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Vertical Integration is eating the world

One of the biggest trends that I’ve noticed in tech recently is the comeback of vertical integration. And, no, this is not another post about Apple and their amazing M1 chip, this trend is literally everywhere ranging from cars to electric bikes, data centers to AI.

Vertical integration is nothing new, however, there seems to be some strong currents supporting its comeback and I wanted to analyze and understand those. 

Vertical? Horizontal? Why do we even care?

Profit motives drive companies to monopolize their markets by reducing the competition. Both vertical and horizontal integration aim to create stronger network effects by monopolizing a different axis of the value chain. Horizontal integration is when a business acquires another business in the same level of the value chain and vertical integration is when a business acquires another business in a different level in the supply chain.

Vertical integration is the oldest trick in the business books, Ford started it with model T by controlling all of its supply chain. Tech companies mostly started with vertical business models (e.g. IBM, Sun) until the PC and internet revolutions created a cornucopia of horizontally integrated unicorns (e.g Google, Facebook). 

From an economic theory perspective, it seems which strategy to employ heavily depends on the maturity of a market. Markets that are not commoditized, such as smartphones and new devices, benefit the most from vertical integration. However, once markets become less differentiated, a specialized approach makes more sense, paving the way for specialized supply chains.

Apple has truly championed a vertical model for over 40 years in the tech industry. Most big tech companies have been following suit (e.g Tesla, Amazon, Netflix) and adopting a vertical model but it’s good to keep in mind that the success of this model wasn’t very obvious to anyone, including Clayton Christensen who wrote the book of disruption theory and was vocally critical of Apple’s approach 1.

Why is vertical integration working so well now?

So, what’s different this time that vertical integration works so well? When will it stop working again? It’s impossible to predict the future but here are a couple of contributing factors that stood out to me in my research.

Shift in behavioral economics

Vertical integration allows selling differentiated goods at high margins. Horizontal integration allows profits through scale, which by extension means being as cheap as possible.

This is why it was believed that during the early stages of an industry, a vertically integrated proprietary solution would always win, because it allows a differentiated product that can meet customer expectations in a specific way. However, once the technology matures, it means standardization and commoditization which means cheaper products for the same price. 

Ben Thompson has a great post explaining why this is not what’s happening in Apple’s case 2, but the summary is consumer decisions are not always rational and they don’t do a strict cost benefit analysis in each purchase decision.

There are also very rational reasons why consumers don’t switch to commoditized products in mature markets. Tech companies figured out how to incorporate habit building into their products so that customers don’t leave! This means the companies who built the best product and captured customers in an early phase of an industry can keep those customers even after the industry matures and products become commoditized.

Shift in scale

Vertical integration historically meant differentiated goods at higher cost whereas horizontal integration meant profits from cheaper goods through scale. Therefore, companies that focused on vertical integration addressed smaller markets.

However, globalization and the internet changed this phenomena allowing vertically integrated companies to address bigger TAMs than they did in the past. When Mac was competing with PCs in the 2000s, they were selling less than 10M machines per year. Today, the iPhone sells over 200M phones every year since the TAM is now the whole world. Apple generates so much cash, it can reinvest the profits to differentiate its products further. Amazon likely has millions of servers in their data centers which means they can benefit massively from vertical integration as well.

The positive effects of scale are told abundantly in any economics class. Vertical integration also meant high communication costs, losing product focus due to procurement focus etc. It seems information technology made great strides on making communication better for bigger companies allowing very large companies to be run effectively. 

Moore’s law enabled big companies not to worry about their costs while they were scaling their operations to billions of users. It also enabled phones to support a bunch of new features every year since the processing power kept going up.

Currently, we are stuck with a problem in our hand, because computation hungry AI applications are enabling new capabilities and single threaded CPU performance is not improving any more. What’s the solution, build your own specialized chips whether it’s on a phone, on a computer or on the data center. 

This means unlocking differentiation and improvements for the vertical players since better integration of software and hardware means the next 10x for both capabilities and cost.

This is the exact reason why Apple is investing in their AI chip, AWS has their own chips at their data center etc. etc.

Increase in small form factor devices

From mainframe computers to laptops, phones to AR glasses, headphones to airpods the form factor of devices is getting smaller and smaller. The limited physical space means less flexibility and smarter solutions on the chip side to address efficiency.

Airpods, AR glasses or Neuralink brain chips, we have lots of products lined up with very small form factors that require very specific computation capabilities. I expect the winners of these markets to be vertically integrated to be successful.

Better communication tools to manage large organizations

Vertically integrated companies were harder to manage given the size and variety in operations, however the communication and productivity technologies made it much easier to manage large scale companies today.


It seems the commoditization is over for the consumer market and we will have tighter integration everywhere at least for the foreseeable future. For tech companies, this means tighter hardware and software integration, ASICs in the data centers and specialized chips on devices (e.g. Tesla AI chip).

However, this trend is so big that we don’t have to focus on tech, from Zillow to Netflix, Starbucks to Ferrero, vertical integration seems to be in the deck for all companies.



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