The economic rationale for vertical integration in the tech sector
The economic rationale for vertical integration in the tech sector
Hardware devices to software to services: Strategic risk-taking, innovation and investments in the pursuit of efficiency and consumer value
Vertical integration is a relatively widespread practice across the economy – both in “digital” and “traditional” sectors. With the advent of digital transformation, many firms across industries, irrespective of their size or market prominence, attempt to add software and/or services to their products or develop partnerships to ensure a coordinated approach to deliver the best end-user experience. When a firm chooses to invest and enter a market served by its suppliers (upward, i.e. backward integration) or in its output/customers’ markets (downward i.e. forward integration), it is delivering additional competition to the economy, a clear pro-competitive effect.
Different companies and value chains have different implications for competition analysis. As is demonstrated in the theory and practice of competition economics, vertical integration strategies are associated not just with harm to competition but also with efficiency and consumer benefits. In fact, these positive aspects are routinely considered and evaluated by competition and regulatory authorities in cases involving markets and regulatory design. Ex-post evaluations have found a degree of support for vertical mergers and acquisitions to be favourable in terms of their market and consumer outcomes due to these efficiencies. Nevertheless, in competition enforcement, the merits of the facts and effects of conduct have to be considered in a case by case assessment.
In summary, vertical integration cannot be reduced to select catchwords or theoretical concerns – it is valuable to study it in practice. It is a broader phenomenon of significant importance to value creation and consumer welfare outcomes in present-day free-market economies. The aim of this study is to shed light on the economic rationale of vertical integration. This is a key aspect defining the business models of some digital players. In turn, this is relevant to important policy conversations on the case for and effects of regulation of various aspects associated with the operation of vertically integrated businesses.
Based on the review of the economic literature, as well as the appraisal of major business developments in tech and the wider economy, of key case studies and of competition authority practice, this study finds:
On efficiencies
Vertical integration is not necessarily a black-or-white, make-or-buy decision; it can involve a range of intermediate (hybrid) arrangements involving various degrees of integration, including platform / ecosystem strategies
Vertical integration is a demonstrated driver of economic efficiencies
Key efficiency mechanisms include the fostering of greater quality across the value chain (compared to what firms provide without vertical integration), the reduction of transaction costs, tapping into synergies and developing emerging markets
On incentives
Vertically integrated firms have incentives to realise these efficiencies without intervention because they have a stake in the end-to-end customer experience: their success depends on the ability to satisfy better end customers’ preferences compared to the alternatives
The value chain related to digital businesses can extend significantly and exhibit different types of competitive constraints at every layer
Managing the complementarities between hardware, software and services over integrated system design is a key manner by which vertical integration in tech can deliver economic efficiencies and consumer value
On regulation
Digital/tech businesses differ significantly from one another, hence any generalisation upon designing regulation can lead to unintended consequences and/or an unlevel playing field
There are material risks from imposing disproportionate interventions such as blanket rules, which could curtail the efficiencies identified in this study
Caution is advised on possible one-size-fits-all regulatory interventions, including in the case of dual role platforms – the regulatory treatment of practices concerning pre-installing apps, access and interoperability can undermine the efficiencies and consumer value driven by vertical integration
In conclusion, policy makers would benefit from taking, as a starting point, the well-established economic evidence on benefits and drivers of vertical integration, while taking a case-by-case approach to regulatory design, balancing demonstrable efficiencies and concerns.
The study is commissioned by Apple.
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