A Curious Case of Vertical Integration

10 April 2012 at 1:51 pm Peter G. Klein 11 comments

| Peter Klein |

The WSJ reports that Delta Airlines wants to acquire a Pennsylvania oil refinery. The reporters, quoting the ubiquitous “people familiar with the situation,” says that Delta “could save between $20 and $25 a barrel on some of its jet-fuel costs by acquiring the refinery, a big advantage as industry costs now approach $140 a barrel, up 11% so far this year.” But how? No particular economies of integration are mentioned in the article (apparently the WSJ doesn’t consider this an important point). Jet fuel is a standardized commodity, so asset specificity isn’t an issue. Organizational capabilities don’t seem to be relevant. Market power? Price discrimination? I don’t see it. In short, I can’t imagine where these cost savings would come from. Any ideas?

Entry filed under: - Klein -, Law and Economics, New Institutional Economics, Strategic Management, Theory of the Firm.

Stylish Academic Writing Dilbert on Jim Collins

11 Comments Add your own

1. Browsing Catharsis – 04.11.12 « Increasing Marginal Utility | 11 April 2012 at 7:06 am

[…] A rather bizarre example of vertical integration. I’m assuming I would be shouted out of the room if I said this is probably just x-inefficiency? Share this:EmailPrintStumbleUponLike this:LikeBe the first to like this post. links ← Marshall’s Evolutionary Economics […]
2. rmakadok | 11 April 2012 at 8:00 am

They come from the imagination of investment bankers who smell a fat bonus check, of course.
3. rmakadok | 11 April 2012 at 8:40 am

It’s Wall Street’s own special version of “creative destruction” — finding ever more creative ways to a destroy shareholder wealth. Just ask Ted Turner how that AOL-Time Warner deal worked out for him… another merger justified on the basis of the nebulous benefits presumed to arise somehow after reciting the magic words, “vertical integration.”
4. Will | 11 April 2012 at 10:12 pm

Tax dodge.
5. Jorge Emilio Emrys Landivar | 13 April 2012 at 5:12 pm

They come from removing double marginalization. Delta can lower its ticket prices due to zeroing out profits at the refinery end. Since Delta sees a very elastic demand curve (airplane tickets are a pretty competitive monopolistic competition), this allows it to lower its prices and increase sales substantially. So it makes more total profits by increases sales.
6. Peter Klein | 13 April 2012 at 10:28 pm

Right, but the double marginalization story requires that both the upstream and downstream firm have market power and set price above marginal cost. Why would this be true for the oil refinery, which sells a homogeneous product in a thick market?
7. beckmill | 14 April 2012 at 8:05 pm

You guys don’t get it. You’ll never get it. And the reason you won’t is that you’re sane, sensible, and informed. You’re not a brain-dead airline executive (sorry to repeat myself there).
8. rmakadok | 14 April 2012 at 8:48 pm

Well, I think I got a piece of it, at least.

In any case, here is a less curious but still interesting case of vertical integration with a connection to competitive advantage (per the 2001 Mahoney Conjecture)…

http://seekingalpha.com/#article/496681-schnitzer-steel-competitive-advantages-in-a-commoditized-industry

RJM
9. George John | 1 May 2012 at 8:48 am

The deal just went through today according to WSJ
10. Peter Klein | 1 May 2012 at 8:50 am

Thanks George. I guess no one involved with the deal is reading O&M.
11. David Hoopes | 4 May 2012 at 3:43 pm

Their loss (in oh so many ways).