Lecnotes05 - ECON 696: Managerial Economics and Strategy...

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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.
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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
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This note was uploaded on 01/04/2012 for the course ECO 696 taught by Professor Staff during the Fall '11 term at Metropolitan NY.

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Lecnotes05 - ECON 696: Managerial Economics and Strategy...

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