Introduction

• A diversified firm is involved in the production of a

number of different goods and services.
• In other words, a diversified firm is a multi-product
firm.
• Large diversified firms which operate in many sectors
of the economy are often referred to as
conglomerates.
 Types of Diversification
• The definition of a market contains both a product
dimension and a geographic dimension.
• Product dimension is closely related in production or
consumption
• Geographic dimension is price in one area changes
demand in other area
• Here diversification is supplying more than one
products that may be related or un related
• There are three types of diversification
1) Product Extension
• A firm can diversify by supplying a new product that
is closely related to its existing products.
• A sweet manufacturer that sells a milk chocolate bar
may decide to produce and sell a dark chocolate bar
as a product extension.
• Diversification by product extension could also
include a move slightly further afield; for example, a
chocolate bar producer might decide to supply closely
related products such as ice cream or snack foods.
• Since almost all firms produce more than one product
line or offer more than one service, all firms are to
some extent diversified.
2) Market extension
• Diversification by market extension involves moving
into a new geographic market.
• For example, the sweet manufacturer that produces
chocolate bars for the UK market might decide to
venture further afield by marketing the same
chocolate bars in the EU
3) Pure diversification
• A pure diversification strategy involves movement
into unrelated fields of business activity.
• Firms that supply unrelated products to unrelated
markets are known as conglomerates.
• Diversification by product extension or market
extension refers to a strategy based on core product
specialization.
• Conglomerates or purely diversified firms do not
specialize in this way.
• Pure diversification is a relatively unusual strategy.
• Most firms tend to diversify by entering adjacent
markets, rather than totally unrelated ones.
• There are two ways in which a diversification
strategy can be implemented:
a) Through internally generated expansion
• Internally generated expansion is likely to require the
simultaneous extension of the firm’s plant and
equipment, workforce and skills base, supplies of raw
materials, and the technical and managerial expertise
of its staff.
b) Through merger and acquisition
• Conglomerate merger involves the integration of
firms that operate in different product markets, or in
the same product market but in different geographic
markets.
• The main requirements for the conglomerate merger
strategy are an ability to select an appropriate target
firm; access to the financial resources required to
secure a controlling interest in the target firm; and an
ability to manage the integrated organization
effectively after the merger has taken place.
• While diversification through internal expansion
leads to an increase in the total productive capacity in
the industry concerned, diversification through
conglomerate merger involves only a transfer of
ownership and control over existing productive
capacity.
 Motives for Diversification

• Why a firm might decide to pursue a strategy of

diversification?
– Enhancement of market power
– Cost savings
– Reduction of transaction costs
– Managerial motives for diversification
a) Enhancement of market power
• The diversified firm which operates in a number of
separate product and geographic markets may enjoy a
competitive advantage over a specialized firm, because
it can draw on (utilize) resources from its full range of
operations in order to fight rivals in specific markets.
• Furthermore, a firm that already has significant market
power in one market might be reluctant to expand
further within the same market, for fear of alerting the
competition authorities.
• A superior and less confrontational strategy might be to
move into other related or unrelated markets.
Cross-subsidization and predatory competition
• The diversified firm may be in a strong position to
compete against a specialized rival by drawing on cash
flows or profits earned elsewhere within the
organization, effectively cross-subsidizing the costs of
engaging the rival in either price or non-price forms of
competition.
• Through a policy of cross-subsidization, the
diversified firm may be in a strong position to compete
against a specialized rival in the rival’s own market,
drawing on cash flows or profits earned elsewhere
within the organization to cover the costs of engaging
in the rival in either price or non-price forms of
predatory competition
• Predatory competition involves diverting resources
from one operation in order to fight elsewhere.
• Under a predatory pricing strategy, for example, the
diversified firm might undercut the specialized firm’s
price in an attempt to force it out of the market
• Once the rival has withdrawn, the price is reset to the
original level or a higher level.
• In order for this strategy to succeed, the predator must
have a deeper pocket (abundant financial resources)
than its rival
• A predatory pricing strategy is only likely to be
profitable if there are barriers to entry.
• Otherwise the sacrifice of profit in the short run may be
in vain.
• ‘Predatory competition is an expensive pastime,
undertaken only if monopoly and its fruits can be obtained
and held’
• However, by signalling commitment, the predator may
develop a reputation as a willing fighter, which itself
serves as an entry barrier
• There may be limits to the usefulness of a predatory
competition strategy for a diversified firm.
• The specialized rival might turn out to be a more effective
fighter, as it would be fighting for its very survival.
• For any firm wishing to eliminate rivalry, there may be
alternative, less costly strategies than predatory
competition, such as collusion or acquisition
Reciprocity and tying
• Reciprocity involves an agreement that firm A
purchases inputs from firm B, on condition that firm
B also purchases inputs from firm A.
• In other words, reciprocity is ‘the practice of basing
purchases upon the recognition of sales to the other
party, rather than on the basis of prices and product
quality’
• It can be argued that, in effect, all economic
transactions involve an element of reciprocity; and, in
the extreme case of barter, transactions are based
solely on reciprocal arrangements.
• Reciprocity becomes anticompetitive if one of the
parties is forced to take part in a reciprocal
transaction in which it would not participate
voluntarily.
• A specialized firm has only a limited range of input
demands, whereas a diversified firm has a much
wider spread of purchasing requirements.
• Therefore, the diversified firm is in a stronger
position.
• Reciprocal trade increases existing entry barriers or
creates new barriers if entrants are effectively
excluded as a result of reciprocal trade arrangements
• Reciprocity is just one method by which a firm can
exploit its existing market power, rather than a
strategy for extending market power.
• Consequently, the practice itself should not be viewed
as particularly damaging to competition.
• Tying involves the linked selling of two distinct
products, in order to purchase good X the buyer must
also purchase good Y
• This practice may be an attractive strategy for a
diversified firm that is seeking to generate sales
across a number of distinct product lines.
• Reciprocity and tying may be attractive strategies for
a diversified firm that is seeking to generate sales
across several distinct product lines.
b) Cost savings
• In theory, a diversification strategy can result in cost
savings in three ways:
– through the realization of economies of scope;
– by reducing risk and uncertainty; and,
– by reducing the firm’s tax exposure.
Economies of scope
• Economies of scale are realised when the firm
reduces its long-run average cost by increasing its
scale of production, while economies of scope are
realised when long-run average cost savings are
achieved by spreading costs over the production of
several goods or services.
• Example; A fruit-grower must leave enough space
between the trees to allow access for labour and farm
equipment. This land can be used to graze sheep.
Then the farmer uses one input, land, to produce two
products, fruit and wool.
Reduction of risk and uncertainty
• All firms are vulnerable to adverse fluctuations in
demand, and increased competition in their product
markets.
• The more products a firm develops, the lower is this
vulnerability.
• The unpredictability of demand creates uncertainty,
which in turn might motivate a diversification
strategy
• Diversification spreads risk and reduce exposure to
risk
Reduction of tax exposure
• Under some taxation regimes, diversification can
enable a firm to reduce its tax liability.
• Profits in one activity can be offset against losses in
another.
• A specialized firm which makes a loss pays no tax on
profit, but the tax payable by other profitable
specialized firms is not reduced.
• A diversified firm might make greater use of debt
rather than equity finance.
• If interest payments on loans are tax deductible, the
overall effect might be a reduction in the firm’s taxable
profit
c) Diversification as a means of reducing
transaction costs
• Motives for diversification or conglomerate merger
can also be identified using the transaction costs
approach.
• These are considered under three headings:
– the conglomerate as an internal capital market,
– the conglomerate as a vehicle for the exploitation
of specific assets, and
– the ability of a conglomerate to deliver services.
The conglomerate as an internal capital market
• In theory, the financial or capital markets should
always reward efficient management by increasing the
market value of the firm.
• In practice, however, investors may be unable to access
accurate information in order to judge the performance
of management, especially since managers are likely to
exercise influence or control over the flow of
information.
• It would require a great deal of altruism for managers
to pass on information which might reflect badly on
their own performance.
• Information impactedness creates a transaction cost that
frustrates the efficient allocation of investment funds.
• In corporate structure the headquarters of the
conglomerate performs the task of allocating funds
for investment between a number of divisions
• The managers of the divisions have autonomy in their
day-to-day decision-making.
• In this coordinating role, the headquarters has two
advantages over the capital market.
• First, the divisional managers are subordinates to the
senior managers, and can be ordered to provide
reliable information.
• An implicit disciplinary threat can be used to
encourage compliance
• It might be easier for divisional managers to share
confidential information with senior managers than
with external investors.
• Second, the headquarters can conduct internal audits
to guard against mismanagement at divisional level.
• Effectively, the conglomerate acts as a miniature
capital market, but enjoys better access to information
and is able to monitor performance at divisional level
more effectively.
• Of course, as the conglomerate grows larger, limits
may be reached to the ability of the senior managers
to monitor and coordinate effectively.
• There is also an opposing view, that the managers of
a large diversified conglomerate might perform the
task of allocating funds less efficiently than the
capital markets.
• The managers might be excessively willing to prop
up ailing divisions at the expense of the profitable
ones.
• Divisions within a conglomerate bargain for funds
and the bargaining power of a division might be
enhanced by investments that do not benefit the
organization as a whole.
• The head office might buy the cooperation of
divisions by diverting investment funds in their
direction
• Effectively, conglomerate acts as a miniature capital
market, but enjoys better access to information and is
able to monitor performance more effectively.
The conglomerate as a vehicle for the exploitation of
specific assets
• Firms’ opportunities for growth derive from their
possession of resources and assets that can be
exploited in other markets.
• If these resources could be sold to other firms through
the market, the rationale for diversification would
disappear.
• Specific assets include new technologies, trade
secrets, brand loyalty, managerial experience and
expertise
• Assets of this kind are termed core competences (core
capabilities )
• In order to capitalize on its specific assets, the firm
can either sell the assets in the market, or diversify
into the relevant industry and exploit the asset itself.
• The decision whether to sell or diversify depends on
the presence of market imperfections which increase
the transaction costs incurred by selling the assets in
the market.
• In summary, most firms possess specific assets that
are of value if exploited in other markets.
• If the transaction costs incurred in trading specific
assets through the market are high, it may be better
for the firm to exploit the assets itself by
implementing a diversification strategy.
The delivery of services
• The role of diversification as a means for eliminating
transaction costs may be applicable to the delivery of
services.
• Unlike physical products, services are intangible and
therefore have the characteristics of experience goods
• Furthermore, services involve interactions between
customers and suppliers.
• These characteristics create difficulties for customers
in comparing the services offered by different
suppliers, which give rise to switching costs.
• Diversified organizations, which supply both goods
and services, may therefore have an advantage over
specialized suppliers of goods only.
d) Managerial motives for diversification
• An important characteristic of the large corporation
is the separation of ownership from control.
• Diversification is the principal method by which
growth in demand is achieved in the long run.
• Conglomerate merger is a strategy that may be
pursued by managers more concerned with the
maximization of growth than with the maximization
of shareholder value.
• If the regulatory authorities make it difficult for
firms to expand horizontally or vertically,
conglomerate merger may represent the best
available alternative strategy.
• There may be several reasons why the managers (the
agents) might wish to pursue growth at a faster rate
than would be chosen by the owners or shareholders
(the principals).
• First, the managers’ power, status and remuneration
might be related to the growth of the organization.
• Second, diversification into new activities might
complement the talents and skills of the managers,
increasing their value to the organization.
• Third, unlike shareholders, who are able to reduce
risk by diversifying their portfolios, the managers’ job
security depends on the fortunes of the firm.
• Diversification might provide a means of reducing
the risk of failure facing the firm and its managers.
• Income from employment represents a large
proportion of the managers’ remuneration, and this
income is correlated with the firm’s performance.
• The risks to the managers’ income are closely related
to the risks facing the firm.
• Since their employment risk cannot easily be reduced
by diversifying their personal portfolios, managers
diversify their employment risk by supporting
strategies of diversification or conglomerate merger.
• Manager-controlled firms are more likely to pursue
conglomerate merger than owner-controlled firms.
 The Multinational Enterprise
• Some firms choose to exploit opportunities for
diversification via expansion into foreign markets.
• Firms found it feasible to undertake direct
investments in foreign production (foreign direct
investment, FDI), rather than rely solely on exports
and imports.
• Why do firms make investments abroad?
• A multinational enterprise that diversified
geographically into a foreign market might benefit
from several advantages, such as
– access to cheap resources,
– reduction of transport costs,
– reduction of tax exposure, and
– financial inducements (incentives) from
government.