Diversification, Ricardian
rents and Tobin’s q
The RAND Journal of Economics (1988): 623-632
Cynthia A. Montgomery
Northwestern University
(now at HBS)
Birger Wernerfelt
Northwestern University
(now at MIT Sloan)
Presented by Carla Fernández-Corrales, Fall 2013
Motivation
• Although multimarket firms play an important
role, the theory of diversification lacked empirical
tests at the time of this article.
• Theory of diversification: if a firm presents excess
of capacity of productive factors, diversification is
an efficient choice (Penrose, 1959)
• The article considers the heterogeneity of factors
and profit/maximizing decisions.
Ricardian rents
• Economics rents from unique factors (e.g.,
good manager, good location, patent).
• Rents also originate from imitable factors, when
imitating them is an uncertain project for
competitors (e.g. brand or reputation).
• Rents likewise can derive from shared factors
(e.g., team of managers that cannot market
themselves as a package, manager or supplier
that makes an unanticipated investment).
Diversification
If a firm owns or share a factor with exceeded
capacity, and this factor is subject to market
imperfections, those are conditions for diversification.
Assumptions:
1. The firm can dispose of excess capacity without
affecting the rest of its operations.
2. If any firm in one industry will participate
uniformly in other, those pair of industries are
considered a single industry.
Diversification
Assumptions
3. Only firms that own or control rent-yielding
factors
4. Static model of the case of a single
diversification move in which a firm with
excess capacity of a factor considers a
marginal expansion of its scope.
Diversification
Hypotheses
Tobin’s q
• Accounting measures are not good proxies for
rent because they don’t consider differences in
systematic risk, temporary disequilibrium effects,
tax laws, and arbitrary accounting conventions.
• Tobin’s q
Value of
Market
value
Replacement
value of
physical assets
intangible
assets
Value of collusive
relationships with
competitors
Ricardian rents
Disequilibrium
effects
Tobin’s q
Specificity
Diversification
Opportunities
s and o are unobservables, therefore,
Industry dummies
Data
• Sample of 167 firms (around 1976)
• q from Lindenberg and Ross (1981)
• Domestic market share data and dollar sales from
Trinet/EIS
• Replacement cost from 10 K's
• Foreign sales estimates from EIS Directory
• Industry estimates of marketing expenditures and
company sponsored R&D from Line-of-Business
Report
• Four-firm concentration ratios growth rates per
SIC code from the Census of Manufactures
Measures
Ai = firm i’s marketing expenditures (sales
weighted)
Ri = firm i’s R&D (sales weighted)
Ci = concentration in firm /'s markets (sales
weighted)
Gi = growth of shipments in firm i’s markets (sales
weighted)
Si = firm i’s market share (sales weighted)
Fi = firm i’s foreign sales (in percent)
Vpi = replacement costs of firm i’s physical assets
Measures
• Diversification
• Concentric index
Percentage of firm
I’s sales in industry
0 if j and l have the same
three-digit code
1 if they have identical
two-digit code
2 if they have different
two-digit code
Tests
After taking logs to reduce measurement error…
Results
Discussion
The farther firms must go to use their factors, the
lower the marginal rents they extract (p 630).
Explanations
1. Firms underestimate the effort to gain rents
2. Free cash flow
3. Firms diversify to overcome moral hazard
problems