PoM L8:

Diversification

By the end of this lecture, you should be able to:

 Assess the relative advantages and motives of diversification in exploiting
the linkages between different business
 Recognize the organizational and managerial issues to which diversification
gives rise and why diversification so often fails to realize its anticipated
benefits

I. Key consideration for diversification

Two issues in firms’ diversification decision

Diversification decision  How attractive is the industry to be entered? And Can
the firm establish a competitive advantage within the new industry?

Vertical integration vs Diversification

 VI: It brings together activities up and down the same value network
 DV: It typically involves more or less different value network
 Imp diagram in notebook

II. The key motivations of diversification

1. Growth
 Diversification can buy growth that cannot be achieved through internal
development
• strong tendency toward “Conglomeration”

q Mangers’ status, security, and power are closely linked to the size of
enterprise they control
 For manager, one way to reduce the risk of poor performance is through
unrelated acquisition
  The performance of a highly diversified firm is likely to mirror the
performance of the overall economy
 Less likely to lead shareholders to fire management
 Managers can pursue their own objects at shareholder expense

2. Risk reduction
q If the cash flows of the different business are imperfectly correlated, then
diversifying them under common ownership reduces the variance of the
combined cash flow
• For example, selling umbrellas when it rains, and sell sunglasses when
the sun rises

q Does diversification motivated by risk reduction create value for

shareholders?
Or, for (top) managers?
• Shareholders of firms can diversify risk by diversifying their own
personal portfolios
• The transaction costs to shareholders of diversifying their portfolios
< the transaction costs to firms diversifying through acquisition

3. Market power
 Four mechanisms to exercise market power
1. Predatory Pricing  Cutting prices to below the level of rivals' costs
2. Bunding  One of direct way to extend its monopoly in one market in to a
related market
3. Reciprocal Buying  Give preference in purchasing to firms that become
loyal customers for another of the conglomerate’s business
4. Mutual Forbearance  Adopt a live-and-let-live policy designed to stabilize
the whole structure of the competitive relationship
Reciprocal Buying
 Diagram in notebook
 Through reciprocal buying among conglomerate 1 and 2 for business A and
B, restrain challenge from their identical competitor (conglomerate 3) for
business A and B.

Mutual forbearance: explanation via game theory (repeated game)

1. Repeated game results in an implicit cartel among conglomerate A and B in
business 1 (DIAGRAM IN NOTEBOOK)
2. If conglomerate A cuts price (breaking an implicit cartel) in business 1,
conglomerate B will attack conglomerate A’s weak business 2 by cutting price

So, in repeated games involving companies that meet in multiple geographical

markets for the same product or service are likely to refrain from aggressive
action in any one market for fear of expansion of competition over their
diversified business (IMP LOOK AT DIAGRAM)

4. Economies of scope
 “Economies of scope exist if the firm achieves savings as it increases the
variety of goods and services it produces.”
 “Economies of scope are usually defined in terms of the relative total cost
of producing a variety of goods and services together in one firm versus
separately in two or more firms
 TC (Qx, Qy) < TC (Qx,0) + TC (0, Qy)
 Sources of economies of scope:
1. Tangible Resources  e.g., distribution network, IT system, sales forces
and brands, and research laboratories
2. Intangible Resources  e.g., brands, corporate reputation and
technology
3. Organizational Capabilities  e.g., LVHM, 3M
 “Does a firm have to diversify across different businesses to exploit
economies of scope?”  Not Always!
  “Economies of scope in resources and capabilities can be exploited simply
by selling or licensing the use of the resources or capability to another
company”

5. Using internal market

 The BCG growth-share matrix
 Key assumption: the diversified firm outperform banks in evaluating and
servicing its investment opportunities
 Possible disadvantages: Some evidences show that diversified firms’
internal capital markets tend to cross-subsidize poorly performing divisions
and are reluctant to transfer cash flows to the divisions with the best
prospects (due to personal feeling, internal lobbying, etc.)
 Via internal labour market  Efficiencies arise from the ability of diversified
companies to transfer employees (especially managers and technical
specialist) between their divisions (the information advantages of
diversified firm), and to rely less on hiring and firing (Advertising, time
spent in interviewing and selection, cost of “head-hunting” agencies, etc.).

III. Diversification and performance

1. The performance of diversified and specialized firms

 There is some evidence that, beyond a certain point, high level of
diversification is associated with deteriorating profitability  the problems
of complexity caused by diversification
 The growing turbulence of business environment  the cost of managing
complex, diversified corporations 

2. Related and unrelated diversification

 The lack of clear performance differences between related and unrelated
diversification
 Two types of relatedness:
 1. Operational Relatedness: synergies from sharing resources across
businesses (common distribution facilities, brands, joint R&D)
2. Strategic Relatedness: synergies at the corporate level deriving from the
ability to apply common management capabilities to different businesses.
 Problem of operational relatedness: The benefits in terms of economies of
scope may be dwarfed by the administrative costs involved in their
exploitation  Ultimately, the linkage between the different business
within a company may depend upon the strategic rationale of the company

IV. Concluding remarks

 The attractions of diversification are obvious, often irresistible. Yet, the
experience is often disappointing.
 The critical issue for diversification is the optimal organizational form for
exploiting economies of scope