Recent studies in the chemicals industry have shown that poor profitability can sometimes be attributed to the way in which vertically integrated companies price their products.

The main concern of an upstream business, where the cost of capacity is high, should be to ensure high plant utilization. Many upstream producers have therefore integrated with downstream ones in an effort to guarantee a market for their output. But such an insurance policy can turn out to be extremely expensive. For when demand is low, the upstream operator is tempted to offer discounts to its downstream associates to maximize market share. Armed with this perceived cost advantage, the downstream operator is in turn inclined to compete for market share by cutting prices.

In the most extreme cases, downstream prices can fall as low as the full chain’s cash cost, which is likely to be below the cash cost of independent producers. As a consequence, independent producers may find themselves pushed out of the market. The customer, meanwhile, has not only been handed a windfall in surplus, but has also gained an insight into the cost structure of the supply chain, making it difficult for the downstream producer to raise prices again....