Chapter Six:

Diversification, Integration and Merger

By
Belaynew B.

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 INTRODUCTION
 Diversification: firm produce totally d/f products
which is not a substitute for the existing products.
 Vertical integration: operations by firm in more
than one successive stages in the flow of
production or distribution.
 Merger: is the integration of two /more firms
 Vertical restriction: is a situation in which a non
integrated firm sign a contractual agreement in
price and other behaviour.

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 6.1. Vertical Integration and Vertical Restrictions
A firm that participates in more than one successive stage of
production or distribution of goods or services is vertically
integrated.
No vertically integrated firms buy the inputs or services they
need for their production or distribution processes from other
firms.
A non integrated firm may write long term binding contracts
with the firms with which it deals, in which it specifies price,
other terms, or forms of behavior.
 Such contractual restraints are called vertical restrictions. 
For example, manufactures commonly restrict their
distributors by determining their sales territories, setting
inventory requirements, and setting the minimum retail price
they can charge
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 6.2. Vertical Relationship as a solution to Economic Problems
(Problem of Double Marginalization)

The price & transactions cost of transferring and delivering

goods from one stage to another is influenced by integration.
But the effects depend on the market structure.
 For instance the case of retailing and wholesaling is
represented as follows:
Case Wholesaler Retailer
I Competitive Competitive
II Competitive Monopolist
III Monopolist Competitive
IV Monopolist Monopolist
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 In which case Vertical integration influnce price?

1. case I: both the wholesaler and retailer operate in perfectly

competitive markets
price = Marginal cost everywhere,
 Hence, vertical integration would have no impact on price.  
2. Case II: a competitive wholesaler and a monopolist retailer.
The competitive wholesalers charge a price equal to marginal
cost. And
The monopoly retailer take the competitive price as its
Marginal cost & charge Profit maximizing price. i.e MR=MC=P
A Profit maximizing Vertically Integrated firm take the
competitive price.
 Vertical integration would have no impact on price.  

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 Cont.…
3. Case III: a monopolist wholesaler and a competitive retailer.
The monopolist wholesaler sets optimal price.
The whole sale price becomes the competitive retailers’
marginal cost, which is the price that a profit maximizing
vertically integrated firm would charge.
Thus, Vertical integration again has no effect on output or price.
4. Case IV: monopoly in both vertical stages, vertical integration
has some effect on price.
Thus, Vertical integration has some effect on output or price.
If the two monopolists vertically integrated, Vertical integration
is better for the two monopolists and better for consumers.
 In this case, public policy should do everything possible to
encourage vertical integration.

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 6.2. The reasons for and against Vertical
Integration
Most firms integrate vertically to reducing costs or
eliminating a market externality.
 A firm needs a good reason to vertically integrate
because integration can involve substantial costs.

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 6.2.1. Reasons against vertical integration
Reasons against vertical integration state the costs
of vertical integration. 
1. The cost of supplying its own factors of production
or distributing its own product may be higher for a
firm that vertically integrates than one that depends
on competitive markets.
2. As a firm gets lager, cost of managing it increase.
3. The firm may face substantial legal fees to arrange
to merge with another firm.
 Because of these costs, firms vertically integrate
only if the benefits outweigh the costs.
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 6.2.2. The reasons for Vertical Integration
This argument states the benefit of vertical
integration.
Integration is so vital since it:

1. Lowers Transaction costs

Firms integrate vertically to lower its transaction
costs. i.e. the transaction costs of buying from or
selling to other companies are avoided.
The desirability of vertical integration increases as
the transaction costs of using the market place rise.

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 Cont.…
 There are four types of transactions in which transaction
costs are likely to be substantial enough to make vertical
integration desirable are transaction:
I. Specialized asset
II. Uncertainty
III. Information asymmetry
IV. Extensive coordination

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 2. It assure supply
 A firm may vertically integrate to assure itself a steady
supply of a key input.
 To do so, the firm may vertically integrate:
a. Backward integration :a firm starts manufacturing
products previously purchased from others in order to
use them in making its original product line.
 A milk product company may have its own dairy farm and
similarly, a bakery may have its own flour mill and so on.
b. Forward integration :the firm moves nearer to the final
market for its product and carries out a function which was
previously undertaken by its customers.
 A shoe making firm may start its own distribution or
selling shops,
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 3. It Eliminate Externalities
Firms integrate vertically to correct market failures
due to externalities by internalizing those
externalities.
 Owning or controlling market ensure a uniform
quality, which results positive externality.

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 4. It avoid Government intervention
Firms are able to avoid government restrictions,
regulations, and taxes by vertically integrating.
 It avoid price controls by selling to itself.
 Shifting profits from a high tax jurisdiction to a low
tax jurisdiction, a firm can increase its profits.
Government regulations create incentives for a firm
to integrate when the profits of only one division of
a firm are regulated.
 Shift profits from its regulated divisions to its
unregulated division; it can effectively avoid the
regulation of its service.
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 5. It increases Monopoly power and
Monopoly profit
Firms vertically integrate to increase or create
market power.
 A firm increase its monopoly profits in two ways :
 First, sole production and sole supplier of product.
 Second, a vertically integrated monopoly supplier
may be able to price discriminate, eliminate
competition, or foreclose entry.

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 6.3. Merger and Takeover(Motives for Merger)
The terms “merger” mean a corporate combination of two
separate companies to form one company.
Mergers are undertaken if it is believed two or more
companies which are merging will be greater together
than sum of its parts.
The math of a merger is “1+1=3” or “2+2=5”.

Types of Mergers
From the perspective of business structure and the
relationship between two corporations,
According to Gaugham (2005), there are three main
categories of Merger: horizontal, vertical and
conglomerate.
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 1. Horizontal Merger
Horizontal Mergers is merging of company which
are from the same business field.
It arise from the possible side effects on
competition in the same industry.
It create monopoly position by decreasing the
number of firms in the same field.
This kind of Merger is the most popular in the
modern world.
It occurs between small or immature firms and
when there is no dominant leader in the same
business.
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 2. Vertical Merger
 Vertical Mergers refer to the vertical integration of two
firms, which operate in the same production line.
There are two major categories of vertical Mergers,
which are:
I. Forward integration (i.e. the acquirer expands
forward of the ultimate consumer) and
II. Backward integration (i.e. the buyer expands
backward to suppliers of raw materials).
The primary reasons for companies to be vertically
integrated are “technological economies such as the
avoidance transaction cost.
 Mergers avoid the uncertainty about input supply.
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 3. Conglomerate Mergers & Acquisitions
 Conglomerate Mergers refer to a combination of two firms
which do business in diverse fields.
 This kind of Mergers is the least popular nowadays.
 There are three categories of conglomerate Mergers:
i. Product extension mergers: is concentric mergers. two
firms merger in related businesses in order to broaden the
product lines of firms.
ii. Geographic market extension mergers: two firms
which have no overlapping businesses, merge in different
geographic areas
iii. Other conglomerate mergers: refers to a pure
conglomerate Mergers in different business field.

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 Motive force for merger
The 7 Specific motives for mergers include the
following:
1. Tax advantages :
 Tax loss carry-forward refers to the ability to deduct
past losses from the taxable income.
2. Increases liquidity for owners : after merger their
shares’ liquidity and marketability become better.
3. Gaining access to funds: merge with healthy
liquidity company.
4. Growth: complementarity lead to high growth
opportunity of firms after merger.
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 Cont.…
5. Synergistic benefits: synergy means the performance of
firms after a merger (in certain areas and overall) will be
better than the sum of their performances before the merger.
Synergy occurs when the whole is greater than sum of its
parts.
In terms of math it could be represented as “1+1=3” or as
“2+2=5”.
 Combined effort exceeds the sum of each performance
before merger.
 Synergy results from:
i. Economies of scale: decreased costs
ii. increased revenues such as cross-selling.
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 Cont.…
6. Protection against a hostile takeover: use as a
defensive acquisition and finance.
7. Acquisition of required managerial skills, assets
or technology: enable to share of all skills and
technology.

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 Summery
Generally the motive of the firm for Merger is
grouped into three main groups:
1. Strategic motive: focused on improving and
developing the business.
 Closely linked to competitive advantage.
2. Financial motives: focused on best use of financial
resources for shareholders.
 Concerned with improved financial performance.
3. Managerial motive: focused on the self-interest of
managers.
 Not necessary in the best interest of shareholders.
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 6.5. The effects of Merger on Competition and
Welfare
Merger increase efficiency if merger is b/n small or medium-
sized firms.
But merger reduce efficiency if it is b/n large firm.
Horizontal merger
 Horizontal merger increase mkt power and reduce costs b/c
of economies of scale.
 Merger create monopoly power.
 It transfer from Consumer surplus to producer profit.
 If reduction effect exceeds over mkt power increase, +ve
welfare effect.
 If reduction effect exceeded by mkt power increase, -ve
welfare effect
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 Vertical merger
Competitive firm VI has no effect
Monopoly (bilateral monopoly) lead to efficiency b/c of
double marginalization.
Conglomerate merger:
Conglomerate merger lead to increase mkt power.
ATTAKS ON CONGLOMERATE MERGER:
 Elimination of potential organization
 Recprocal buying
 Cross-subsidization
 Economic forbearance

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 Thank you!!!

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