Lecnotes05 - ECON 696 Managerial Economics and Strategy...

ECON 696: Managerial Economics and Strategy
Lecture Notes 5: Diversification
Chapter two discussed reasons for diversification, or horizontal expansion, in terms of
developing economies of scale and scope. Chapters three, four and five then discussed
vertical expansion in terms of reducing efficiency and agency costs. Chapter five returns
to the discussion of diversification.
This chapter extends the discussion in a few different directions, but they can be
summarized very briefly:
• The most important lesson to take away from this chapter is contained in the quote,
"...scope economies can come from spreading a firm's underutilized managerial and
organizational resources to new areas." (p. 175)
• The chapter discusses some different rationales for diversification. When these
reasons deviate from truly economic explanations, it is very often the case that the
authors explain why popular, non-economic explanations seem irrational.
• How do we assess whether or not diversification actually helps firms achieve
whatever goals they have in mind? What empirical evidence is there and what does it
suggest?
The Best Reason for Diversification
A firm is a collection of resources, some of which are available only in discrete
quantities, which may or may not be able to fully exploit. The firm's level of efficiency is
determined by how well it makes use of these resources. If a firm's main area of business
leaves some of these resources under-exploited either on an ongoing or on a cyclical
basis, and if the firm can identify other lines of business which can specifically use these
under-exploited resources when they tend to be idle, then it may be able to achieve
greater efficiencies by expanding horizontally.
These under-exploited resources may be machines that are of a certain size but frequently
run below capacity or managers who are hired full time in order to retain their expertise
but who have some relatively slow months each year. If horizontal expansion provides
new work for these fixed inputs when they are most likely to be idle, the firm can achieve
greater efficiency.
Other Reasons for Diversification
The text describes other reasons for diversification, but just because the authors mention
them doesn't mean that they believe in them. Indeed, the authors mention some of these
others reasons only to explain why they may make no sense for a profit-maximizing firm.

In reading through these, there are a number of important underlying assumptions to
remember:
• Most parts of the world with large firms also have well-functioning financial markets,
and if a firm wants to borrow money for a profitable activity there should be no
impediment to its borrowing in financial markets.
• Diversification of individual or institutional portfolios is best achieved through
purchasing shares of other firms rather than assuming control of them.