cost-effective solution.
▪Significant cost savings can be made by linking the production of a key input with a given
product.
▪Production cost economies resulting from locating successive stages of production next to each
other do not necessarily require single ownership of each stage: independent firms will locate
such plants close to the source of the input if there are significant gains to be made.
▪The controller of a firm inside an integrated firm has the power to allocate resources among div
isions and to change output at various stages of the process.
▪If the input is obtained from a separate supplier, the company seeking a change in supply will ne
ed to renegotiate or enforce the terms of the contract.
▪By avoiding the separate market, the integrated firm can avoid market transaction costs but does
incur additional costs for managing a larger firm.
▪Therefore, it is anticipated that the total management function expenses for the single company
will be less than those for two separate companies that are connected through market
transactions.
▪On the other hand, the increased complexity of the firm may increase management costs
compared with separately owned operations.
▪However, even if management costs are higher they may be offset by production cost savings.
▪Vertical integration may reduce the uncertainties faced by non-integrated firms.
▪The controller of a firm is a boundedly rational individual making decisions with imperfect
information in an uncertain environment.
▪The controller may be called on to react to unexpected or unforeseen events.
▪Vertical integration may be seen as a way of reducing information deficiencies and having to
react to market or industry changes.
➢The sources of uncertainty in relation to supply include:
[Link] unreliability of suppliers to deliver on time and the consequences for production
scheduling of losing critical supplies.
[Link] use of monopoly power by suppliers.
[Link] quality of input that affects quality of output.
➢The sources of uncertainty in relation to selling the product include:
[Link] output due to fluctuating price movements, which may result in output reductions or
increased storage of unsold output.
[Link] changes in demand with similar consequences.
[Link] certainty of access to sales outlets, particularly if the sector is dominated by powerful
monopsonistic groups.
❖Vertical integration allows the firm to become more of a planning system.
[Link] enables management to overcome uncertainties relating to quality of product, uncertainty of
supply and unexpected changes in prices for inputs.
[Link] does not, however, remove uncertainty relating to the market for final users in the production
chain.
❖Vertical integration may give the firm two advantages in relation to information:
[Link], the firm learns about the production issues relating to all aspects of linked activities
compared with competitors who are not integrated and,
[Link], the vertically integrated firm may also be able to hide information from competitors
since all processing takes place in-house.
➢Transaction cost economics is a key component of the more recent ideas explaining the drivers
of vertical integration.
➢ It is argued that vertical integration will result in;
[Link] in transaction costs by not using the market, whereas buying through the market
involves: incurring costs in searching for suppliers, discovering prices; writing, agreeing and
monitoring contracts.
[Link] management costs because internalized activities will require supervision and co-
ordination.
✓ Thus, the increase in management cost has to be less than the savings in transaction costs
to justify vertical integration and also avoids problems associated with contracts.
▪If incomplete, long-term contracts are signed, they can create problems when unforeseen
changes take place in the business environment and the contract has to be revised; this gives the
supplier the chance to engage in opportunistic behaviour, particularly if the buyer wishes to
increase the quantity supplied.
▪If suppliers have invested in highly specialized assets to produce the required input, then they
may be able to exploit this to negotiate a higher price.
▪Vertical integration allows the buyer to avoid opportunistic behaviour by the supplier.
❑Vertical Integration and Profitability
▪Lessons learned from several vertically integrated acquisitions indicate that the corporate
parent's influence over the acquired business is the primary factor determining success or
failure.

➢ For this to have a favourable impact:

[Link] acquired business must have the potential to improve its performance independently of its
relationships with other divisions or business units within the company.
[Link] parent company must have the skills or resources necessary to help the business. In
practice, they may not have the skills, and the methods chosen to integrate the company may
cause more problems than they solve.
[Link] parent company must understand the business well enough to avoid influencing it in ways
that damage its performance.
❖MERGERS
▪This term refers to the amalgamation or integration of two or more firms. The firms under
different ownership and management controls come under a united one through merger.
▪The terms ‘acquisition’ and ‘takeover’ are also used for ‘merger’, which implies that a firm
acquires assets or stocks in part or full, of other firm(s) to get operational control over them.
▪In legal sense, there is a difference between these terms but from the point of view of the
economic analysis they are similar.
▪The important feature of merger, that is relevant to us, is the transfer of control of business
activity from one or more firms to another.
➢The Nature of Merging
▪The words ‘‘merger’’ and ‘‘acquisition’’ are used interchangeably.
▪NB: If the two terms are to be distinguished, then a merger occurs when two or more firms are
voluntarily combined under common ownership, while an acquisition, or takeover, occurs when
one firm acquires or buys the assets of another without the agreement of the controllers of the
target company.
➢Types of Mergers
✓ Economists have identified three types of mergers formed by firms. These are:
1. Horizontal mergers
2. Vertical mergers and
3. Conglomerate mergers.
▪Horizontal mergers occur when two firms in the same market are consolidated into a single
enterprise; this means that the new enterprise will have increased its market share. This type of
merger is designed to acquire market power.
▪Vertical mergers take place between firms, which engage in successive stages of production
such as brewing and running public houses; so both upstream (backward) or downstream
(forward) are possible. The output of one stage of operation serves as an input or market outlet
to the other stage.
▪Conglomerate mergers occur when two firms producing independent products for different
markets merge. Conglomerate mergers create larger diversified firms.
✓ Although these do not generate concerns about market dominance, there are concerns about
their ability to compete unfairly against undiversified competitors because of their ability to
cross-subsidize.
▪Types of mergers will vary according to the nature of the industry and the degree of
fragmentation.
▪In a sector like legal services, the vast majority of mergers will be horizontal because there are
large numbers of small law practices that are currently consolidating. Some may be of a
conglomerate nature in that firms in different industries may merge (e.g., legal and accountancy
firms).
▪In other industries that are more concentrated but have strong vertical linkages, mergers are less
likely to be horizontal in nature and more likely to involve vertical integration.
➢Motives for Merging
▪The motives for merging are different in managerial and owner-controlled firms: the former
may be more concerned with increasing the growth rate of the firm, while owners are presumed
to be more concerned with increasing profits or shareholder value.
▪The main sources of economic gain which enable firms to achieve higher growth and/or higher
profitability through the pursuit of mergers are the same.
▪There are different causes/motives for mergers, among which, the following are included:
[Link] relating to the structure of markets, i.e. the pursuit of either of economies of scale or of
market power;
[Link] which center on management efficiency;
[Link] based on the tax effects of merger.
[Link] of scale: Efficiency Gain
▪The first efficiency argument is the advantages of economies of scale. Perhaps the most
obvious justification of merger is a desire to reap economies of scale and hence enhance
efficiency.
▪There are assets, which are costly, indivisible and ‘fungible’ (that is capable of being used in
several industries).
▪Such assets give rise to ‘economies of scope’: they make it relatively easier for a company to
enter new lines of business.
▪When fungible assets are the motive for merger, the result is likely to be diversification.
[Link] Performance: Merger as the Outcome of ‘Market of Corporate Control’:
Efficiency gain
▪The second efficiency argument is based on the fact that the existence of market for corporate
control can lead to efficiency gain through mergers.
▪The underlying theory of this outlook lies in both the ‘managerial’ and ‘principal-agent’
theories of the firm. It is all about allocational takeovers.
▪This is all about ‘market for corporate control’ that may lead to hostile take-over. Participants in
this market are the management teams of companies, together with financiers or investors.
▪Managers (both incumbent and raider managers) engage in competition for the control of
companies.
▪This competition takes the form of bids: ‘raiding’ teams bid for the control of other companies
by offering cash or securities (bonds or shares) to investors.
▪The implication of this competition in management is the fact that this spurs efficiency.
▪If managers fail to maximize profits they lay themselves open to takeover.
▪The causes of inefficiency are not difficult to list. Attaining least-cost requires attention and
vigor and, if the pressures of competition are not too great, it is clear that slackness on the part
of management will suffice.
✓ Inefficiency may also arise from the incentive structure of the company.
▪It can be hypothesized that since mergers are indeed a market for corporate control, then a
merger should be followed by an enhanced performance in terms of higher sales and/or an
increase in profits.
✓ One of the critics forwarded against this role of mergers is that of short-termism.
▪The argument that mergers are a spur to management to run companies efficiently has its
converse side. Mergers (or that simply the threat of mergers) force managers to maintain profits
and dividends in the short run for the sake of bolstering share values.
✓ This could lead to a tendency to reduce capital spending or investment in R&D.
3. Taxation effect of merger
▪Another hypothesized cause of mergers is taxation:
✓ Merging may have the effect of reducing the aggregate tax liability of the companies concerned.

▪Tax authorities treat transactions differently. Since interest payments on companies’ borrowed
funds are tax-deductible there is an incentive to issue bonds against shares.
▪Rebalancing a company’s capital structure so that there are fewer shares and relatively more
bonds is not easy to negotiate, but mergers can provide an opportunity.
▪Second, while company profits are taxed, losses entitle a company to a refund or a reduction in
future tax. These losses may be ‘carried forward’ from the year in which they are sustained and
used in a year in which profits are made, a process of smoothing or averaging. Such credits can
also be transferred to an acquiring company.
✓ This feature of the tax system in some countries means that a profitable raider, which acquires a victim with
tax losses can use those losses to reduce its own tax liabilities.
❑Mergers and growth
▪Marris (1964) in his analysis of growth visualized the firm having to create opportunities for
growth to satisfy managerial preferences.
▪If the firm is limited in its growth opportunities in its existing activities, then the acquisition of
other enterprises is one way of increasing its size and increasing its average growth rate as long
as the acquired activity is in a faster growing sector.
▪Acquisition is viewed as a more rapid way of achieving greater size and a higher growth rate
than pursuing internal or organic growth.

❑Mergers and market power

▪Market power arises from a firm having a significant presence in a market.
✓ Greater market power can be achieved by increasing market share at the expense of rivals.
▪Competing away the market share of rivals requires the firm be in a relatively stronger
competitive position than its rivals;
▪ This may be achieved by having superior products, lower costs and better distribution systems.
▪These advantages allow the firm to undercut its rivals’ prices or to achieve a higher profit
margin at any given price.
▪As the competitive process evolves, some firms will gain market share at the expense of others
and some firms may withdraw or be forced from the market; this will free up market share
which existing competitors can strive to win.
▪The second way of achieving a higher market share is to acquire a rival; this eliminates a
competitor and at the same time increases the market share of the acquiring firm.
▪The firm can strive to maintain this increased market share against its remaining competitors.
▪ The larger the firm relative to its remaining competitors the greater its ability to raise prices above marginal
cost; this allows the firm to increase revenue and its profits, as a consequence of restricting output.
❖ Acquiring competences
▪A firm may be motivated to acquire another because of the assets the target firm possesses.
▪In particular, the concern is to acquire intangible assets or competences that cannot be
purchased in the market.
▪These assets may include knowledge of a particular market, or of a particular technology, or a
strong reputation for product quality.
▪Such knowledge is embedded in individuals and the architecture of the firm; this means that
these resources can be utilized within the firm at a constant or declining marginal cost and have
high market transaction costs, so that the most profitable way to exploit them is within the firm
and the only way to acquire them is through acquisition.
▪It is these competences that make a firm potentially more profitable than its competitors, but it
is also these competences that make the firm a potential target.
✓ The problem with acquiring a firm for its competences is that they reside in one or more individuals; so, if
they leave after the acquisition, then the takeover may have been in vain.
❖Mergers and cost savings
▪The majority of mergers are intended to produce cost savings from synergy between existing
and acquired activities; these may arise from reorganizing the production, selling, distribution
and management functions of the combined enterprises.
▪The main source of these gains will be: economies of scale as production is concentrated at
fewer facilities; from economies of scope as administrative functions are shared and purchases
of raw materials are co-ordinated; and from economies of size, which allows larger firms to
achieve lower costs than smaller ones. For example, motor car assemblers who merge their
operations may be able to achieve benefits from all three sources.
▪Whether the expected cost savings are achieved depends on the success or otherwise of the
acquiring firm to integrate the new operation into its existing organizational and management
structure and to pursue the necessary restructuring.
▪If the costs of restructuring and setting up new management structures prove more expensive
than anticipated, then the merger may not achieve its expected benefits.
❖Defensive and opportunistic reasons
▪The management of a firm may seek to merge for defensive reasons, such as to protect their
own positions, to avoid bankruptcy or to avoid being taken over by an unwelcome bidder.
▪Alternatively, an acquisition may be made because a company becomes available. If a firm
fears that it will become the subject of a takeover bid, then it may itself launch a bid to increase
its size and make the firm a more expensive target. An alternative approach to such a threat or
to a launched bid is to seek another firm, or suitor, of the firm’s own choosing to take the firm
over in preference to the original bid.
▪Opportunities to make acquisitions or seek mergers may present themselves from time to time.
Two smaller firms in a market might merge to create a stronger firm to survive the challenge of
a larger rival. There may be opportunities to deploy liquid assets (or a cash mountain) to
acquire companies, which will improve the growth prospects of the firm and keep shareholders
happy because of their dislike of excessive non-working assets.
❖ Changes in the economy
▪Mergers are sometimes motivated by general changes in an industry, such as changes in demand
and technology, and trends in the economy as a whole, such as globalization.
✓ For example, declining demand in the defence sector following the end of the cold war led to mergers of defence
companies and consolidation of the industry.
▪The general state of the economy may also be conducive to mergers.
✓ For example, boom conditions with rising stock market prices may make takeovers financed by shares extremely
attractive and encourage predatory firms to seek targets.
▪Changes in particular economic policies may create opportunities for merger activity as previous
restrictions on firm behaviour are removed.
✓ Deregulation in the US airline market created new opportunities for business experiment and consolidation.

▪Deregulation and privatization, which have been features of economic development in many
countries, created market structures that were designed by committee.
✓ The new firms that were created have often taken the opportunity to merge with each other or have
themselves been taken over by others keen to enter the market.
❖Profit and efficiency benefits
▪The economic case for horizontal mergers is generally based on higher unit revenues from the
use of market power and lower unit costs from efficiency savings.
▪If two firms were to merge, then the new firm could use its market power to restrict output and
raise prices.
▪For vertical mergers there may be cost savings where two technologically linked stages of a
production chain are joined together under common ownership.
▪Such a link avoids recourse to market transactions and avoids transaction costs; however, these
may be offset by increases in governance costs.
▪For conglomerate mergers where the activities are unrelated, the cost savings may arise from
more efficient management, from a lower cost of capital for market funding and from operating
an internal capital market.
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