Vertical Linkages

Firms in value chains can be linked vertically or horizontally, and they all must cooperate to get a product from inception to the final consumer. Buying and selling relationships link firms vertically, and through these links firms engage in market and non-market interactions while performing different functions (i.e., operating at different levels) in the value chain. In addition to buying and selling, vertical linkages allow firms to exchange knowledge, information and technical, financial and business services. These non-financial transactions are important elements of buyer-seller relationships and are central to sustained value chain competitiveness.

Micro and small enterprises (MSEs) are vertically linked to a varied range of market actors including wholesalers, retailers, exporters, traders, middlemen, input dealers, suppliers, service providers and others. The nature of vertical linkages—including the volume and quality of information and services disseminated—often defines and determines the benefit distribution along the chain and creates incentives, or constraints, for firm-level upgrading, defined as innovation to increase value added. Moreover, the efficiency of the transactions between vertically linked firms in a value chain affects the competitiveness of the entire industry.

In many value chains, powerful actors have the resources and influence to define and impose the parameters of commercial transactions in their supply chain. These actors are known as lead firms. They set product and process standards across the value chain and act as coordinators and/or integrators of the value chain. The control that lead firms wield may be based on ownership of well-established brand names, proprietary technology, monopolistic or oligopolistic power, or exclusive information about different product markets. Lead firms can exert substantial influence and, more often than not, drive the upgrading decisions and create incentives and punitive systems for firms lower in the value chain. Lead firms can catalyze changes in a value chain by ensuring that knowledge and information move down the chain. In some instances, however, a clear lead firm is missing and other vertically or horizontally linked actors become the sources for the flow of goods, information and services through the chain.

Characteristics of Effective Vertical Linkages

In many value chains, there is a gap between what end markets want and what MSEs produce due to a win-lose mentality or lack of trust between vertically linked firms. As a result, the flow of information between consumers and producers is blocked. Such inefficient vertical relationships negatively affect the competitiveness of the value chain and can prevent MSEs from effectively meeting market demand. Mutually beneficial vertical linkages, on the other hand, facilitate a smooth transmission of information from end markets to small producers.

The ability of a firm within an industry to supply its buyers with a product or service that meets all the buyer’s requirements depends on the ability of the value chain to deliver information, skills, resources and benefits to all participants in the chain.

Effective vertical linkages are generally characterized by:

Mutually beneficial relationships. Symbiotic relationships that benefit all of the actors in a value chain are a major trait of effective vertical linkages. In such a scenario, various market actors focus on their own core competencies and through collaborative action realize synergies that improve the competitiveness of the entire chain. Trust, long-term joint vision, and mutual respect usually form the foundations for developing such relationships.
Knowledge transfer. Upgrading of production processes, technology, equipment, management systems, etc. is critical for the survival and growth of firms in a competitive marketplace. It is often difficult for small firms to access information about global best practices. Effective vertical linkages facilitate the transfer of knowledge between firms and create the incentives and knowledge platforms required for effective upgrading of MSEs. Prompt information transfers and transparency between vertically linked firms help a value chain respond effectively to changes in market demand.
Quality standards. Well-defined, widely understood, and constantly upgraded quality standards are another defining element of effective vertical linkages. Vertically linked firms are proactive, not reactive: Large firms empower and help small firms to understand and adopt the quality standards to meet market demand.
Embedded services. The frequent provision of high-quality embedded services (where a service is provided as part of the transaction at no extra cost) typifies effective vertical linkages. Lead firms can provide a wide range of embedded services to affiliated suppliers and buyers to ensure consistent quality of end products and services. These embedded services are often seen as an integral part of business transactions and considered a necessary cost of doing business.
Financial flows. Effective vertical linkages are often accompanied by a high volume and variety of financial flows. Larger firms may employ a variety of financial instruments (supplier credit, working capital loan, leasing services, etc.) to support the operations of their linked suppliers.

The nature of the vertical relationship between buyers and sellers is typically varied and dynamic and affected by end market requirements, the business enabling environment, product attributes, technology, socio-economic conditions and competitive pressures.

Recommended Good Practices

Market and social forces on their own may lead to the emergence of effective vertical linkages over time. However, development projects often play the role of facilitator and catalyst to transform or strengthen vertical linkages in order to increase value chain competitiveness and ensure a greater distribution of benefits to smaller firms. Some recommended good practices to enable the development of win-win relationships are given below.

Understand the imperative for behavior change.
Identify leverage points in vertical chains.
Identify catalytic firms.
Understand relationships.
Foster trust.
Demonstrate that collaboration is preferable to confrontation.
Understand the role of traders and middlemen.
Clarify the value addition of donor projects.

Lessons from the Field

Forging and sustaining effective vertical linkages is a challenging endeavor. The presence of vertical links does not automatically lead to increased benefits to MSEs, since such linkages could have both predatory and symbiotic elements. Vertical linkages can, however, be configured to ensure a maximum flow of benefits to MSEs while facilitating improved value chain competitiveness. The following examples from the field contain lessons about developing mutually beneficial vertical linkages and the types of benefits that can result.

Lead firms can sometimes drive change in value chains more quickly and effectively than outside catalysts.
A lead firm may have the incentives to provide embedded services to MSEs to ensure a consistent supply, higher quality and greater control over production.
Suppliers of goods and services can be an important leverage point for increasing benefits to MSEs and the entire supply chain.
Local traders or other intermediaries can be used to improve value chain efficiency and transparency.
Trust is a major factor in the relationship between different firms, but it takes time to develop.
Win-win relationships in which value chain actors engage in behaviors that lead to mutual improvement in productivity and the adoption of innovation are fundamental to long-term competitiveness.