Examples Of Vertical Separation Of A Firm
When looking at this question, let's first consider what is meant by vertical separation of a firm. Vertical separation of a firm is when that firm sells the good or service they produce through an independent retailer rather than sell its product itself directly to customers which is vertical integration. So when it come to incumbent firms, firms in which are already well established and selling within a market would it be better off if that firm is operated as one firm that is integrated or if in fact it would be better off if the company was separated. For example if the company that provide telecom infrastructure supplies the framework as well as the actual service itself or should it be managed by two different firms? When first answering the question does vertical separation of these incumbent introduce more competition into the industry, we must first understand the way in which the firm would work as one firm or two independent firms. Taking into account first, if the goods and services were provided by two different independent firms. Both firms have market power and would set their own prices
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above the marginal cost, likewise the other firm would also push its prices up to above marginal cost. This would cause the effect of double marginalization. Taking the example of the telecom industry, the two firms introduce two different markups in the price, these individual markups will create a deadweight loss and as there is two markups, there will be a double deadweight loss. The infrastructure manager will not internalize any externalities it's creating on the downstream operator, this will lead to higher prices for consumers and a loss in welfare. However if vertical separation or integration were to occur the problem of double marginalization would be avoided.
Customers would face only one markup and the market would have one less deadweight loss. Therefore the price in which consumers would face would be lower, less cost to society as the burden of only one deadweight loss could be passed on to the consumer instead of the initial two. The lowered price of the goods or services for buyers will increase its demand and allow the firm to gain more profits. The firms profits could also be increased if the firm in the primary or secondary production part of the supply chain are able to cause an appreciation of the good before it is sold at tertiary level it will also increase demand and in turn the companies profits. So in this case both firms and consumers are benefiting from vertical
separation.
Next, aside from market power, we must analyze how costing situations are affected as a result of vertical integration and separation. However, this is not as easy as it seems as each theory seems to be contradicting the next theory. Theory one was first put forward by late 1900's economist Oliver Williamson. He derived that it was optimal for firms to come together as one, to instruct managers to act as though the firms had not in fact joined and to continue to operating as if they are still a single firm. Whilst this would not result in any cost saving, there would be add on effect of the merger as the firm would be acting as before. There are some small level gains, however, such as both firms bulk purchasing as one, having one location where they both work from. Vertical separation would impose significant costs on consumers, based both on any efficiencies that are lost and the additional systems costs for separation. Separation will reduce the operating efficiencies that are currently used to help fund uneconomic services, particularly in rural part of the UK when it comes to the telecommunications industry. Finally also separation will put out negative signals to investors and potential investors. The second theory works by stating that if in fact there are gains they would only be felt if the firms actually come together and act like one firm only and yet still control the same stake in the market.
By becoming one it allows each firm to bring new skills and specialized departments into the business which will compliment the skills and expertise of the original business. Also growing the firm will enable the company to diversify its output and will therefore help to reduce the risk to the firms of changes to demand conditions. If the demand for one of its services falls then the firms can rely on sales of the other products to secure profits, which in turn could all lead to lower costs for the firm. Economies of scale exist whenever the costs of production fall as output increases and economies of scope exist when there are cost savings from performing two or more different economic activities at the same time. Economies of scale and scope are prominent features of the telecom network. Moreover, vertical economies of scope between upstream and downstream markets are usually important in this industry as compared with other regulated industries. To answer the original question of whether vertical separation of an incumbent firm eases competition into the market, we only have to look over the last decade at the telecommunications sector, and most specifically BT. Coming into the early 21st century, BT had established itself as the market power in the telecommunications sector, with its advanced services. However, following the 2005 investigation by national regulatory body OFCOM, replacing OfTel, BT agreed to create a new branch, OpenReach, to operate its local access networks and to increase its customer reach by making its products more readily available to a larger audience. However, integration of firms NTL and Telewest to form Virgin Media, was the main reason of competition to BT's major power dominance. Coupled with the newer, agressive policy issued by OFCOM following a review of the telecommunications sector via an unbundling regulation, the emergence of broadband allowed
more and more companies, both well known and underdog providers to enter the market. The part of vertical separation within BT cannot be ignored when looking at the increase in competition within the telecommunication sector over the last decade, however we cannot simply look at vertical separation as an alternative around the regulations set in place by body's such as OFCOM, but as a result of the efficiency of their regulatory framework.
above the marginal cost, likewise the other firm would also push its prices up to above marginal cost. This would cause the effect of double marginalization. Taking the example of the telecom industry, the two firms introduce two different markups in the price, these individual markups will create a deadweight loss and as there is two markups, there will be a double deadweight loss. The infrastructure manager will not internalize any externalities it's creating on the downstream operator, this will lead to higher prices for consumers and a loss in welfare. However if vertical separation or integration were to occur the problem of double marginalization would be avoided.
Customers would face only one markup and the market would have one less deadweight loss. Therefore the price in which consumers would face would be lower, less cost to society as the burden of only one deadweight loss could be passed on to the consumer instead of the initial two. The lowered price of the goods or services for buyers will increase its demand and allow the firm to gain more profits. The firms profits could also be increased if the firm in the primary or secondary production part of the supply chain are able to cause an appreciation of the good before it is sold at tertiary level it will also increase demand and in turn the companies profits. So in this case both firms and consumers are benefiting from vertical
separation.
Next, aside from market power, we must analyze how costing situations are affected as a result of vertical integration and separation. However, this is not as easy as it seems as each theory seems to be contradicting the next theory. Theory one was first put forward by late 1900's economist Oliver Williamson. He derived that it was optimal for firms to come together as one, to instruct managers to act as though the firms had not in fact joined and to continue to operating as if they are still a single firm. Whilst this would not result in any cost saving, there would be add on effect of the merger as the firm would be acting as before. There are some small level gains, however, such as both firms bulk purchasing as one, having one location where they both work from. Vertical separation would impose significant costs on consumers, based both on any efficiencies that are lost and the additional systems costs for separation. Separation will reduce the operating efficiencies that are currently used to help fund uneconomic services, particularly in rural part of the UK when it comes to the telecommunications industry. Finally also separation will put out negative signals to investors and potential investors. The second theory works by stating that if in fact there are gains they would only be felt if the firms actually come together and act like one firm only and yet still control the same stake in the market.
By becoming one it allows each firm to bring new skills and specialized departments into the business which will compliment the skills and expertise of the original business. Also growing the firm will enable the company to diversify its output and will therefore help to reduce the risk to the firms of changes to demand conditions. If the demand for one of its services falls then the firms can rely on sales of the other products to secure profits, which in turn could all lead to lower costs for the firm. Economies of scale exist whenever the costs of production fall as output increases and economies of scope exist when there are cost savings from performing two or more different economic activities at the same time. Economies of scale and scope are prominent features of the telecom network. Moreover, vertical economies of scope between upstream and downstream markets are usually important in this industry as compared with other regulated industries. To answer the original question of whether vertical separation of an incumbent firm eases competition into the market, we only have to look over the last decade at the telecommunications sector, and most specifically BT. Coming into the early 21st century, BT had established itself as the market power in the telecommunications sector, with its advanced services. However, following the 2005 investigation by national regulatory body OFCOM, replacing OfTel, BT agreed to create a new branch, OpenReach, to operate its local access networks and to increase its customer reach by making its products more readily available to a larger audience. However, integration of firms NTL and Telewest to form Virgin Media, was the main reason of competition to BT's major power dominance. Coupled with the newer, agressive policy issued by OFCOM following a review of the telecommunications sector via an unbundling regulation, the emergence of broadband allowed
more and more companies, both well known and underdog providers to enter the market. The part of vertical separation within BT cannot be ignored when looking at the increase in competition within the telecommunication sector over the last decade, however we cannot simply look at vertical separation as an alternative around the regulations set in place by body's such as OFCOM, but as a result of the efficiency of their regulatory framework.