Explanation:
Backward integration takes place when a firm enters a merger with a supplier to take advantage of specialized resources and protect the quality of the goods and services produced. Firms participate in backwards integration to protect the supply of raw materials, thereby creating a competitive advantage. Usually, this type of integration creates barriers to entry for the competitors that wish to enter a sector or an industry because the firm controls the scarce resources and the raw materials Furthermore, it creates economies of scale as, due to the merger, the new firm lowers the repair costs as well as the suppliers’ expenses. The only shortcoming that needs attention is that this may also lead to increased monopoly power.
Example:
Company ABC is a manufacturer of frozen food and seeks to acquire one of their suppliers who owns a poultry processing plant. By acquiring the poultry processing plant, the company will be able to control the cost of production, the quality of raw materials, and the quality of the produced food. Furthermore, the company will be able to differentiate its products from its competitors as by assuming control over the supplier it will hinder competitive companies from buying supplies from the poultry processing plant. In doing so, the company will control the scarce resources and the raw materials, but also its costs due to the economies of scale.In a nutshell:
- Backward integration is when a company expands its role to fulfill tasks formerly completed by businesses up the supply chain.
- Backward integration often involves buying or merging with another company that supplies its products.
- Companies pursue backward integration when it is expected to result in improved efficiency and cost savings.
- Backward integration can be capital intensive, meaning it often requires large sums of money to purchase part of the supply chain.
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