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COMPETITION, CONTRACT, and VERTICAL INTEGRATION FRIEDRICH Kesslert RICHARD H

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COMPETITION, CONTRACT, and VERTICAL INTEGRATION FRIEDRICH Kesslert RICHARD H THE YALE LAW JOURNAL VOLUM E 69 NOVEMBER 1959 NUMBER 1 COMPETITION, CONTRACT, AND VERTICAL INTEGRATION FRIEDRICH KESSLERt RICHARD H. STEHH VERTICAL integration, the coordination of successive stages of production or distribution,' has received considerable attention in recent years. This at- tention, however, has been confined largely to integration by stock or asset acquisition--ownership integration. Contract integration-vertical contractual arrangements such as requirement, output, exclusive dealing, franchise, con- signment, and agency agreements 2 --has just begun to be treated as a form of vertical integration 3 although it is widely used to achieve industrial coordina- tJustus S. Hotchkiss Professor of Law, Yale Law School. tTrial Attorney, Antitrust Division, U.S. Department of Justice. This Article was prepared prior to Mr. Stern's entering government service; the views expressed are those of the authors and do not necessarily represent those of the Department of Justice. The authors wish to thank Mrs. Jonathan Fine of the Massachusetts Bar for valuable assistance in research; our greatest debt is to Ward S. Bowman, Jr., Professor of Law and Economics at the Yale Law School, who gave us the benefit of his great learning and creative perception with unsurpassed generosity and cordiality of spirit. 1. Cole defines "vertical integration" as "that type of organization that comes into existence when two or more successive stages of production and/or distribution are com- bined under the same control." Cole, General Discussion of Vertical Integration, in VERTICAL INTEGRATION IN IRLUUETING 9, 99 (Bureau Econ. & Bus. Research, U. Ill., No. 74, 1952). According to Adelman, "a firm is called vertically integrated when it transmits from one of its departments to another a good or service which could, without major adaptation, be sold in the market." Adelman, Integration and Antitrust Policy, 63 HARv. L. REv. 27 (1949); Bork adopts this definition in Vertical Integration and the Sherman Act: The Legal History of an Economic Misconception, 22 U. Cni. L. REv. 157 n.1 (1954). For Frank, "[Vlertical Integration may be described as the functional co-ordination of one or more units in each of the several successive stages of production, so that they are all operated as a single, unified industrial process." Frank, The Signili- ance of Industrial Integration, 33 J. PoL. EcoN. 179 (1925). See also Buans, TnE DE- CLINE OF CoETrmoI 421 (1936) (salability of intermediate products). 2. The vertical joint-venture agreement might be added to this list of contractual coordination devices. Joint venture is a hybrid integration device which combines owner- ship and contract. Typically, a supplier and his customer set up a jointly owned subsidiary in order to transact their business. See note 14 infra. 3. See McLaren, Related Problems of "RequiremnentI' Contracts and Acquisitions in Vertical Integratim Under the Anfi-Trust Laws, 45 Iu. L REv. 141 (1950); Adelman, Corporate Integration, in How To CO=PLY WrrE TEE ANTITRUST LAws 290, 303-04 (Van Cise & Dunn ed. 1954); Rostow, Over All Size, in id. 311, 323; Hia & HA.E, HeinOnline -- 69 Yale L.J. 1 1959-1960 THE YALE LAW JOURNAL [Vol, 69:1 tion and even control. Nor have informal understandings which are ancillary to formal contracts and which aim at coordination 4 been included in an overall concept of integration. As a result, the functional similarities or differences between these alter- native methods of integration have been underemphasized or ignored. Con- tractual arrangements aimed at coordinating the supply of materials or dis- posal of output frequently affect the contracting firms, as well as the rest of the industry, in much the same way as ownership of suppliers or outlets does. But important differences may attend the two devices-differences in business effectiveness and in legal consequences. With an eye toward possible differences between ownership and contract, part I of this Article will deal with the industrial and economic aspects of vertical integration. The remain- ing parts are devoted to legal problems: part II examines the effect of the antitrust laws on integration systems and part III considers the impact of pricing regulations. I. VERTICAL INTEGRATION IN ITS BUSINESS SETTING THE IMPACT ON THE FIRM Cost reduction is the principal technological justification for vertical in- tegration.5 "Cost reduction," however, is a broad term which requires further MARKET POWER: SIZE AND SHAPE UNDER THE SHERMAN AcT 204 (1958) ("vertical control"). Compare id. n.12 (§ 3 of the Clayton Act not applicable) ; Levi, The DuPont Case and § 7, 3 ANTITRUST BULL. 1, 10 (1958). However, the courts have been aware that contractual arrangements may serve as alternatives to ownership integration. See Standard Oil Co. v. United States, 337 U.S. 293, 319 (1949) (dissenting opinion of Douglas, J.) ; cf. Mandeville Island Farms, Inc. v. American Crystal Sugar Co., 334 (I.S. 219, 243-44 (1948); Gulf Ref. Co. v. Fox, 297 U.S. 381 (1936). Contractual arrangements aiming at vertical integration extend over a wide range, verging at one extreme on the permanence and control of ownership integration, and at the other approaching the impermanence and lack of control of the spot-market transaction. 4. For example, manufacturers frequently have an understanding of exclusive dealing with their dealers, although exclusive dealing is not required by the formal sales contract. This is particularly common when the manufacturer leases the premises to the dealer. Loans or extension of credit may assure an outlet or secure a source of supply, and thus serve as devices of vertical industrial coordination. See International Shoe Co., TRADE REG. REP. (1957-1958 FTC Cas.) U 26611 (1957), consent order entered, id. Ui 27074; Hearings Before the Subcommittee on Antitrust and Monopoly of the Senate Coln- inittee on the Judiciary, 84th Cong., 1st Sess., Ser. 3, pt. 6, at 2598-99 (1955) [hereinafter cited as 1955 Sen. Hearings]; id. pt. 7, at 2665-66, 2668; Bus. Week, May 19, 1951, p. 26 (General Motors lends to steel companies to secure their output) ; United Stateg v. National City Lines, 186 F.2d 562 (7th Cir.), cert. denied, 341 U.S. 916 (1951). 5. Adelman, Integration and Antitrust Policy, 63 HARv. L. Rxv. 27, 48 (1949) ("Ste- cessful integration . consists in the saving of overhead, and results in doing a given job more cheaply."). Of course, vertical integration may occur without any rational justification. Historical accident and mere chance may cause a vertical integration pattern in an industry where there are no economies or diseconomies of scale. Adelman, Concept and Statstiual HeinOnline -- 69 Yale L.J. 2 1959-1960 1959] VERTICAL INTEGRATION analysis, for it encompasses a multitude of reasons for adopting integration." Perhaps the most important of these is the increased stability of operations that coordination affords. Consumer outlets, sources of supply, and uniform- ity of quality are made more secure, thus increasing the feasibility of long- range planning.7 Facilities can be fully utilized, overtime production or idle plant minimized, s and inventory reduced.9 foreover, vertical integration eliminates many costs incurred in the transfer of goods from one control to another. The most obvious of these are marketing expenses.10 Also, when goods are manufactured for general salability rather than for a specific known function, many all-purpose features unnecessary to each individual buyer are incorporated, thereby raising the cost of production in order to increase market appeal." Such "functional cross-hauling" costs can be eliminated by integration. Measuremet of Vertical Integration, in BusINESS CONCENTRATION AND PRICE POLICY 281, 320 (1955). For a discussion of underwriters' profits as a motivation for ownership integration, see Thorp, The Persistence of the Merger Movement, 21 Am. EcoN. REV. 77, 85-86 (Supp. 1931). And psychological factors such as power and prestige should not be ignored. See 2 DEvING, FINANCIAL POLICY OF CoRroRATioNs 812 (5th ed. 1053): Adelman, supra note 5, at 34; JmVIES, ORDA. BY PLANNING 29, 30 (1948). 6. For example, to the extent that vertical integration lessens human wear and tear attendant to the constant making of sales contracts, it is a cost reduction factor. See Llewellyn's excellent discussion of this point in Book Review, 52 HAnv. L. REv. 700, 701 (1939), referring to the human economies of standardized contracts. 7. See DEAN, MANAGERIAL EcoNoMics 117 (1951) ; Girdner, Inlegrated Marketing Institutions, 209 ANNALS 55 (1940). In Goodyear Tire & Rubber Co., 22 F.T.C. 232. 287 (1936), respondent defended itself against a charge of violation of § 2 of the Clayton Act by asserting that the large assured volume obtained from its requirements contract integration with Sears, Roebuck served to "remove hazards and insure stability by avoiding the fluctuation of profit inevitable in respondent's other business... :' See note 526 infra. See also KImDALL & KIMBALL, PRINCIPLES OF INDUSTRIAL ORGANIZATIO.N 61 (6th ed. 1947) ("danger of having production slowed up because of lack of supplies greatly reduced") ; FoLTs, INTRODUCTION TO INDUSTRIAL MANAGEMENT 169-70 (1938). 8. This factor is most significant when overhead costs are large. See DAVIS, VFsRT- CAL INTEGRATION IN THE TEXTnE INDUSTRIES 3 (1938). 9. KIMALL & KIMBALL, op. cit. supra note 7, at 61; Frank, The Significance of Industrlal Integration, 33 J. POL. ECON. 179, 190-91 (1925); see NEvi.s, Foro: Tnn TimEs, THE MAN, THE COM PANY 336 (1954). But see DE CuAzEAv & KAs, I.TEG;rATh'. IN THE OIL INDUSTRY 454 (1959). 10. CON-VERSE & HUEGY, ELEMENTS OF MARKETING 199 (3d ed. 1947) (savings on "salesmen, advertising, sales promotion, sales managers, buyers"). See also Girdner. supra note 7; Frank, supra note 9, at 179, 190-91. These expenses also include handling. transportation (geographical cross-hauling), and credit losses. 11. A familiar example of this is the "Swiss Army" knife, wfith saw, file, curkscrew, awl, bottle opener, screwdriver, can opener, and scissors, in one package.
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