Specialized Assets and Vertical Integration in the Aluminum Industry

The metal content and chemical composition of bauxite ore, used to produce aluminum, vary from deposit to deposit, so each type of ore requires a specialized refinery— that is, the refinery must be designed for a particular type of ore. Running one type of bauxite through a refinery designed for another type reportedly increases production costs by 20% to 100%. Thus, the value of an investment in a specialized aluminum refinery and the cost of the output produced by that refinery depend on receiving the right kind of bauxite ore. Imagine that an aluminum company has to decide whether to invest in an aluminum refinery designed to refine a certain type of ore. Also assume that this ore is extracted by a company that owns a single bauxite mine. Using a different type of ore would raise production costs by 50%. Therefore, the value of the aluminum company’s investment is dependent on the price it must pay the bauxite company for this bauxite. Recognizing this, once the aluminum company has made the investment in a new refinery, what is to stop the bauxite company from raising bauxite prices? Nothing. Once it has made the investment, the aluminum company is locked into its relationship with its bauxite supplier. The bauxite supplier can increase prices because it knows that as long as the increase in the total production costs of the aluminum company is less than 50%, the aluminum company will continue to buy its ore. Thus, once the aluminum company has made the investment, the bauxite supplier can hold up the aluminum company. How can the aluminum company reduce the risk of holdup? The answer is by purchasing the bauxite supplier. If the aluminum company can purchase the bauxite supplier’s mine, it need no longer fear that bauxite prices will be increased after the investment in an aluminum refinery has been made. In other words, vertical integration, by eliminating the risk of holdup, makes the specialized investment worthwhile. In practice, it has been argued that these kinds of considerations have driven aluminum companies to pursue vertical integration to such a degree that, according to one study, 91% of the total volume of bauxite is transferred within vertically integrated aluminum companies.