Does Vertical Integration Effect Market Power? Evidence from U.S. Food Manufacturing Industries

Article excerpt

The issue of whether vertical integration can raise market power is hotly debated because firms have a market power-related incentive to integrate vertically. Using a sample of U.S. food manufacturing industries, this "market power" motive is empirically tested in this study. Empirical analysis shows that forward vertical ownership integration (or vertical mergers) did not increase food manufacturers' market power in the final product market. The study, however, shows that both market structure and conduct significantly influenced market power in the food industries.

Key Words: food industries, market power, vertical integration, vertical merger

JEL Classifications: L13, L22, Q13

Some form of vertical coordination, whether in the form of contracts or outright ownership, is an integral part of the industrialization process of the U.S. food manufacturing industries. As the U.S. food system becomes more and more consumer driven, vertical coordination, either through outright ownership integration (i.e., mergers) or through contracts, as a business strategy has become increasingly important because it allows both farmers and food manufacturers to manage and customize their production according to market needs. Among the food industries, the poultry industry has been vertically integrated since the early 1960s, whereas vertical coordination (mostly in the form of production contracts) has been spreading rapidly since the early 1980s into other food industries. For example, the percent of total production under ownership integration and contracts during the early 1990s was 100% in the poultry industry, 98% in the processed vegetables industry, 26% in the processed milk industry, 16% in the meat packing industry, and 21% in the hog industries (O'Brian), and the trend is continuing. Vertical integration in lamb and sheep production has increased from 12% in 1970 to 28% in 1990, and vertical integration in potato production and marketing increased from 25% in 1970 to 40% in 1990 (Martinez and Reed).

It is believed that vertical integration and contracts have resulted in improved, consistently higher-quality, more-uniform food products and more choices of food products for consumers. Critics argue, however, that such vertical coordination, particularly vertical integration, may increase market power and, thereby, adversely affect market performance. That is, increased market power results in higher welfare loss. Thus, whether vertical integration can raise market power is a hotly debated issue in the industrial organization literature (Carlton and Perloff, p. 379). Whereas the Chicago School argues that vertical mergers cannot transfer market power from one level to another, the opposite view is that "when vertical mergers displace open transactions, it often forecloses the market and excludes rivals" (Shepherd and Shepherd, p. 255). Given such a debate, the principal objective of this study is to examine the question, "Does vertical integration raise market power in the U.S. food industries?"1

This study is limited to a snapshot of vertical ownership integration or vertical merger (these two terms are used here interchangeably) as it relates to market power at that point in time. To maintain that focus, no attempt was made to analyze changing vertical ownership or merger activities in the food industries, e.g., this study does not analyze why mergers take place in the food industries. Additionally, this study addresses only the downstream or forward ownership integration (see Frank and Henderson for backward integration in the U.S. food industries).

Review of the Literature

Economics literature has abundant studies that show beneficial impact of vertical integration. One strand of such literature, led by Williamson, argues that vertical integration creates efficiencies by reducing the transaction costs associated with market exchange. According to this strand of literature, typical of the Chicago School for which the reliance on open market transactions is considered too risky or unreliable, integrated firms may be able to reduce allocative inefficiency by diversifying risks, assuring supplies or markets, capturing economies of scope or scale, and internalizing externalities in production, pricing, and marketing decisions (Klein, Crawford and Alchian; Perry). …