Diversification

Ricardian Rents, and Tobin's q

Presented by: Sandra Corredor

Cynthia Montgomery Northwestern - Harvard

RAND Journal of Economics (1988)

Birger WernerfeltNorthwestern - MIT

Cited: 591 times (Google Scholar)

Motivation

Idiosyncratic firm capabilities shape both diversification strategy as well as firm performance

Extant theory (RBV, Evolutionary T.): firms diversify in response to excess capacity of factors that are

subject to market failure.

Firms that choose to diversify more should expect the lowest average rents (proxy by Tobin’s Q).

Thus: a resource’s rent-generating capacity should be inversely related to its range of useful applications.

Wider diversification suggests the presence of less specific factors that normally yield less competitive advantage.

A given factor will lose more value when transferred to markets that are less similar to that in which it originated.

Assumptions: Application in a firm's current domestic or foreign

markets should be the most profitable. Markets are efficient (Tobin’s Q).

Mechanism

1. Collusive relationships with competitors

3. Unique factors = Ricardian Rents

* Firm owns unique/uncertain-imitable factors.

* Firm shares unique/uncertain-imitable factors: firm appropriate substantial rents as trading partners of a unique/uncertain-imitable factor-owner… Ex/A-apropriation mechanism: relationship-specific investments that cement the relationship.

2. Disequilibrium effects (luck – info. asymmetries)

Sources of Rents

1. A firm owns or share a factor with excess capacity

2. If the factor is subject to market imperfections the firm may decide to use the capacity internally instead of selling or renting (Williamson’s TCE).

a) Assumption. 1: divisible factorsb) Assumption. 2: no natural economies of scopec) Assumption. 3: the firm owns or controls rent-yielding factorsd) Assumption. 4: static model. Evaluates a marginal expansion of firm’s

scope

3. Choice: The firm will diversify. (Teece 1982 already provided a framework)

4. Direction: The firm will diversify to the “closest” market, where factor yields higher economic rents.

The more a firm has to diversify (or the farther from its current scope) → ceteris paribus → the larger will be the loss in efficiency and the lower will be the competitive advantage conferred by the factor… until marginal rents become subnormal.

The Process

1. A firm owns or share a factor with excess capacity

2. If the factor is subject to market imperfections the firm may decide to use the capacity internally instead of selling or renting (Williamson’s TCE).

a) Assmpt. 1: divisible factorsb) Assmpt. 2: no natural economies of scopec) Assmpt. 3: the firm owns or controls rent-yielding factorsd) Assmpt. 4: static model. Evaluates a marginal expansion of firm’s

scope

3. Choice: The firm will diversify. (Teece 82 already provide a framework)

4. Direction: The firm will diversify to the “closest” market, where factor yields higher rents.

The more a firm has to diversify (or the farther from its current scope) → ceteris paribus → the larger will be the loss in efficiency and the lower will be the competitive advantage conferred by the factor… until marginal rents become subnormal.

The ProcessThe finance literature:

• Diversified firms traded at a discount prior to diversifying

So: diversifying and non-diversifying firms differ systematically

• It has been shown that the new markets of diversifying firms were also discounted prior to the diversification.

….

Ultimately: what is really diversification? How we define if the firm is entering a new market or not? How do we define

“farther from the firm’s scope”?

Ceteris paribus: Total value of the firm will depend negatively on the optimal extent of diversification

THUS: Why do we observe diversified firms still obtain rents?

Factor specificity

Less specific factors are those that lose less efficiency as they are applied farther from their origin

Specificity

Factor specificity

Less specific factors are those that lose less efficiency as they are applied farther from their origin

• Specificity is DIRECTLY related to the possibilities of economies of scope.

• Asset vs. Factor specificity (?):

Williamson (1988): Asset specificity has reference to the degree to which an asset can be redeployed to alternative uses and by alternative users without sacrifice of productive value.

• Penrose’s (1956) and Teece’s (1982) ideas about fungibility and specialization have the same prediction.

• Teece (1982) considers the indivisible case for physical, human and cash flow factors.

Some notes…

Prediction

A capital-market measure for: considering capitalized

rents, differences in systematic risk, temporary

disequilibrium effects, tax laws, and arbitrary accounting

conventions. Assumption: Efficient Market Hypothesis.

A capital-market measure combined with an accounting

measure for: capturing levels of value instead of only

changes in firm value. Test is about “lower rents”, and an

efficient mkt will already incorporate diversification effect.

Solution: Tobin’s Q

Q=M/VP=1+(VI+VC+VR+VE)/VP

VR/ VP =f(specificity + ; diversification -)

Diversification=f(specificity - ; opportunities +)

Measures

Large firms in otherwise fragmented industries reap high Ricardian rents.

As firms diversify more widely, their average rents decline… this does not mean that diversification conflicts with value maximization. A firm's marginal investments should still have a q that

exceeds one, even where this q is below the average q of the firm's other activities

The farther they must go to use their factors, the lower the marginal rents they extract.

Results

Assumptions allow to focus on key implications of

factor heterogeneity.

Comments:

There is no indication that the authors sample only

firms with no significant announcements during the

period of study: Ricardian rents could also be

capturing response to other news…

Markets have shown to be efficient in the more

median-to-large run: larger term would also help

rule out the effects of possible news.

Other notes…