ATSC Project Proposal Group-6 | Section B 1. Theory- Vertical Integration Theory 2.

Project Topic Study vertical integration for two industries one with high concentration and another low concentration (but with reasonably large players) and establish under what conditions the vertical integration theory holds. High Concentration Industry selected is Carbonated beverage industry with reasonably large players- Coca Cola and PepsiCo while Low Concentration Industry selected is Pharmaceutical Industry. 3. Literature Survey A recent wave of large vertical mergers presents a challenge to established theories of vertical integration. The large mergers that have occurred in the pharmaceutical industry between drug manufacturers and companies that manage drug insurance benefits (such as Merck's acquisition of Medco) do not seem to fit traditional economic theories of vertical integration (Klein & Murphy, 1997). The empirical literature on vertical integration has focused on two main, interrelated questions: First, what types of transactions are best brought within the? And second, what are the consequences of vertical integration for economic outcomes such as prices, quantities, investment, and profits? The answers to those questions are important in that they can inform managers' decisions directly and also help into the development of sensible vertical merger policy and government intervention in vertical relationships (Lafontaine & Slade, 2007). Firms also evaluate the relative costs of alternative governance structures (spot market transactions, short term contracts, long-term contracts, vertical integration) for managing transactions (Coase, 1937). While it is generally recognized that transaction costs are very important in determining the decision between make or buy or between sell or use, the theory lacks a satisfactory treatment of the disadvantages of vertical integration. Some explanations, such as the presence of managerial diseconomies, incentive disabilities, or the emergence of mistakes in allocating factors when firms size and the number of inputs become large (the merger between USAir and Piedmont Aviation in 1987) have been put forward, but the boundaries of the firm remain somehow not precisely defined. It is not clear why a firm, by Akshi | Abhisheak | Arati | Divya C | Divya K | Mayur | Nisha | Supriya

using selective interventions, cannot continue to integrate forward and backward and perform better than decentralized competitors. Carbonated beverage industry has a very high concentration ratio with the oligopoly of CocaCola, PepsiCo, and Dr Pepper Snapples. From an oligopoly model perspective, vertical integration solves the problem of double marginalization since a downstream firm cannot maximize profits anymore by equating marginal costs and marginal revenue. Hence, the model suggests that prices will be lower in a vertically integrated market compared to a vertically unintegrated market. Although indeed a price reduction by about 3-5 percent can be observed, empirical evidence, nevertheless, shows that double marginalization is not the main reason for vertical integration. The main rationale is, in fact, the elimination of inefficiencies. In sum, the statistical data emphasize the claim that vertical integration leads to a price reduction for retail products. However, the price reduction is not mainly a consequence of eliminatin g bottlers market power but rather of increasing efficiencies and reducing marginal costs. Vertical integration incentives are not constant through time. Ohanian (1994) found that recent entrants in the pulp industry were more affected by specific assets in their vertical integration decisions, while established firms were less prone to alter their integrated structure. The same issue is implicit in Tapons analysis, following which the technological progress in pharmaceutical R&D rendered firms internal laboratories inefficient as compared to independent laboratories. With similar arguments, Muris et al. (1992) individualized in the change of technology, and in the need for more coordination in the distribution of products, the increased stimulus for firms operating in the carbonated beverage industries to integrate towards the bottling activities over the last 20 years. Finally, Weiss (1994) was interested in explaining the timing of mergers and divestitures. In particular, he argued that Pepsico acquired one of its independent bottlers because the specific investments were increasing in importance through time 4. Key problem from gaps in Vertical Integration theory Vertical Integration motives do not remain constant with time and change with changing industry dynamics. Technological progress in pharmaceutical R&D rendered firms internal laboratories inefficient as compared to independent laboratories. With changes in technology, and in the need for more coordination in the distribution of products, there was an increased stimulus for firms operating in the carbonated beverage industries to integrate towards the bottling activities over the last 20 years.

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 Traditional TCE theory focuses on transaction and agency costs in determining the optimal boundary of the firm. But this ignores the importance of organization in coordinating complementary activities that require different types of know how. The capability theory which focuses on a firms knowledge, skills and experience is the best economic rationale for deciding the extent of vertical integration for the firm Knowledge tacitness and qualitative coordination of tasks amongst a large set of heterogeneous capabilities are important for determining a firms boundaries. For example, the vertical integration between cola manufacturers and their bottlers were drives as a result of obstacles that prevented the industry from growing. Traditional TCE focuses a lot on the provision of incentives and hold-up problems that are an important driver of vertical integration. However, lot of cases show that hold up problems do not get resolved by integrating the buyer and seller into one entity Unlike the large corporations of a hundred years ago, current efforts are not leading to fullblown vertical integration. Today companies are buying key parts of their supply chains but most don't want end-to-end control. There is an increase in selective vertical integration unlike the theory of vertical integration. The dominant approaches emphasize transactions costs and agency costs in determining the vertical boundaries of the firm. Both of these approaches see firms as organizational structures that address incentive problems. This narrows the focus on incentives and has ignored the role of firms in addressing coordination problems associated with arm's length exchange. A study of various research on vertical integration across different industries and sectors would give us an idea of the rationale for deciding firm boundaries in dynamic environments. We will also refer to the path taken by some of the major firms in the carbonated beverage industry and pharmaceutical industry to decipher the logic of such decisions and the benefits created thereby. The analysis of the different firms and their success after vertical integration will give us an idea of the key factors and validity of the gaps identified in deciding a firm s boundaries.

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5. References Klein B., Murphy K. Vertical Integration as a self-enforcing contractual agreement. The American Economic Review, Vol. 87, No. 2, page 415-420 Lafontaine F., Slade M. Vertical Integration and Firm Boundaries: The Evidence. Journal of Economie Literature Vol. XLV (September 2007), pp. 629-685

Kench, Brian T.; Knox, Trevor M.; Wallace, H. Scott. Dynamic Transaction Costs and Firm Boundaries in the Soft Drink Industry. Academic journal article from Journal of Economics and Economic Education Research, Vol. 13, No. 1 Gropp J. Vertical Integration in Soft Drinks. Retrieved on August 4 2013 from http://econ243.academic.wlu.edu/term-papers/vertical-integration-in-soft-drinks/

Akshi | Abhisheak | Arati | Divya C | Divya K | Mayur | Nisha | Supriya