So now that you have some idea what we mean by vertical and horizontal scope, let's begin by digging in a little deeper into vertical scope. In corporate strategy, we often talk of vertical scope and vertical integration together, as if they're the same thing. Why? Because when we think about vertical scope, there are really two related questions. The first question is, which parts of the value chain or the value network a company should operate in? Keep in mind that this can change over time. A company can choose to jump into a new stage of the value chain and the same time get out of another. There are lots of examples of companies that started in retailing or distribution and then decided to go into manufacturing a product and stop being a retailer or a distributor. Now, why would a company do that? Quite simply because another part of the value chain might be more profitable than the one they are in. Now, this is essentially a business strategy question. Notice what I'm describing is a case of a company stopping its operations in one part of the value chain or value network and then refocusing on a different part of the value chain or value network. So in fact, this is a fundamental business strategy question about which business or businesses you want to be in. You can address this question with the tools of business strategy. Such as whether the business is attractive, based on the Porter's Five Forces analysis or if the company has a significant sustainable competitive advantage in this particular business or this particular stage of the value chain. By the way, this is also true when thinking about horizontal scope as well. There's a similar business strategy analysis that can be applied to the choice of which businesses to operate in. So this first question, whether you apply it to the vertical or the horizontal case, is not really a corporate strategy question, but instead, it's a set of business strategy questions. Generally, you want companies to try and be in more profitable businesses or more profitable value stages if they can. Then the important question for corporate strategy is whether the same company should be integrated across specific value stages. This is the classic vertical integration question. Does managing these different parts of the value chain within the same company create more value which exceeds the sum of the parts if these different stages where managed across separate companies? But first, I want you to get familiar with a little terminology. What do we mean by vertical integration or vertical scope as opposed to horizontal integration? How to keep this idea clear in your mind? Similarly, we often hear the term forward integration or backward integration. What does that mean? If you have done a course on business strategy, certainly with my course on business strategy, you're familiar with the idea of a value chain. So we start with a value chain and turn this on its side, you get a value chain that's oriented from the bottom to the top, and that's this vertical idea. If you think of many such vertical businesses, possibly in different industries, side-by-side, integrating across those businesses, that's horizontal integration. So if you look at this value chain, at the very front end is the customer, and the closer you get to the customer, that's what we think of as forward integration. At the back end, where the raw materials come in, the closer we get to that end, that's what we think of as backward integration. So for example, if your business is currently in final production and it decides to get into distribution and logistics or even further down into marketing and sales itself, then that would be an example of forward integration. On the other hand, if the same company decides to integrate into intermediate stages like making components or get into supplier logistics, or even get into raw material production, that would be an example of backward integration. Now, all activities don't naturally fall within this vertical forward, backward way of looking at things. For example, there are all the support activities. In non-manufacturing businesses, the value chain itself may make little sense and you may want to use a value network instead. But even in these cases, there is such a thing as vertical integration. You just need to break free of the origins of the vertical metaphor and simply think about whether an activity is part of the value creation process for the business. Another trigger is anytime you think of outsourcing. So if you're thinking about outsourcing and the choice around outsourcing a particular activity; that's an example of vertical integration. A classic example would be information technology. Should you build the information technology system yourself that supports your business internally? Or should you outsource this to someone else? That's a vertical integration choice, even though IT is not a primary activity that lies along the value chain. So how can we think about this decision to outsource or vertically integrate? Often, companies outsource when they don't have the quality of the needed resources or capabilities to handle an activity. So for example, it may just be difficult for the University of Illinois to reproduce the software and technology skills that Coursera has built, and is able to add to in its Silicon Valley location. I will note here, and this is something I've done some research on, that this kind of reliance on another firm, due to a lack of capabilities, can be self-reinforcing. What I mean is that, Coursera, in our example, is constantly able to keep learning and improving its capabilities as long as we and others keep outsourcing to them, and it becomes harder and harder to catch up once we start that outsourcing. Now some companies may be strategic about this and actively try to learn from their outsourcing partners to develop their own capabilities in the long run so that they can stop eventually outsourcing a critical or profitable activity. Another reason to outsource maybe that the partner firm maybe better able to aggregate demand and build scale. We can see many examples of this, both on the upstream and downstream end of vertical integration. For example, companies often outsource primary material supplies like steel, aluminum, or petrochemicals, and downstream activities like distribution and retail. Quite simply, it's hard for say, an appliance company or a plastic products company to develop scale and making the needed input materials. Or for companies to aggregate downstream consumer demand in the way that say, a Walmart can. Similarly, by serving many different universities and learners from all over the world, Coursera can aggregate demand and build scale in a way that the University of Illinois might not be able to. Also, it's likely that a standalone organization like Coursera is likely to be much more responsive to market and technology trends in online education. Because it is focused on a narrow specific activity, Coursera is likely to stay at the cutting edge of that activity, and if it doesn't, then we can simply switch to another supplier that does. So on the other hand, why might it make sense for companies to integrate? One argument maybe market power, such as the possibility of creating entry barriers by controlling a key resource. For example, perhaps the University of Illinois might reduce the extent of competition in the online educational space by owning a popular online platform. Or such ownership may allow the university to have better control over the prices it wants to charge on such a platform. Now keep in mind that both these hypothetical reasons are limited by the presence of competition and by antitrust or anti-competition laws. In my judgment, market power arguments often have serious flaws when applied to corporate scope decisions. Another more valid argument might be that integration can help the university improve quality or cost by giving it more control over the operations of the platform. Similarly, there may be advantages in planning, coordinating, or controlling operations on the online platform and you own it rather than working with a supplier. Finally, there's another important argument often made in favor of vertical integration, which is investments in specialized assets. As we will see shortly, if we need investments from the supplier that are specific to the buyer, then this creates what we might call a hold-up problem, that it may not be possible to resolve without vertical integration.
