Chapter 5.
Consolidation of Market Power:
DIVERSIFICATION, INTEGRATION AND MERGER
A. Diversification
• Is a situation when a firm produces a totally d/t product
w/c is not a substitute for the existing products in the
market
• example, a firm producing margarine starts producing
soap
• This enables expansion of market 'area' of firm
from one class of consumers to another one
• Diversification is thus "the spreading of its
operations by a business over dissimilar
economic activities
• Diversification significant changes in its areas of
operations related to technological base, market
areas and productive activities
• According to Penrose, diversification thus cannot be
conceived of changes in the products only; it implies the
other two aspects of the change also, i.e. changes in the
technological base and market areas
Types of Diversification:
• There are four types of diversification
Lateral diversification
Conglomerate diversification
Vertical diversification and
Diagonal diversification
Lateral Diversification
• When a firm produces d/t goods which diverge
from the same process or source or which are
used as materials for the same process/market
• Examples, a leather tanning firm starts making
boots and shoes leather garments and suitcases
• If meat seller starts selling hides, horns, bones and
even raw wool
• If soap manufacturer starts margarine and
chemical manufacturing which are used in soap
making
• All the above businesses diverge from the same
source or process.
Reasons for lateral diversification
A firm may resort to lateral diversification because
of the following reasons:
When production of one cdty necessarily involves
production of another, say in by-product form
there would be a natural scope for lateral
diversification in order to avoid wastages and gain
advantages from the business
Production of mutton and wool, bitumen,
lubricants, paraffin, raw chemicals, etc., together
with petroleum refining, coal, coke, and by-
products such as benzene, etc are few examples
• When market demand for the existing products
is declining or stagnant, a firm diversify business
• Better utilization of existing facilities such as
managerial talents, R&D and machineries‘
• The market complementarities or interlocking
pattern in seasonal demands also leads to lateral
diversification. Eg, one may produce colours and
water sprayers together for festivals
• To maintain the rate of growth, without being
accused of monopolizing
• Lateral diversification is an effective barrier to
entry and thus reduce potential competition
Conglomerate Diversification
• In this type of diversification, the products need
not to have diverged from the same product or
source, or converge at the same process or market
• The products will be quite unrelated or not close
substitutes
Reasons;-
helps in extension of market power of the firm
stability in earnings through cross-subsidization
causes an increase in the barriers to entry
provides more options for risk taking for the sake
of profits
• Maintains the process of growth
• better utilization of some facilities, etc
Vertical Diversification
• This is vertical integration in fact
• It involves diversification into process of
manufacturing or distribution w/c precedes or
succeeds in w/c the firm is already engaged
• It can be either 'backward diversification' or 'forward
diversification‘
• Backward divesrisification when firm starts
manufacturing products previously purchased from
others in order to use them in making its original
product line
• Example: A milk product company may have its
own dairy farm and similarly, a bakery may have
its own flour mill and so on
• Forward diversification occurs when the firm
moves nearer to the final market for its product
and carries out a function which was previously
undertaken by its customers
• Example: A shoe making firm may start its own
distribution or selling shops, a flour mill may
start making its own bakeries; a spinning mill
may also start weaving activities etc
Reasons/motives for vertical diversification
• To maintain security to business/assure market
for its product
• To increase efficiency
• To gain economies in marketing such as saving
of transportation, advertisement, procurement
and selling costs
• To save by eliminating 'the middle man' and to
extend profit margins
• To strength to the barriers to entry
• To gain market power and thus reduce
competition in the market.
Diagonal Diversification
• It consists of the provision within same
organization of auxiliary goods and services
required for the several main processes or lines
• Example a firm may have its own power house
to generate electricity or machine
• The motives of diagonal diversification is more
or less the same as for lateral and vertical
diversification
• the major aim will be mopping up of excess
capacity and reduction of the risks
Motives for all types of diversification can be
summarized as
Profitability or earning motive
Stability motive
Growth motive and
Market power motive
In general, a new industry will have higher degree
of diagonal and vertical diversification but a
mature industry will resort to more lateral
diversification
B. Integration
• It refers to operations by a firm in two or more industries
representing successive stages in the flow of materials or
products from an earlier to a later stage of production or
vice versa
• Vertical integration is because of vertical restriction
• like long term binding contracts w/c the firms deals,
determination of sales territories, setting inventory
requirements and setting the minimum retail price to be
charged
• if the process takes place by merging of two different
firms then it is 'vertical merger'.
• However, vertical integration is a popular term for all
these.
Motives/Reasons for integration
• The motives for vertical integration is the same
as vertical diversification.
• The two general motives, i.e., stability and
growth are equally sustained through vertical
integration
• Generally, there are 6 major advantages of
vertical integration
1. Integration to lower Transaction costs
• There are four types of transactions in which
transaction costs are likely to be substantial
enough to make vertical integration desirable
These are :
• specialized assets
• uncertainty that makes monitoring difficult
• information asymmetry
• extensive coordination
2. Integration to assure supply
• A firm may vertically integrate to assure itself a
steady supply of a key input (backward)
• Assurance of supply is important in markets
where price is not the sole device used to
allocate goods
3. Integration to Eliminate Externalities
• A firm may vertically integrate to correct market
failures due to externalities by internalizing those
externalities
4. Integration to avoid Government intervention
• A firm may be able to avoid government
restrictions, regulations, and taxes by vertically
integrating.
• A vertically integrating firm can avoid price
controls by selling to itself
5. Integration to increase Monopoly profits
• A firm may vertically integrate to increase or create
market power
• A firm may be able to increase its monopoly profits
in two ways by vertically integrating
• 1st a firm that is a monopoly supplier of a key input
in a production process used by a competitive
industry may be able to vertically integrate forward,
monopolize the production industry, and increase
its profits
• 2nd a vertically integrated monopoly supplier may be
able to price discriminate, eliminate competition, or
foreclose entry
6. Vertical Integration to Monopolize another Industry
A victim of another firm’s market power may vertically integrate
to eliminate that power.
For example, dairy farmers contended that they faced a single
processor that bought their milk at a low, monopolistic price
To raise the price of milk, dairy farmers vertically integrated
forward to form their own processors
C. Merger
The term merger refers to amalgamation or
unification of two or more firms.
The firms under different ownership and
management controls come under a unified one
through merger
The terms 'acquisition' and 'takeover' are also
used for merger, which implies that a firm
acquires assets or stocks in part or full, of other
firm or firms to get operational control over
them
In legal sense, there is difference between these
terms but from the point of view of the
economic analysis they are alike
An important feature of merger is the transfer
of control of business activity from one firm or
firms to another
Motives/Reasons for Merger
• The motives of diversification will therefore be
equally applicable to merger also
• However, there are some other important
motives of merger. These includes
Market power
Efficiency gains
Financial Motives
Risk Reduction
Empire Building
Failing firm and aging owners
• For conglomerate mergers the following factors
are mentioned as sources for market power
extended monopoly power
encouraged cross-subsidization
increased deep pocket advantages
increased entry barriers
increased non-economic reciprocity arrange
ments
increased macro-concentration, and
Increased size of power groups/economic
forbearance
5.3. Implication for Public Policies
• Diversification and integration, whether vertical,
horizontal or conglomerate, are important
market strategies which affect the competitive
environment of an industry and economy as a
whole
• such competition will be b/n large firms only
• They find diversification a way to maintain their
growth and market power without being
charged for monopolizing in the market
• large firms control the market and put barriers
to entry for new competitors
• This leads to an increase in market concentration so
that we may say that diversification explicitly or
implicitly causes market concentration
• Under such situation there is a direct implication of
diversification for public policy as no welfare state will
allow concentrating market for a commodity in the
hands of few firms
• Similarly, it is generally agreed that vertical integration
does have the potential to increase market power
either by reducing the competition or through
economies of scale
• For horizontal and conglomerate mergers, there is
greater probability of causing market concentration,
so, they are strictly regulated through-public laws
• A public policy is designed to achieve some chosen
objectives or goals, say for instance
To diffuse economic power
To have efficient allocation of scarce resources
To ensure economic freedom of mass participation in
the economy
Most governments appoint Antitrust or Monopoly and
Restrictive Trade Practices Commissions for this
purpose.
There will be a set of rules or guidelines which will be
implemented by such commissions to regulate mergers
and diversification strategies of the firms by
maintaining a balance between private and public
interests
Thank you for Attention
