The Law of Vertical Integration and the Business Firm: 1880-1960

• Author: Herbert Hovenkamp
• Position: Ben V. & Dorothy Willie Professor, The University of Iowa College of Law. I wish to thank the participants in the Iowa Legal Studies Workshop.
• Pages: 03

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I Introduction

Vertical integration occurs whenever a business firm does something for itself that it might otherwise have obtained on the market.¹ The very concept is artificial because production and distribution processes can be divided up arbitrarily. For example, the village cobbler who maintains his own shop, makes three pair of shoes per week by hand, and sells them directly to consumers is vertically integrated "upstream" into shoe-making machinery and "downstream" into shoe retailing.² Nevertheless, his firm is very small. With the rise of machine manufacture, the cobbler's individual business functions gradually became vertically dis-integrated. For example, the formation of united shoe Machinery company in 1899 created a firm that made only shoe-manufacturing equipment and leased it to shoe manufacturers, who in turn sold the shoes to distributors or perhaps directly to department stores for resale.³ What had once been the work of a single firm now became that of at least three or four.⁴ By the 1960s, the Supreme Court even found competitive harm in a shoe manufacturer's acquisition of its own retail stores.⁵ The combined making and selling of one's own product-an inherent feature in the history of shoemaking as well as most other businesses-had become contrary to the public interest.

Vertical integration could occur by three different legal devices. First, a firm could simply begin doing something for itself, rather than purchasing that thing on the market or selling to an intermediary retailer-such as the cobbler who merely started selling his own shoes directly to customers. This type of "de novo" vertical integration, or integration by new entry into the vertically related market, was typically regarded as the least damaging to competition, although Page 866 U.S. legal policy in the 1930s and after became hostile.⁶ Second, a firm might acquire a different firm in a vertically related market, such as when Brown Shoe, a manufacturer, acquired Kinney Shoe's chain of retail stores in 1956.⁷

The third type of vertical integration was achieved by a long-term, or "relational," contract between two vertically related firms that maintained legally separate ownership. The rapid rise of franchising and independent dealer networks in the 1920s and after indicates just how important this type of vertical integration was to become. Indeed, today many firms incorporate for no other reason than to function as a kind of contractually controlled "subsidiary" to a parent firm. This includes car dealerships, fast-food franchises, and many other consumer businesses. While contracts generally produced the loosest forms of vertical integration, they also invoke the angriest controversy and some of the most aggressive special-interest legislation. Legal policymakers viewed such arrangements as uniting two sets of "independent" businesspersons, each of whom had legal prerogatives worthy of protection. The independent dealer had a legal status that the mere employee or agent did not. The origin of United States policy toward contractual vertical integration lay in intellectual-property law, although in the early twentieth century that role largely became the province of antitrust law.⁸

Few areas of economic law have experienced more fumbling, experimentation, and interest-group activity than the law of vertical integration during the marginalist revolution in economics. Marginalism, later to be called neoclassicism, substituted the forward-looking concepts of marginal utility, marginal revenue, and marginal cost in the place of the historical averages that classical political economists previously used to explain economic activity.⁹While classical economists tended to assess behavior by looking at historical experience, marginalists believed that people's anticipation of the future determined their choices. This fact made marginalism a powerful tool for assessing preference, but it also injected significant uncertainty into the calculus of value. Value for classicists depended on the law of past averages, while neoclassicists relied on rational expectations. The change in perspective had a dramatic influence on the legal attitude toward business conduct.

Marginalism abruptly halted a period of relatively stable and largely benign economic and legal thinking about competition and business firms. Page 867 While the classical economists were somewhat preoccupied with monopoly in land, in manufacturing they tended to see either competition or monopoly, and monopoly was generally regarded as exceptional. The rise of marginalist economics in the 1870s threatened that vision by dividing markets into degrees of competitiveness. This further led to a search for the preconditions for perfectly competitive markets, and the developing intuition that such markets were quite rare. one result that quickly followed was the rise of modern, interventionist competition policy.¹⁰

The marginalist crisis in competition policy did not find a satisfactory solution until the middle of the twentieth century. Because markets are populated by firms, the principal actors in this crisis were business corporations. Economists in the first half of the twentieth century probed the firm's nature, structure, motives, and extent of operations at an unprecedented level. Competitive markets were impossible without competitive firms. In legal policy, the main sources of government intervention were, first, the common law and then later state corporate law. Antitrust did not emerge as an important regulator of firm structure until well into the twentieth century.

Much of the fumbling in the formulation of legal policy about vertical integration resulted from the fact that both economists and lawyers understood it so poorly. Today, it is all too easy to see the history of business regulation in the United States as little more than a series of interest-group clashes.¹¹ Many historians have seen regulation mainly as a political process in which well-organized, dominant interest groups obtain political advantage and protect their particular industry from competition, typically at the expense of consumers.¹² Page 868

But the reductionist impulse to explain regulation as nothing more than interest-group politics clearly overstates the case. For example, in our federalist system, many markets are governed by the individual states, each of which has its own legislative process. Nevertheless, in nearly every state, state-controlled, local monopolies deliver electricity and natural gas while groceries and clothing are sold in competitively structured markets. These results did not occur simply because interest groups backing the electricity and natural gas industries were better organized than were the purveyors of groceries, shoes or lumber. In fact, policy-making in these markets was heavily driven by theory. At the same time, interest-group pressures in a complex democracy cannot be ignored, particularly in a political regime like that which existed in the late nineteenth and early twentieth centuries, when fundamental changes in technology and corporate structure created much hardship for established small businesses that were crushed in the process. The period witnessed the dramatic rise of the large, multistate business firm, followed by significant but volatile economic growth, and culminated with the Great Depression and the rise of the welfare state.

When robust economic theory indicates that a particular regulatory regime is best for a particular industry, that theory weighs heavily in policy-making. Indeed, broadly accepted theory is often decisive in the formulation of the core features of regulation, although less so at the margins. often robust economic theories reflect-or are reflected by-popular views about the benefits or costs of government policy. In such cases theory and politics converge. By contrast, when the theory is controversial or many features of a market are not well understood, then interest-group pressures acquire greater sway and tend to drive policy-making. This view of regulation takes ideas about the economic merits of regulation more seriously than does a great deal of writing in both history and political or public-choice theory.

Neoclassical policy-making about the business firm concerned mainly corporate finance and the theory of firm organization. These two bodies of literature rarely cited one another, but they subscribed to a common vision about the firm's nature and goals. Both were strictly marginalist. By the middle of the twentieth century, corporate-finance theory came to see the firm as a maximizer of its own value. Yale economist Irving Fisher's "separation theorem," published early in the century, distinguished the firm's profit-maximizing goals from the preferences of individual shareholders. This line of thinking culminated with the efficient capital market hypothesis in the 1960s. Neoclassical finance theory was relentless in separating the goals and...