Oil refinery in California. The oil and gas industry exhibits a degree of vertical integration, where firms sometimes operate at the exploration, production, refining and marketing stages. (Source: California Energy Commission)

Vertical integration represents the degree to which a firm uses internal transfers to connect successive stages of production instead of doing it through the market. Since the time of Adam Smith, it has been known that all transactions in the economy are not necessarily most efficiently consummated using the price mechanism. The cost savings attributable to vertical integration (economies of vertical integration, EVI) arise from the technical interdependencies between the stages of production, the avoidance of transaction costs that could occur in a decentralized market (where the primary determinant is "asset specificity"), and the existence of different market imperfections, such as imperfect competition, uncertainty or asymmetric information. If vertical integration or desintegration occur in an industry, welfare may increase or decrease. Public policy then, like antitrust laws or public intervention, by regulating or deregulating certain industries, becomes an important issue. In the case of deregulation, the savings obtained from undertaking different activities together should be kept in mind by the legislator when restructuring an industry. For example, in the electricity industry there are many vertical disintegration experiences which have been carried out in different countries. The avowed aim has been to foster competition in the sector by introducing incentives to reduce costs. The difficulty of this policy lies in the existence of EVI, which stem from powerful technical interdependencies as well as from high market transaction costs. In a decentralized model, the problem of technical interdependencies can be solved with an independent system operator in the transmission stage, one who has authority over individual producers. In any case, the greatest problems for the deregulation process arise in the course of designing and operating the market.

Oil refinery in California. The oil and gas industry exhibits a degree of vertical integration, where firms sometimes operate at the exploration, production, refining and marketing stages. (Source: California Energy Commission)

Vertical integration represents the degree to which a firm uses internal transfers to connect successive stages of production instead of doing it through the market. Since the time of Adam Smith, it has been known that all transactions in the economy are not necessarily most efficiently consummated using the price mechanism. The cost savings attributable to vertical integration (economies of vertical integration, EVI) arise from the technical interdependencies between the stages of production, the avoidance of transaction costs that could occur in a decentralized market (where the primary determinant is "asset specificity"), and the existence of different market imperfections, such as imperfect competition, uncertainty or asymmetric information. If vertical integration or desintegration occur in an industry, welfare may increase or decrease. Public policy then, like antitrust laws or public intervention, by regulating or deregulating certain industries, becomes an important issue. In the case of deregulation, the savings obtained from undertaking different activities together should be kept in mind by the legislator when restructuring an industry. For example, in the electricity industry there are many vertical disintegration experiences which have been carried out in different countries. The avowed aim has been to foster competition in the sector by introducing incentives to reduce costs. The difficulty of this policy lies in the existence of EVI, which stem from powerful technical interdependencies as well as from high market transaction costs. In a decentralized model, the problem of technical interdependencies can be solved with an independent system operator in the transmission stage, one who has authority over individual producers. In any case, the greatest problems for the deregulation process arise in the course of designing and operating the market.