Question

A manufacturer of pencils contemplates backward (vertical) integration into production of mustard seed oil, a key ingredient in manufacturing the eraser. Mustard seed oil is traded in world commodity markets, and its price fluctuates as supply and demand conditions change. The pencil manufacturer argues this: “Pencil production is very utilization sensitive (i.e., a plant that operates at full capacity can produce pencils at a much lower cost per unit than a plant that operates at less than full capacity). Owning our own source of supply of mustard seed oil insulates us from short-run, supply-demand imbalances and therefore will give us a competitive advantage over rival producers.” Explain the merits and problems with this argument.

          A manufacturer of pencils contemplates backward (vertical) integration into production of mustard seed oil, a key ingredient in manufacturing the eraser. Mustard seed oil is traded in world commodity markets, and its price fluctuates as supply and demand conditions change. The pencil manufacturer argues this: “Pencil production is very utilization sensitive (i.e., a plant that operates at full capacity can produce pencils at a much lower cost per unit than a plant that operates at less than full capacity). Owning our own source of supply of mustard seed oil insulates us from short-run, supply-demand imbalances and therefore will give us a competitive advantage over rival producers.” Explain the merits and problems with this argument.

Added by Audrey W.

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