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31 2 Rise and Fall of Vertical Integration in the Midwest [Hyundai officials] know that the Detroit area is the brain center of not only the global automobile industry, but particularly the North American automobile industry.1 Thousands of companies were established to build cars in the United States in the first years of the twentieth century.At the end of the first decade of the twenty-first century, there were only three American-owned carmakers—Chrysler LLC, Ford Motor Co., and General Motors Corp. By 1910 Ford and GM had emerged as the two top-selling carmakers in the United States and worldwide, and they remained so until they were passed by Toyota in the first decade of the twenty-first century. Many reasons accounted for the success of Ford and GM, but arguably the most important was the ability of the two companies to make most of their own parts instead of buying them. Ford and GM both regarded the strategy, known as “vertical integration,” as an important competitive advantage. Chrysler, the third of the Detroit-based Big 3 carmakers, was somewhat weaker in large measure because it was less vertically integrated than its two larger competitors. Unable to compete with the Big 3 on price and quality, other carmakers were driven out of business, and independent suppliers were relegated to a marginal role in the production process. Vertical integration was also the basis for the dominance of motor vehicle production in the Midwest, especially in southeastern Michigan. At the height of vertical integration, parts-making was more highly clustered in southeastern Michigan than was final assembly. Parts produced in southeastern Michigan were shipped to final assembly plants located near big cities around the country, like New York and Los Angeles. After nearly a century of making most of their own parts, GM and Ford both exited the parts-making business within a year of each other, in 1999 and 2000, respectively. Making their own parts had become a liability rather than an asset for GM and Ford because other carmakers 32 Klier and Rubenstein were buying better quality parts from independent suppliers at lower prices. Just as the rise of vertical integration underlay southeastern Michigan ’s dominance of the motor vehicle industry for much of the twentieth century, so has the end of vertical integration triggered hard times in Michigan. At the height of vertical integration, immediately before and after World War II, Ford and GM together made about 60 percent of their parts in Michigan but assembled only about 15 percent of their vehicles there. At the beginning of the twenty-first century, Michigan’s share of Ford and GM’s North American final assembly operations had increased to 20 percent, but the state’s share of parts production had fallen to about 25 percent. BENEFITS OF VERTICAL INTEGRATION Every manufacturer needs inputs into its production process and ways to get its goods to customers. Vertical integration measures the extent to which a firm is integrated with its “upstream” sources of inputs and its “downstream” distribution to customers. A firm must either procure inputs from other firms or control the input sources itself. A firm that is relatively integrated upstream produces most of its raw materials and semifabricated inputs itself. Similarly, a firm either turns over its output to other firms or controls the sources of distribution itself. A firm that is relatively integrated downstream controls most of its own distribution activities instead of turning over its goods to independent wholesalers and retailers. The benefits of vertical integration were recognized by economists long before the establishment of the motor vehicle industry. Industrial organization textbooks (e.g., Scherer and Ross 1990) distinguish several motives for vertically integrating a business activity. Vertical integration can have the following benefits: • Reducing costs. According to Nobel Laureate Ronald Coase, who proposed a transaction cost theory of firms, activities will be collected in a firm when the cost of using the price mechanism (procuring across markets) exceeds the cost of organizing those same activities through direct managerial control. Several Rise and Fall of Vertical Integration in the Midwest 33 empirical studies have shown that auto manufacturers tend to integrate the production of a component if the production process generates very specialized and nonpatentable know-how (Masten , Mehan, and Snyder 1989; Monteverde and Teece 1982). • Enhancing control. Producers have more control over their economic environment; for example, they are provided with immunity from total interruption in the supply of a part. • Optimizing scale...


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