Diversification, Ricardian rents, and Tobin’s q Cynthia A. Montgomery and Birger Wernerfelt RAND Journal of Economics (1988), 19(4): 623-632 Presented by Julie Ao, Fall 2017

Summary Prevailing theory of diversification is based on excess capacity of productive factors (Caves, 1971; Gorecki, 1975; Penrose, 1959; Teece, 1982) Failure in the markets for these factors may make diversification an efficient choice, although the factors are expected to lose some efficiency in the transfer This article extends the theory by considering the heterogeneity of factors and profit-maximizing decisions of firms The article also shows how Ricardian rents are shown in Tobin’s q Main argument: the wider the firm diversifies, the lower of its average rents

Sources of Ricardian Rents Rents can result from: Collusive relationships with competitors → Monopoly rents Disequilibrium effects → Luck (Schumpeterian rents) Unique factors → Ricardian rents (FOCUS) Economic or Ricardian rents are thought of as accruing to owners of unique factors, or factors subject to uncertain imitability (rights to a brand name or reputation)

Diversification to Appropriate Ricardian Rents If factor is subject to market imperfections, firm can use capacity internally instead of selling or renting it, this circumstance leads to diversification (Williamson, 1985) Four assumptions: Excess capability Cases with natural economies of scope are not considered Concentrate on firms that own or control rent-yielding factors Static model evaluating a single diversification move of a firm with excess capacity of rent- yielding factor considers a marginal expansion of scope The total value of the firm will, ceteris paribus, depend negatively on the optimal extent of diversification

However, all things are not equal… Firms’ factors may vary based on their specificity Less specific factors: Those that lose less efficiency as they are applied farther from their origin Since less specific factors support wider diversification, their relatively lower value will strengthen the negative relationship between the extent of the diversification and average rents

Given the specificity of a set of factors, the optimal decision for a firm is to apply its excess capacity to the closest entry opportunity As optimal diversification increases, average rents decline

Tobin’s q --- A Measure of Rents Accounting rates of return have problems considering differences in systematic risk, temporary disequilibrium effects, tax laws, and arbitrary accounting conventions Pure-capital-market measures only changes in firm value, not levels of value Tobin’s q: The ratio of market value to the replacement cost of the firm

Data, Measures, and Tests (I) Guided from Lindenberg and Ross (1981) estimates of 1976 q for a random sample of 246 firms Sample of 167 firms, from different sources Construct estimates of the following variables:

Data, Measures, and Tests (I) ß(0) should be roughly 1 (value of q under perfect competition) ß(1) should be 10/3 and ß(2) should be 10 (Salinger, 1984: intangible assets) ß(3) is unlikely to be significantly different from 0 (Smirlock et al.,1984: concentration) ß(4) expected to be positive (market share; sign of Ricardian rent) ß(5) predicted negative (wide diversification → low rent) ß(6) difficult to predict (foreign sales) ß(7) expected to be positive (Salinger, 1984: disequilibrium effects) Modified from Eva’s slide, Fall 2016

Results Firms earn decreasing average rents as they diversify more widely Consistent with idea that diversification is prompted by excess capacity of factors that are subject to market failure

Diversification From Ramanujam and Varadarajan (1989): Studies of diversification have focused on the extent (less or more), direction (relatedness or unrelatedness), and mode (internal vs. acquisition-based) of diversification.

Linking to RBV Considering heterogeneity factors of firms From Mahoney and Pandian (1992): The result of this article supports the resource-based hypothesis that expansion by firms into activities in which they have comparative (competitive) advantages is most likely to yield rents (Penrose, 1959) The resource-based theory of diversification is helpful in explaining the performance of related diversifiers relative to unrelated diversifiers

Discussion What are the measurement problems in the article? Specificity (s) and opportunities (o) are unobserved; they used average industry-level diversification as a proxy for s and o Firms may vary with diversification level Sales and market share cannot measure intangible assets Are there omitted variables in the model?