Vertical Integration and Communication

Author(s): Kenneth J. Arrow

Source: The Bell Journal of Economics, Vol. 6, No. 1 (Spring, 1975), pp. 173-183
Published by: RAND Corporation
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 Vertical integration and communication
Kenneth J. Arrow

Professor of Economics
Harvard University

Among the many possible motives for vertical integration, the

one emphasized here is uncertainty in the supply of the up-
stream good and the consequent needfor information by down-
streamfirms. The basic conclusion is that, even ivhen the initial
conditions are of the type usually thought of as competitive, the
upshot will be a tendency to impeifect competition.
A simple model is analyzed. The supply of each upstream
firm is a random variable, vhich cannot be altered by any
decisions. Each such firm know)s its supply (or has some infor-
ination about it) one period in advance. Downstream firms op-
erate under constant returns and risk neutrality with two inputs,
the upstream product and capital; the latter must be chosen one
period in advance of output. There is a spot market for the
upstream product.
Then, if there is no vertical integration to begin with, a
downstream firm wvill have an incentive to buy one or more
upstream firms because this improves his forecast of the spot
price of upstream product and therefore his ability to choose the
level of capital. There is no incentive, howt ever, to acquire the
upstreamfirm for any other reason. Similarly, given any owiner-
ship pattern of upsttream firms by downstream firms, there will
alwvays be an incentive for each dowvnstream firm to acquire
more upstream firms, to improve its forecasting. Hence, no
competitive equiilibrium with many firms can survive.

a The possible motives for vertical integration are many.' In 1. Introduction

this paper, I want to emphasize the role of uncertainty in the
supply of the upstream good and the need for information by the
downstream firms. Though in fact it will be shown that imper-
fect competition is a necessary outcome, the initial conditions
will be of the sort that we usually associate with perfect compet-
ition.
In the model, there are two kinds of firms. The upstream
firms have a product, to be referred to as "raw materials." The
production conditions are marked by uncertainty; to make the
point more dramatic, I shall assume that the output of each

Kenneth Arrow received the B.S. from the City College in 1940, the M.A.
from Columbia University in 1941, and the Ph.D. from Columbia in 1951.
Currently, he is studying information and economic behavior in relation to
equilibrium.
This work was supported by National Science Foundation Grant GS-40104
at the Institute for Mathematical Studies in the Social Sciences, Stanford Uni-
versity. VERTICAL INTEGRATION

1 See, for example Williamson [2]. AND COMMUNICATION / 173

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174 / KENNETH J. ARROW
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upstream firm is a random variable, unaffected by any possible
decision on its part. It will be clear that generalization to make
the output of an upstream firm a random function of inputs will
not make much difference, indeed, no difference at all if the
inputs have to be chosen before the random factors are known
to the firm. The output of different upstream firms may and in
general will be correlated with each other.
Each downstream firm has a production function for its out-
put, called "final product," as a function of two imputs, raw
materials and "capital." The latter is purchased on competitive
market whose price is a known constant. There is no uncer-
tainty in the production function for the final product. The
production function has constant returns to scale, so that, essen-
tially there is free entry and therewith the basic prerequisites for
competition.
Finally, we assume that raw materials are traded on a market
which clears in each time period. Hence, the downstream firms
have no uncertainty about raw material supply per se, but only
about its price.
The competitive equilibrium for this system of markets in the
absence of vertical integration is easily understood and will be
developed in Section 2 below. The question that has to be asked
is, is there any incentive for vertical integration which will upset
that equilibrium? It is fairly obvious that in the absence of
production lags, there would be no incentive. We therefore
assume that capital has to be purchased one time unit before the
acquisition of raw materials in the downstream production pro-
cess. Even so, as will be seen, there is no incentive to vertical
integration unless there is also an information lead; in the simp-
lest case, the upstream producer knows his output one time unit
before it appears on the market. Then indeed there is an incen-
tive to integrate; but the incentive is not to insure in advance a
quantity of raw materials, but rather to acquire information rel-
evant to its market price.
In Section 2, the model and the competitive equilibrium
conditions in the absence of vertical integration are set forth in
detail. In Section 3, it is shown that there is an incentive for any
one downstream firm to acquire one or more upstream firms. In
Section 4, it is argued that a competitive equilibrium with verti-
cal integration in which no firm has a large fraction of the raw
material production is also impossible; given any such conceiv-
able equilibrium, it will always pay one of the integrated firms to
buy more upstream firms. In Section 5 it is argued that, in the
absence of monopoly power to a fully integrated industry (i.e.,
given a highly elastic demand for the final product), there will be
an equilibrium which is, in a sense, competitive but in which
there exists only one firm owning the entire upstream production
and producing all the final product. Finally, in Section 6 some
possible extensions of the model are discussed briefly: some
inconclusive comments on the possibility of imperfectly com-
petitive equilibria, an exploration of the possible substitution of
a futures market for vertical integration, the possible inefficiency
of vertical integration in the marketing of intermediate products,
and the role of risk aversion.
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* We now give an explicit formulation of the model and discuss 2. Competitive
its equilibrium when both vertical and horizontal integration are equilibrium
forbidden. There are n upstream firms referred to, for conveni- without vertical
ence, as u-firms. The number n is finite but sufficiently large so integration
that each u-firm regards itself as engaged in perfect competition.
The output of the ith u-firm is xi, taken to be a random variable
with a distribution known to all participants on the market. The
variables x1, . . . , xt, have a joint distribution, and, in general,
will not be independent; hence, any one u-firm has, by observing
its output, some information on the outputs of other firms. We
do assume that the successive drawings of the random vector of
xi's are independent over time. Finally, we assume that the
value of xi is known to the ith firm one time unit before it is
ready for sale. The significance of this predictive ability will be
seen below.
With regard to the downstream firms, referred to as d-firms,
it is assumed that there are an indefinite number, a continuum if
you will, each producing the final product under conditions of
constant returns. Each firm has the same production function
F(x,y), concave and homogeneous of degree one, expressing
output as a function of the use of the raw material, x, and of
another input, y, which has been called "capital." It will be
assumed that the capital input has to be chosen one time period
before the raw material. Any lag of output behind the acquisition
of raw material will have no significance to our problem, so we
shall assume without loss of generality that there is no such lag.
We assume risk neutrality on the part of all firms; I wish to
avoid the analysis of vertical integration as a portfolio problem.
Capital is available to our industry in perfectly elastic supply; its
price is constant over time, and we shall take it to be 1.
There are two markets endogenous to the model, those for
raw materials and for the final product. They are cleared simul-
taneously, since there is no lag between raw material acquisition
and final production in the downstream industry. The amount of
raw material on the market is a random variable,
it

x = >x. (1)
i=l

Let p and q be the prices of the final product and raw material,
respectively. At the time the markets open, the capital must
have already been purchased. Hence, y is given to these mar-
kets and is independent of the realized value of x. The demand
for raw material is then governed by the marginal productivity
relation,

pFx(x,y) = q. (2)
The output of the final product is F(x,y) and the demand func-
tion for the final product then determines p as a function of x,
for given y. If, as we shall sometimes assume, the demand for
the final product is perfectly elastic, p will be a constant. Given
p, constant or a function of x for given y, we find q as a function
of x, again for given y.
The capital is determined so as to maximize expected profits; VERTICAL INTEGRATION

the d-firm in a competitive market takes the functions p(x) and AND COMMUNICATION / 175

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 q(x) as given and is unaware of the influence of y on them.
Remember that, because of the lag structure of production in the
d-firms, y must be chosen before the prices of the raw material
and of the final product are known. The d-firms are assumed to
be aware of the dependence of p and q on the random total
output of raw material

E[p(x)F^,(x,y)]= 1. (3)
The equilibrium is defined by (2), (3), and the demand func-
tion for final product; specifically, these relations determine the
functions p(x) and q(x) and the value y. If, in particular, the
demand for final product is perfectly elastic, then p does not
depend on x, y can be solved for from (3), and q(x) immediately
determined from (2).

3. The incentive * Now assume that vertical but not horizontal integration is
for incipient permitted. This amounts to opening a new market, that for
vertical integration u-firms. The previous equilibrium remains an equilibrium if, at
the market price for u-firms, there is no demand by d-firms.
Under risk-neutrality, the market price for a u-firm would be
simply the expected value of its profits, the price being reckoned
on a flow or equivalent income basis rather than as a capital
value. Let Pi be the price of the ith u-firm:

Pi = E[q(x) xi]. (4)

At these prices and at the random prices p(x) and q(x), would it
pay for a d-firm to purchase one or more u-firms? Suppose it
did. What would its optimal policy and payoff be? Let y' be its
purchase of capital and x' its use of the raw material. Once the
market for raw materials is opened, the integrated firm could
just as well sell all of the raw material output from its
u-department and buy what it needs and wants for use in its
d-department. The two activities are thus completely separable.
From the viewpoint of any decisionmaking in the d-department,
the price of the raw material is effectively the market price, q(x);
the fact that the firm owns some of the raw material is irrelevant
at that stage, since it can sell it in the market. Thus, in a sense,
owning a u-firm is no protection against scarcity as reflected in
high prices; the shadow cost to the integrated firm of the raw
material is not affected by owning any. There might conceivably
be a portfolio diversification benefit, but I am ruling that out by
my assumption of risk-neutrality.
Since Pi is the expected value of the raw material output of
u-firm i, the expected value of the u-department is zero, and by
the assumptions it is not affected by any decision. Let us then
concentrate on the decisionmaking in the d-department. This is
significantly affected by the vertical integration in terms of in-
formation. The integrated firm knows the value of xi; and by
assumption it knows this value early enough to make use of it in
deciding on the level of capital used. Thus vertical integration in
this model is essentially a way of acquiring predictive informa-
tion.
176 / KENNETH J. ARROW Let x' and y' then be the amounts of raw material and capital,

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respectively, used by our integrating firm in production of final
product. Let x and y be the total amounts used in the industry; x
is a random variable, given to all participants, and in seeking a
competitive equilibrium we can regard y as given parametrically
to all and in particular to our integrating firm. Once investments
have been made, then, since we are testing whether the equilib-
rium without vertical integration remains an equilibrium, the raw
material market clears in such a way that the ratios of the two
inputs are the same throughout the industry:

x x (5)
y' y

The profits from the d-department are

p(x)F(x',v') - q(x)x' = y(6)

since F is homogeneous of degree one. From (5),

G(,) = G(-). (7)

Since the integrated firm knows xi at the time y' is deter-

mined, its aim is to maximize the conditional expected profit
given xi,

Ex[y G(-x )xi = y 'Ex[G() Xii (8)

where the subscript x reminds one of the variable with respect to

which the expectation is taken. Since y is taken as parametric by
the integrated firm, the expression in (8) is simply proportional
to y'; hence optimization requires a positive, indeed an
indefinitely large, value of y' for those values of xi for which,

H(xi) = Ex G(yk xij > 0, (9)

and y' = 0 whenever the contrary holds. In the long run, the
profits of the firm are given by the unconditional expectation of
y'G(x'ly'), where y' is taken to be a function of xi. Thus, in
particular, let y0 > 0 be some fixed value of y', and let y' = yO
whenever (9) holds, and = 0 otherwise. By a well-known princi-
ple of probability theory, the unconditional expectation is the
expected value of the conditional expectation. That is, if U and
V are any two random variables, the conditional expectation,
Eu(U/V) is a function of the random variable V and therefore a
random variable itself; then its expectation is the unconditional
expectation of U,

EV[Eu(UIV)] = E(U).
Then,

Erj y f G(xr, = Ex,, Ex y f G( ( xi10

=Exj tY'Ex GI x- Xi]

VERTICAL INTEGRATION

=y,,Ex, [H+(xi)] . ( 10) AND COMMUNICATION / 177

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 where

H+(xi) = H(xi)

when it is positive and - 0 otherwise.

Since H+(si) _ 0 always, the expectation in (10) is nonnega-
tive and is positive if and only if (9) holds with positive probabil-
ity. But from constant returns and risk neutrality, we must have
in equilibrium,

0 Ex= Y() G | = Ex IExyLG( ) xxi yEx, [H(xi)] (1 1)

so that H(xi) is a random variable with mean 0. Clearly, under
any reasonable set of assumptions, G(x/y) will be correlated
with the output of any one firm, and H(xJ) will not be a degener-
ate random variable. Hence, it must be positive with some
positive probability. But then we have shown that the integrat-
ing firm can make a positive profit, indeed an indefinitely large
one. Positive profits are, however, incompatible with equilib-
rium, since they would be destroyed by entry of d-firms.
The information about total profits conveyed by knowing the
output of one u-firm arises from an improved ability to predict
total raw material output. This can arise in two ways: (1) the
obvious one, that total output is the sum of the outputs of the
individual u-firms, and therefore knowing the output of one firm
conveys information about the total in the absence of negative
correlations; (2) in general, we may suppose that there is a
positive correlation among the raw material outputs of the dif-
ferent firms, arising perhaps from a common factor (e.g.,
weather) which affects them all.
It follows that the competitive equilibrium in the absence of
vertical integration can no longer continue to be an equilibrium
in its presence. If vertical integration is permitted, then any
equilibrium must in fact contain some. But it must be em-
phasized that the value of vertical integration is the information
acquired about total raw material in production.

4. Competitive * Can there then be a competitive equilibrium in which in fact

equilibrium with there are one or more integrated firms? Suppose there were. The
many firms and first point is that, because of free entry of d-firms and a competi-
vertical integration tive market for u-firms, the expected profits of any integrated
firm must be zero. Let the firm own a set, A, of u-firms. Then it
chooses its capital, y', as a function of xi (i E A), and its raw
material input x' on the market for raw materials. In gen-
eral, each firm has chosen its capital as a function of some set of
xi's, so that the aggregate amount of capital, y, is a function of
x, . . ., x1,. Given y, the demand for the raw material is its
marginal productivity, while the supply is, as before, simply the
random total. So, p and q are related,

pFX(x,y) q,

as in (2) above, and p and q are determined jointly by this

equation and the demand for the final product. But since y is
178 / KENNETH J. ARROW now a function of the xi's, q will be a function q(x1, . . ., x1), not

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in general determined merely by the total x. As before, equation
(5) holds. The following modification of (6) holds for the profits
of the d-department:

p(xl, x. .., x) F (x', y') - q (x1, X n *, Xn) X' -y- = y'G );(12)

and from (5),

y'GX)- y'G: X)

For simplicity of notation, let XA be the vector xi (i E A), and

let X be the vector of all xi's. The integrated firm wishes to
maximize,

y 'Ex[G(Y XAI, (13)

for given XA. Clearly, then, equilibrium requires that,

ExLG( y )XA] < 0 with probability 1. (14)

On the other hand, if the strict inequality held with probability

1, the integrated firm would not in fact be in business, which is
hardly a relevant case:

Ex[G(2y)XA = 0 or; a set of positive probability. (15)

The market price of the ith u-firm must be at least expected

sales, otherwise the owner of the firm would not sell:

Pi >- E[q(x1 , . . -, xn)lxi] * ( 16)

On the other hand, any owner of a u-firm would certainly sell
at a price above the right-hand side. Hence, if any u-firm is not
sold, the equality must hold in (16). Consider now a u-firm
which has been sold to an integrated firm. The expected profits
of that firm are zero. The expected profits of its d-department
must be zero by (14). Hence, the expected profits of its
u-department must be zero, and that means that the price paid
for the u-firms it owns must equal their expected sales:

E pi = E q(xl,. , x.) , xiJ]

and, in view of (16), this can hold only if equality holds in (16)
for each i:

Pi = E[q(x1, . . . , x,d)xi. (17)

Some aspects of the competitive equilibrium with some ver-
tical integration have been described on the hypothesis that it
exists. It will exist if and only if there is no incentive for any
firm to acquire an addition u-firm. As before, the incentive, if
any, must be solely in the improvement in the d-department. If
the firm acquires another u-firm, i, not in A, the change is that it
can choose y' as a function of both XA and xi. This will be
profitable only if,
VERTICAL INTEGRATION

Ex[G(-Y-)XA,xil > 0 with positive probability. (18) AND COMMUNICATION / 179

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 Take any XA for which (15) holds. Then,

0 OExG(-Y) XAI - Exi {Ex[( ) XA ,Xi]j.

Under almost all reasonable conditions, xi gives inform

additional to XA concerning the value of G(x/y). (Remember
that, under competitive assumptions, the potential integrator
assumes that the functions p(x1, . . .x,, x) and q(x1, . . , x,,) do
not change with his planned acquisition of firm i.) Then,

EX[G(x,y)jXA ,xi.,
as a function of xi for fixed XA, is a random variable with a
nondegenerate conditional distribution; since its mean is zero, it
is positive with positive conditional probability for each XA for
which (15) holds; but since (15) holds on a. set of positive
probability, (18) is verified.
Just as in Section 3, we can conclude that no competitive
equilibrium is possible where there is vertical integration but no
firm owns all the u-firms.

5. A monopoly * The argument in the preceding section showed that if a com-

equilibrium with petitive equilibrium formed with a given pattern of vertical inte-
no monopoly power gration, it would be upset because any firm would always have
an incentive to acquire one more u-firm. This suggests that there
will be a tendency to increase consolidation of u-firms into
integrated firms to the point where the competitive nature of the
markets is destroyed.
Of course, there is in any case an impulse to merge to
achieve market power, and I want to avoid confusing the incen-
tive of monopolization with that of minimizing the inefficiency
due to uncertainty, the point I am trying to stress here. The
model has prohibited horizontal mergers, at either level; but
vertical integration, if pursued sufficiently, will include a hori-
zontal integration upstream. To purge the model of monopoliz-
ing incentives, let me assume that the demand for the final
product is perfectly elastic. We might think of the upstream and
downstream industries as belonging to a small country whose
final products are sold on world markets in competition with
other companies.
Under these conditions there can be a "competitive"
equilibrium in which there is but one active firm, one which has
bought up the entire u-industry. Capital decisions are now made
with no uncertainty. The total supply, x, is known to the firm at
the time of choosing capital, so that,

F_(x,y) = 1, (19)
yielding y as a function of x. The price of the raw material is
again determined by (2):

pFx(x,y)=q(x),

where p is now assumed to be a constant. Because of competi-

180 / KENNETH J. ARROW tion and free entry in the d-sector, the original owners of the

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u-firms reap the full benefit of the rationalization of industry, in
the form of the prices paid for the firms:

Pi, = E[q(x)xj],

in form the same as before, but the value of q(x) will in general
be higher.
The only way this equilibrium could be upset is if an outsider
were to enter and possibly buy one or more of the u-firms (or
even try to operate a d-firm with no it-department). Clearly,
however, any such firm will have less information than the
"'monopolist." Hence, his expected profits in the d-department
will have to be less, because his adaptation of capital to supply
of raw material is less good. Since the "monopolist," however,
is making zero profits in the d-department, the potential entrant
will be making negative profits there. Under competition and
risk-neutrality, he can have zero expected profits in the
u-department. Therefore the potential entrant will find it
unprofitable unless, indeed, he buys out all the u-firms. But then
that is simply a change of monopolists and no true change in the
equilibrium configuration.
The outcome is socially optimal, since all the available in-
formation is used perfectly. Of course, it must be repeated, this
beneficent result of the invisible hand occurs only when there is
no monopoly power in the system as a whole. Otherwise, we do
have a situation in which the advantages of merger to improve
information are accompanied by an opportunity to exercise
monopoly power.

m It is conceivable that there are imperfectly competitive 6. Some concluding

equilibria. That is, one can imagine the possibility that there are comments
a few large vertically integrated firms, each aware of its effect on
the market and of the others; they play some sort of non-
cooperative game. Even in the absence of monopoly power in
the industry as a whole, each firm could have an influence over
the raw materials market. Any one firm might be restrained from
expanding by consideration of its increasing portion of the raw
materials market.
It is difficult to construct a believable model of this possibil-
ity and, therefore, to see whether this imagined world is consis-
tent. The trouble is that there will necessarily be few individuals
on either side of the raw materials market in that case, and so
the rules of the game are hard to define. I would conjecture that
these imperfectly competitive worlds cannot in fact exist-that
is, no matter how they are defined, it would always pay an
integrated firm to acquire the additional information contained in
additional u-firms.

El I have not considered various auxiliary markets which might

convey the information without integration. I assume first of all
that the information about upstream production cannot itself be
sold; the argument for that is fairly familiar. Second, I assume VERTICAL INTEGRATION

the absence of suitable contingent markets. Since they do not in AND COMMUNICATION / 181

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 fact exist, there are presumably good reasons in terms of cost
factors, such as the specification and verification of the possible
outcomes.
In this model, a third possibility cannot be so easily ruled
out-that of futures markets. Since the raw materials sellers do
know their future product, they could offer valid contracts one
period in advance. If the market works smoothly enough so that
it does not create an additional delay in diffusing the needed
information, the d-firms could make the correct investment deci-
sions on the basis of the futures price.
However, a small modification of the model would deprive
the futures market of much of its usefulness. Suppose what each
u-firm knows one period in advance is not its actual output but
an indication of it, that is, a signal correlated with its output
(and/or with total output) but not perfectly. Assume further that
a futures contract must in fact always be honored, or else that
there is a severe penalty for failure to deliver. Then the indi-
vidual u-firm can make futures contracts only up to the
minimum output which is absolutely assured, given the signal.
Thus there will remain an active spot market whose price will
not be known in advance with certainty. The futures price will
be socially useful primarily as a signal, but it will not convey the
same information as acquiring all the u-firms. On the other hand,
the arguments presented above concerning vertical integration
remain valid without change; it was not necessary that the
"monopolist" have perfect information, only that the acquisi-
tion of successively more u-firms represent an increase in
information .2

O Another possible modification is that the vertically integrated

firm might be less efficient than the sum of the firms. (Jerry
Green has used this assumption in a different approach to verti-
cal integration.3) A particular form of this, which has some
realism, is that a vertically integrated firm will not sell the raw
material, though it may buy additional amounts on the open
market. This condition will certainly operate to restrict the in-
centive for vertical integration. Preliminary analysis suggests
that this restriction will lead to extremes; either there will be no
vertical integration at all, or, as in this paper, it will proceed to
the limit.

O Finally, the hypothesis of risk neutrality might be relaxed.

However, it is not clear that risk aversion provides much of an
incentive to vertical integration. If demand for the final product
is highly elastic, then it is easy to show that upstream sales and
downstream profits are positively correlated. Hence, acquiring a
ti-firm does not seem to be the best possible portfolio
diversification.

2 I am indebted to the members of the Interdisciplinary Colloquium on

Mathematics in the Behavioral Sciences, University of California at Los
Angeles, for raising the question of the futures market as an alternative to
vertical integration.
182 / KENNETH J. ARROW 3 In [1].

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References

1. GREEN, J. "Vertical Integration and Assurance of Markets." Harvard Insti-

tute of Economic Research, Discussion Paper No. 383, 1974.
2. WILLIAMSON, 0. E. "The Vertical Integration of Production: Market Fail-
ure Considerations." The American Economic Review, Vol. 61, No. 2 (May
1971), pp. 112-123.

VERTICAL INTEGRATION
AND COMMUNICATION / 183

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