Corporate Diversification

Montgomery, 1994

Corporate Diversification

Firms are homogeneous producers of single products. This abstraction has a powerful impact on the way we think about economic behavior: firms in an industry look like one another and management, who by definition is located at the business (as opposed to the corporate level), makes decisions without regard to the firm's participation in other markets.

While the popular press and some researchers have highlighted recent divestiture activity among these firms, claiming a "return to the core," some changes at the margin must not obscure the fact that these firms remain remarkably diversified.

While the average level of diversification may increase or decrease some-what in the decades ahead, multiple-line businesses are here to stay and will remain a dominant feature in the economic landscape. This paper examines what economists know about this important phenomenon and suggests where we may best place our attention moving forward.

Why Do Firms Diversify?

Many arguments have been made about why firms diversify. This paper will examine three comprehensive perspectives that synthesize a number of individual points. Two of these, the market-power view and the resource-view, are consistent with profit maximization, but only the latter is consistent with the efficient use of resources. The other, the agency view, is managerial in nature, and is consistent with neither profit maximization nor efficiency.

The Market-Power View

Diversified firms will "thrive at the expense of nondiversified firms not because they are any more efficient, but because they have access to what is termed conglomerate power"

Economists following Edwards have emphasized three ways in which conglom-erates may yield power in an anti-competitive way: cross-subsidization, wherein a firm uses its profits from one market (sometimes known as "deep pockets") to support predatory pricing activities in another; mutual forbearance, where competitors meeting each other in multiple markets recognize their interde-pendence and compete less vigorously (Bernheim and Whinston, 1990); and reciprocal buying, where the interrelationships among large diversified firms foreclose markets to smaller competitors. The fear is that these practices will lead to reduced competition and higher industry concentration. Gribbin adds: a firm with insignificant positions in a number of markets will not, in sum, have conglomer-ate power.

Absent significant ownership stakes, managers pursue value-reducing strategies to further their own interests at the expense of the firm's owners. Mergers, particularly conglomerate mergers (Mueller, 1969), appear to be a convenient vehicle for doing so.

Besides the pure pleasures of empire-building, at least two other reasons have been proposed for why a self-interested manager might pursue excessive expansion. First, a manager might direct a firm's diversification in a way that increases the firm's demands for his or her particular skills. Shleifer and Vishny  term this behavior managerial entrenchment, and argue that in pursuing such interests, "managers often invest beyond the value-maximizing level." The second rationale is based on the idea that although shareholders can efficiently diversify their own portfolios, managers cannot so efficiently diversify their employment risk. Accordingly, managers may pursue diversified expansion as a means of reducing total firm risk, thus improving their personal positions while not benefitting the firm's stockholders. According to Amihud and Lev, such mergers "may be viewed as a form of managerial perquisite intended to decrease the risk associated with managerial human capital. Accordingly, [their consequences] may be regarded as an agency cost."