Diversifiction, Ricardian Rents, and Tobin’s q (Montgomery and Wernerfelt 1988) Group 1 Meredith, Barclay, Woo-je, and Kumar

Introduction Economic analysis does not have a great deal to say about firm diversification and existing theory is largely untested Prevailing arguments are based on excess capacity of production factors Failures in the market may make diversification and efficient choice This paper attempts to extend the prevailing theory by considering the heterogeneity of factors that prompt diversification and profit maximizing decisions of the firm

Sources of Ricardian Rent Economic rents can result from collusive relationships with competitors, disequilibrium effects (luck) and unique factors (Ricardian rents) Ricardian rents are ordinarily thought of as accruing to owners of unique factors Firm operated by a good manager, owning attractively located land, patents Owning factors subject to uncertain imitability

Sources of Ricardian Rent Ricardian rents are only part of the story Firms may also appropriate economic rent as trading partners of factor owners, and share the factor in question Firms may employ a manager or supplier who creates switching costs

Diversification as a Way to Appropriate Ricardian Rents Four important assumptions for author’s argument: 1. Assume that the firm can dispose of excess capacity (sell at price zero) without affecting the rest of its operations 2. Do not consider cases where there are natural economies of scope between 2 industries 3.Concentrate on firms that own or control economic rent-yielding factors 4.Conduct the analysis in a static model and evaluate the case of a singe diversification move in which a firm with excess capacity of a rent yielding factor considers a marginal expansion of its scope

Diversification as a Way to Appropriate Ricardian Rents With respect to a marginal change in the scope of a firm, the givens are a set of factors and a list of markets to which they may be transferred and result in smaller or greater competitive advantages Market in which the factor yields the highest economic rents are “closest” The more the firm has to diversify, i.e., the farther from its current scope it must go, ceteris paribus The larger will be the loss in efficiency The lower will be the competitive advantage conferred by the factor

Diversification as a Way to Appropriate Ricardian Rents Marginal rents Diversification Distance More specific factors Less specific factors Hypothesized Relationship Between Diversification Distance and Marginal Rents for Different Degrees of Factor Specificity

Diversification as a Way to Appropriate Ricardian Rents Give a specific set of factors, the optimal decision for a firm is to apply its excess capacity to the closest entry opportunity. The economic rent the firm can extract from the move depends on the specificity of the factors and the closeness of the new market These conditions result in the following stylized relationships. a) Firms with less specific factors and nearby entry opportunities will diversify narrowly and extract medium rents on average b) Firms with more specific factors whose closest entry opportunity is “nearby” markets will diversify narrowly and extract high rents c) Firms with less specific factors with “distant” opportunities will diversify widely and extract low rents d) Firms with more specific factors and no nearby opportunities will not be able to diversify at positive marginal rents. These firms are likely to have very high average rents, although it is clear that their total profits would increase if they had the opportunity to diversify

Diversification as a Way to Appropriate Ricardian Rents (a) Medium diversification, medium average rents (b) Narrow diversification, high average rents (c) Wide diversification, low average rents (d) No diversification very high average rents Prediction: As optimal diversification increases, average economic rents decline

Tobin’s q as a Measure of Rents Tobin’s q is defined as the ratio of market value to the replacement cost of the firm q = M/V p = 1 + (V I + V C + V R + V E )/V P (1) M = market value of the firm V P = replacement value of physical assets V I = value of intangible assets purchased by firm V C = value of collusive relationships w/competitors V R = capitalized Ricardian rents V E = disequilibrium effects

Tobin’s q as a Measure of Rents Estimate (1) using conventional proxies for V I, V C, VE to focus on the relationship between V R and multi-market activity Relationship is not straight forward. If we denote d as diversification, s as specificity, and o as opportunities our theory is that V R /V P (s,d) (increasing function s, decreasing ofd) (2) d (s,o) (decreasing function of s, increasing of o) (3) Problem: s and o are unobserved, industry dummies as instrument for d in V R /V P (d) (4) This amounts to using the average industry level diversification, rather than each firm’s own diversification level as a proxy for s, and o

Data, Measures, and Tests Data were gathered from multitude of sources, and from these data estimates of the following variables were constructed A i =firm i’s marketing expenditures (sales weighted) R i =firm i’s R&D (sw) C i = concentration in firm i’s market (sw) G i =growth of shipments in firm i’s markets (sw) S i = firm i’s market share (sw) F i = firm i’s foreign sales (in percent) V pi = replacement costs of firm i’s physical assets

Data, Measures, and Tests Diversification measure (D i ) requires more explanation, because goal is to differentiate between more and less similar diversification,and have chosen the concentric index of Caves et al. (1980) D i =Σ m ij Σ m il r il j = 1 nn l =1 Where m ij is the percentage of firm i’s sales in industry j and r jl is zero if j and l have the same three digit code, 1 if they have different 3-digit codes but identical 2-digit codes and 2 if the have different 2-digit codes

Data, Measures, and Tests Regression equations q = β 0 + β 1 A/V p + β 2 R/V P + β 4 C+ β 5 D+ β 6 F+ β 7 G + Є q = β’ 0 + β’ 1 A/V p + β’ 2 R/V P + β’ 4 C+ β’ 5 Ď+ β’ 6 F+ β’ 7 G + Є Where Ď indicates that D is estimated through the instruments Because both sides are divided by V P, measurement error in this variable induces some problems. Therefore, they follow Grilliches (1981) and take logs, using the x≈log(1+x) approximation

Results Table 1 Regression Results: Firm Value of Extent of Diversification

Discussion/ Conclusions Using Tobin’s q authors have tested the hypothesis that large firms earn decreasing average rents as they diversify more widely Results indicate that the farther a firm must go to use their factors, the lower the marginal economic rents they extract Explanation of negative relationship between market valuation and diversification Faulty beliefs in rents diversification “Free cash Flow” hypothesis

Discussion/ Conclusions Limitations of study: Several simplifying assumptions Pertains only to large firms Test refer to average rents, not total profit Assumptions allow the focus of few key implications of factor heterogeneity and are sufficient to explain the evidence