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