CHAPTER SIX
DIVERSIFICATION, INTEGRATION
AND MERGER
A. Diversification: refers to a firm's strategy of
expanding its operations into different economic
activities.
• This involves producing new products that are not
substitutes for its existing products.
• For example, a margarine producer starting to
produce soap is diversification.
• According to Penrose, diversification occurs when
a firm, without abandoning its old products, begins
producing new, significantly different products.
• This can involve changes in technological bases,
market areas, and productive activities.
• Penrose identifies four possibilities for
diversification:
1. Additional products within existing technological
bases and market areas.
2. Products involving existing technological bases
but targeting new market areas.
3. Products with new technological bases for
existing markets.
4. New products with new technological bases for
new market areas.
• Diversification implies changes not only in products
but also in technological bases and market areas.
B. Vertical integration: involves a firm operating
in multiple industries that represent different
stages of production, from raw materials to
finished products.
• It is a form of diversification, also known as
'vertical concentration.'
• When this process involves the merging of two
different firms, it is called a 'vertical merger.'
• Vertical integration can occur in two ways: a
firm starts producing all intermediate products
itself, or different firms at various production
stages merge together.
C. Merger: A merger involves the
amalgamation or integration of two or more
firms under different ownership and
management into a unified entity.
• Terms like 'acquisition' and 'takeover' are also
used, indicating that one firm acquires assets
or stocks of another to gain operational
control.
• The key feature of a merger is the transfer of
control from one firm to another.
• There are three types of mergers:
1. Horizontal Integration: Firms with identical
products merge, having high cross elasticity of
demand and supply.
2. Vertical Integration: Firms with a successive
functional link between their products merge,
where the output of one firm is the input for
another.
3. Conglomerate Integration: Firms producing
entirely different products merge, resulting in
a market-diversified firm.
• Diversification is also implied in vertical mergers.
6.2. Motives for Diversification, Vertical
Integration and Merger
I. Diversification: the motives for
diversification vary based on its types.
• To understand these motives, it's helpful to
examine the different types of diversification
observed in practice and their specific
motivations.
1. Lateral Diversification occurs when a firm
produces different goods that originate from the
same process or source, or are used as materials
for the same process or market. Examples include:
• A leather tanning firm starting to make boots, shoes,
leather garments, and suitcases.
• A meat seller beginning to sell hides, horns, bones,
and raw wool.
• A soap manufacturer starting to produce margarine
and chemicals used in soap making.
• The motive behind lateral diversification is to
expand the firm's product range by leveraging its
existing processes or materials.
• Firms may pursue lateral diversification for several
reasons:
By-products: When producing one commodity
results in by-products, lateral diversification helps
avoid wastage and gain business advantages (e.g.,
mutton and wool, petroleum refining by-
products).
Market Demand: If demand for existing products
declines or stagnates, lateral diversification helps
maintain or increase earnings.
Utilizing Existing Facilities: Better use of
managerial talents, R&D activities, and certain
Market Complementarity: Seasonal demand
patterns can lead to lateral diversification
(e.g., producing colors and water sprayers for
festivals).
Growth Maintenance: Diversifying helps
maintain growth without accusations of
monopolizing.
Barrier to Entry: It serves as an effective
barrier to reduce potential competition.
2. Conglomerate Diversification: involves a firm
producing unrelated products that do not
share the same source, process, or market.
• The motives for conglomerate diversification
include:
Extension of Market Power: Expanding the
firm's influence in different markets.
Stability in Earnings: Achieving financial stability
through cross-subsidization, where the loss from
one product is offset by gains from another.
Increased Barriers to Entry: Making it harder for
new competitors to enter the market.
Risk-Taking Options: Providing more
opportunities to take risks for potential
profits.
Growth Maintenance: Sustaining the firm's
growth trajectory.
Pecuniary Gains: Achieving financial benefits.
Better Utilization of Facilities: Making more
efficient use of existing resources and
facilities.
• These motives are similar to those for lateral
diversification.
3. Vertical Diversification is essentially vertical
integration, involving diversification into
manufacturing or distribution processes that precede
or succeed the firm's current operations. It can be:
• Backward Integration: The firm starts producing
products it previously purchased from others to use in
its original product line (e.g., a milk product company
owning a dairy farm, a bakery owning a flour mill).
• Forward Integration: The firm moves closer to the final
market for its product, taking over functions previously
done by its customers (e.g., a shoe-making firm opening
its own retail shops, a flour mill starting its own
bakeries, a spinning mill beginning weaving activities).
• Vertical diversification, whether initiated by a firm itself
or through merging with other firms, has several
motives:
Security: Ensures a reliable supply of materials
(backward integration) or a stable market for products
(forward integration).
Economies of Linked Processes: Enhances efficiency and
capacity utilization.
Marketing Economies: Reduces costs related to
transportation, advertisement, procurement, and selling.
Eliminating Middlemen: Saves costs by removing
intermediaries and their profit margins.
Market Power: Increases market power through size,
cost advantages, and pecuniary gains, strengthening
4. Diagonal Diversification or
Integration: involves a firm providing auxiliary
goods and services required for its main
production processes.
• Examples include a firm having its own power
house to generate electricity or machine tool
making units.
• The motives are similar to those for lateral and
vertical diversification, with key reasons being:
• Mopping up Excess Capacity: Utilizing any surplus
capacity efficiently.
• Risk Reduction: Minimizing risks associated with
• The motives for all types of diversification can be
summarized as:
Profitability: Utilizing resources and capacities fully to
increase earnings.
Stability: Reducing risks and uncertainties through assured
supplies and markets.
Growth: Expanding productive capacities without being
accused of monopolizing, even with market limitations.
Market Power: Increasing barriers to entry to enhance
market power.
• In general, new industries tend to have higher degrees of
diagonal and vertical integration due to the lack of available
auxiliary services, while mature industries, like textiles,
often resort to more lateral diversification as independent
units efficiently supply these services.
II. Vertical Integration: involves the integration of two or
more firms, which also implies the integration of their
products.
• The main motives for vertical integration include:
Profitability: Achieving higher profits through fuller
utilization of resources and cost savings via backward
or forward integration.
Stability: Ensuring stability in operations and supply
chains.
Growth: Supporting the firm's growth objectives.
• These motives influence the price and quantity of
output in the industry to which the firms belong.
III. Merger
• A merger involves the integration of two or more firms,
which implies diversification except for horizontal
integration. The motives for diversification also apply to
mergers, but there are additional specific motives:
Increase in Profitability: Achieved through greater
diversification, increased efficiency, and enhanced market
power.
Stability in Earnings: Merging firms can stabilize their
combined profit rates, reducing fluctuations and risks
through cross-subsidization.
Stock Market Gains: Firms may merge to benefit from
differences in earning-price ratios or market prices of their
shares.
Efficiency: Particularly strong in horizontal and vertical
mergers, leading to economies of scale, reduced costs, and
better management.
Market Power: Enhanced through reduced competition,
increased barriers to entry, and greater control over pricing
and output decisions.
Growth: Mergers enable firms to expand their assets, sales,
and market power.
• For conglomerate mergers, additional sources of market
power include extended monopoly power, cross-
subsidization, deep pocket advantages, increased entry
barriers, non-economic reciprocity arrangements, macro-
concentration, and larger power groups.
6.3 Implications for Public Policies
• Diversification and integration, whether vertical, horizontal,
or conglomerate, are key market strategies that impact the
competitive environment of an industry and the economy.
• When a firm diversifies, it triggers competitive responses
from rivals, especially when products are closely related,
increasing industry competition.
• This competition often involves large firms, which use
diversification to maintain growth and market power
without monopolizing.
• However, when a few large firms dominate the market and
create entry barriers, market concentration increases,
raising public policy concerns.
• Vertical and horizontal integration also affect market
power.
• Vertical integration can reduce competition or enhance it
by bypassing monopolistic suppliers, leading to a debate
on its impact.
• Horizontal and conglomerate mergers are more likely to
cause market concentration and are thus strictly
regulated by public laws.
• Public policies aim to:
– Diffuse economic power.
– Ensure efficient allocation of scarce resources.
– Guarantee economic freedom and mass participation.
• Governments often appoint Antitrust or Monopoly and
Restrictive Trade Practices Commissions to regulate
mergers and diversification strategies, balancing private
and public interests.
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