Product variety and vertical integration

Abstract

Research summary: In vertical relationships, the potential for scale economy in manufacturing often calls for specialization and outsourcing. Specialization, however, depends critically on the stability of the task and contractual environment. In a highly uncertain environment, the need for frequent mutual adjustments favors integration instead of outsourcing. To evaluate vertical relationships in value chains where one stage competes on product variety under great uncertainty and the other stage competes on scale, we compare operations data at about 300 distribution centers within a major soft-drink bottler before and after it was integrated into an upstream concentrate producer. We find that vertical integration improved coordination for the integrated firm by aligning incentives and reducing strategic information asymmetry, but it worsened coordination for upstream rivals that shared the same downstream facilities. Managerial summary: Managers make frequent decisions about outsourcing versus integration. This article helps to crystalize the costs and benefits of integration by pointing to two important factors: the potential for economies of scale and the need for coordination under uncertainty. It studies an industry where one stage of the value chain competes on product variety under great uncertainty and the other stage competes on scale. Based on operations data at about 300 distribution centers within a major soft-drink bottler before and after it was integrated into an upstream concentrate producer, we find that vertical integration improved coordination for the integrated firm (by reducing both stockouts and inventory, and improving sales forecasts), but it worsened coordination for upstream rivals that shared the same downstream facilities. Copyright © 2016 John Wiley & Sons, Ltd.