It's easiest to understand horizontal and vertical integration if you picture the production process for a given item as a vertical process. At the top you might have mining and collection of raw materials, then transporting them, refining them, forming them into a product, maybe forming them into another product, then packaging, shipping, and other distribution. Most companies don't handle every single part of this process for their given product. They usually leave the gathering of raw materials or shipping to other companies (like mining companies and UPS). However, by outsourcing these steps of production companies can end up losing competitive advantage and money. A company that controls every single part of the production process has efficiency and monopoly advantages compared to companies that rely on other companies to get their work done.
Controlling the steps of the production process in order to reduce costs is vertical integration—companies doing so control each part of the production vertical. This could mean a steel company was involved in mining, smelting, steel production, shipping, and retail. Vertical integration can be great, however, if a step of the production process is controlled by another company, full vertical integration won't be possible. See, the whole idea behind vertical integration is that by producing your own product from end-to-end you have control over prices and do not have to pay what others tell you for production inputs. To use the economic term, you are not a price taker.
THE DIAMOND INDUSTRY
Imagine trying to create a vertically integrated diamond jewelry company. To start with, almost all the diamond mines in the world are owned by De Beers. They have dominance across this stage of the production process, and so you can't just go mine your own diamonds. You would have to pay the price they set, making you a price-taker. Ultimately, this would reduce your profits and gains from vertical integration, as you do not truly control the production process. On the other hand, if De Beers wanted to vertically integrate, they would benefit from lower costs than anyone else in the industry. They can sell themselves diamonds cheaply and cut costs while making every other industry player pay high prices—lowering competitors’ profit margins and ability to compete. Vertically integrating production while controlling at least one aspect of production with horizontal integration gives a company ultimate dominance. This is the strategy Standard oil used
THE STANDARD OIL METHOD—HORIZONTAL INTEGRATION
Horizontal integration, as the name implies, involves controlling an entire step of any given production process, thus giving the firm control over market price. Standard Oil stands to this day as the most textbook example of horizontal integration, although their horizontal integration was achieved through vertical integration as well. At the time, Standard Oil referred to their strategy as consolidation. They first gained a great deal of market power by selling their product more cheaply than others due to an agreement with railroad companies giving them low shipping rates in exchange for a guaranteed quantity shipped daily. What’s more, their competitors had to pay more than normal, and were effectively subsidizing Standard’s shipping.
ECONOMIES OF SCALE
As the company grew, they got to experience the benefits of economies of scale—decreasing marginal costs as production increases, where marginal cost is the cost of producing an additional unit. Economies of scale arise because the fixed costs of production (capital, land) are reduced (on a per unit basis) when more units are produced. Say up-front costs are $1,000, and per-unit costs of $5. If you make 10 items, the average cost of each is $105. But, if you make 100 items, the average cost of each is $15. Bulk discounts on materials also help drive down costs for large-scale producers. See how producing more can reduce costs?
MERGING AND ACQUIRING
Price advantages gained from economies of scale and cheap transportation costs allowed Standard to acquire other competitors. Merging was their favored method of consolidation. If a company didn’t want to sell, Standard would cut prices—driving them down market-wide—until the company was nearly bankrupt, forcing them to sell. Soon, Standard controlled kerosene refining. They were then able to monopolize the petroleum industry because of their horizontal integration at the refining level—made possible by transportation deals—and vertical integration in the production process.
DON'T TRY THIS AT HOME
Today we call this monopoly on transportation and collusion to raise rivals’ costs a cartel.¹ The Sherman Anti-Trust Act (along with other later anti-trust and anti-monopoly legislature) stopped all Standard’s success. Today, Standard Oil’s legacy has become even greater. All the laws and policies created to stop them have meant that it is nigh impossible for horizontal integration to occur on this scale today, making Standard look that much more impressive (and evil). Government policies can shut monopolies down just as easily as they can give them power; no amount of price-cutting or consolidation can challenge the courts of law. This is fortunate for consumer welfare, as today Standard Oil is merely a textbook example rather than the first in a long series of manipulative monopoly² companies. Obviously companies have found many other ways to fix prices and be evil, but these are stories for another time.
¹Not to be confused with drug cartels. They're pretty different. Question of the day: If pharmaceutical companies conspired to lower costs, would it be called a drug cartel? Food for thought.
²Try saying that 5 times fast