'The Great Fallacy of Vertical Integration'


Delta Airlines has been thinking about buying an oil refinery near Philadelphia, on the theory that this will let the company cut fuel costs. Former Reason editor Virginia Postrel explains why that isn't a smart idea:

Wrong Delta.

Delta simply seems to be falling for the great fallacy of vertical integration: the belief that the inputs you get from an in-house supplier are cheaper than those you buy in the open market. There's no markup. You've cut out the middle man!

But this story misses the real cost of those inputs.

Consider a thought experiment. Suppose Delta owns the refinery and the market price of jet fuel goes so high that buying fuel on the open market would make many of Delta's flights unprofitable. Should Delta managers sigh with relief and fly those otherwise unprofitable flights, using fuel from their own refinery? Or should they take that fuel, sell it at those high market prices, and cancel the unprofitable flights?

The real cost of the fuel is not whatever expenses the company incurs to produce it. The real cost is what the company is giving up to use the fuel itself: the price it would command in the market (markup included). If managers sacrifice refinery profits to fuel their flights, those costs are just as real as out-of-pocket expenditures.

To read the rest of the column, including an interesting historical argument about why vertical integration made more sense a century ago, go here.