Cynthia Montgomery
Northwestern - Harvard
Birger Wernerfelt
Northwestern - MIT
Diversification
RAND Journal of
Economics (1988)
Cited: 591 times
(Google Scholar)
Ricardian
Rents, and
Tobin's q
Presented by: Sandra Corredor
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.
Mechanism
 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).
Sources of Rents
1. Collusive relationships with competitors
2. Disequilibrium effects (luck – info. asymmetries)
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: relationshipspecific investments that cement the relationship.
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)
b)
c)
d)
Assumption. 1: divisible factors
Assumption. 2: no natural economies of scope
Assumption. 3: the firm owns or controls rent-yielding factors
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
A firm owns or share
a factor
with excess
capacity
The
finance
literature:
1.
2.
factor is subject
to market
imperfections
theto
firm
may decide
•If the
Diversified
firms traded
at a
discount prior
diversifying
to use
the capacity
instead of
selling
or renting
So:
diversifying
and internally
non-diversifying
firms
differ
systematically
(Williamson’s TCE).
1: divisible
factors
•a) It Assmpt.
has been
shown
that the new markets of diversifying firms
b)
Assmpt.
2: no
natural
economies prior
of scope
were
also
discounted
to the diversification.
c)
d)
3.
4.
Assmpt. 3: the firm owns or controls rent-yielding factors
Assmpt. 4: static model. Evaluates
….a marginal expansion of firm’s scope
Ultimately:
what
is really
diversification?
How provide
we define
Choice: The
firm will
diversify.
(Teece 82 already
a if the
framework)
firm is entering a new market or not? How do we define
“farther from the firm’s scope”?
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.
Specificity
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
Some notes…
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.
Prediction
Measures

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 +)
Results
 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.
Other notes…
 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.