Abstract
Diversification is the process by which the modern corporation extends its activities beyond the products and markets in which it currently operates. It is a major determinant of the structure of modern industrial economies and has important implications for competition and efficiency. Robinson (1958, p. 114) defines diversification as ‘the lateral expansion of firms neither in the direction of their existing main products, as with horizontal integration, nor in the direction of supplies and outlets, as with vertical integration, but in the direction of other different, but often broadly similar, activities’. The extent of diversification can be measured in a number of ways, but is hampered by the difficulty of precisely defining the boundaries between different products, markets and industries. It is not a simple task to assess the degree to which a firm spreads its operations over different activities. The more narrowly defined are these activities the greater will be the apparent degree of diversification. These problems are not unique to the measurement of diversification and similar difficulties arise in the measurement of concentration in industry. Indeed the process of diversification itself has played a major part in blurring the distinction between industries and in creating these measurement problems. However, it is clear that diversification must involve the firm in producing new products which are sufficiently different from its existing products to involve the firm in new production or distribution activities. Diversification may therefore involve only a small change of direction, or a dramatic switch into an entirely new line of business. In the literature the former is referred to as related, or narrow spectrum diversification and the latter as unrelated, or broad spectrum diversification.
Diversification is the process by which the modern corporation extends its activities beyond the products and markets in which it currently operates. It is a major determinant of the structure of modern industrial economies and has important implications for competition and efficiency. Robinson (1958, p. 114) defines diversification as ‘the lateral expansion of firms neither in the direction of their existing main products, as with horizontal integration, nor in the direction of supplies and outlets, as with vertical integration, but in the direction of other different, but often broadly similar, activities’. The extent of diversification can be measured in a number of ways, but is hampered by the difficulty of precisely defining the boundaries between different products, markets and industries. It is not a simple task to assess the degree to which a firm spreads its operations over different activities. The more narrowly defined are these activities the greater will be the apparent degree of diversification. These problems are not unique to the measurement of diversification and similar difficulties arise in the measurement of concentration in industry. Indeed the process of diversification itself has played a major part in blurring the distinction between industries and in creating these measurement problems. However, it is clear that diversification must involve the firm in producing new products which are sufficiently different from its existing products to involve the firm in new production or distribution activities. Diversification may therefore involve only a small change of direction, or a dramatic switch into an entirely new line of business. In the literature the former is referred to as related, or narrow spectrum diversification and the latter as unrelated, or broad spectrum diversification.
One possible measurement of the extent of diversification involves identifying the number of industries, or products in which the firm is involved. The other main approach is to measure the proportion of the firm’s activity in its core business in comparison with the proportions in its diversified activities. This measure has been refined in a number of ways to take account of the number and importance of these diversified activities (e.g. Berry 1975; Jacquemin and Berry 1979; Utton 1979).
The process of diversification is not a new phenomenon, but the principal empirical studies (Gort 1962; Rumelt 1974; Berry 1975; Utton 1979) have demonstrated a marked increase in the degree of diversification over the past few decades. The studies suggest that diversification tends to be narrow spectrum diversification into similar industries. However, both Gort and Rumelt were able to discern some shift towards broad spectrum diversification. The intensity of narrow spectrum diversification was found to be industry related, but the extent of broad spectrum diversification was independent of the primary industry from which diversification was occurring. Rumelt was also able to identify a growth in importance of acquisitive conglomerates and there can be little doubt that their importance has grown further since his study. There was general agreement that firms tended to diversify into industries characterized by high research and development intensity and rapid technological change. The industries also tended to be faster growing, but showed no significant differences in terms of profits variability, or the degree of concentration, than industries less popular with diversifying firms. The industries from which higher levels of diversification occurred were not slower growing than other industries, but did tend to be characterized by a higher degree of seller dominance. Such industries might give less scope for firm growth by capturing market share. The more rapid diversifiers tended to be larger firms with higher proportions of scientific and technical employees and this is consistent with the importance of technological industries as diversification choices which was noted above. Finally firms with above average rates of diversification tended to have above average rates in subsequent periods. This may be related to the organizational changes associated with diversification which have been identified by Chandler (1963) and others (e.g. Williamson 1970; Channon 1973). This issue is explored further below.
The growth of firms and the role of diversification in this growth process were elucidated in the pioneering work of Penrose (1959). Penrose identified three explanations for diversification: first, as a response to specific opportunities; second, as a response to specific threats; and third, as a general strategy for growth. The opportunity to diversify arises naturally as a byproduct of the existing activities of the firm. A key area is the research and development activities of the firm. Such activities develop the firm’s knowledge of its technology which is unlikely to be product specific. Furthermore whether research is carried out only to improve the firm’s existing products, or the develop new products, it is likely to provide new opportunities for diversification. The knowledge of the markets for its existing products and their channels of distribution provide the firm with other opportunities for diversification. Another opportunity for diversification arises from retained earnings from existing activities. The finding that these earnings are invested in diversification rather than, for example, paying dividends, is probably associated with the growth orientation of management and the tax position of shareholders. Thus the normal operations of the firm create both new opportunities for expansion and the availability of unused productive resources to meet these opportunities. The second explanation offered by Penrose concerns the exposure declines in demand for their products. Diversification is a means of spreading risk through reducing the firm’s dependence on a few products. The reduction in perceived risk may also reduce the cost of capital to the firm. Diversification may also occur in response to diversification by a competitor. This type of competitive strategy raises the question of the implications of diversification for competition and this issue is examined below. Finally diversification may occur as part of a general policy for growth. This part of Penrose’s work has been taken further by Marris (1964). Marris gives diversification a central role in his model of the growth of firms. The management of firms have a strong motivation to seek growth since it confers on them improved status, salary and security. But growth within their existing markets will eventually be limited by the growth of demand for these products and diversification is the means by which this demand constraint may be overcome. It has been argued above that a certain degree of diversification will be both natural and beneficial as opportunities are exploited. However, Marris argues that management will be prepared to press growth, and hence diversification, beyond the level which is optimal for shareholders. The drawback of too rapid a rate of diversification is a higher failure rate of new products due to a lack of managerial, financial, development and marketing resources. This may be a less reasonable proposition when the possibility of growth through merger is recognized. However before considering this it is worth looking at the changing structure of firms which has evolved with diversification.
The development of the M-form, divisionalized company was identified by Chandler (1963) to be a response to the growth and, more particularly, diversification of the modern corporation. Subsequent research (e.g. Channon 1973; Rumelt 1974; Williamson 1970, 1975) has reinforced their inter-connection to such a degree that it is necessary to interpret the consequences of diversification within the context of the divisionalized company structure. In this structure responsibility for profitability is restored to divisional managers whose performance can be assessed. Top management is freed from day-to-day operational decisions and can concentrate on the allocation of funds between the divisions and other aspects of strategy. The divisional structure significantly reduces the organizational constraints of diversified growth, particularly growth by acquisition. The acquisition of new divisions, or sub-divisions, by takeover can be achieved quickly and with minimum disruption. Diversification through merger is often seen as less risky since it involves the acquisition of the physical assets, existing products and channels of distribution required and brings with it management and employees who are experienced in this area of activity. Furthermore, entry is achieved without initially having to compete for a market share. On the other hand if the motive for diversification is to utilize spare resources within the firm, or to exploit some technological development, then diversification by internal growth may be preferred. It appears that the importance of diversification mergers has increased in recent decades, partly as a response to the increase in strength of competition policy.
The US merger laws have evolved into a potent deterrent against sizeable horizontal and vertical mergers. It is doubtful, however, whether they have had much impact on the overall level of merger activity which has continued at high levels (Scherer 1980, p. 588).
A substantial controversy surrounds the question of what impact diversification has on competition and efficiency. At first sight the creation of large, non-specialized firms would be expected to reduce both, but there are counter arguments. The evidence does not suggest that diversification raises market concentration. Indeed, broad spectrum diversification may be a force for reducing concentration in individual markets. Large firms diversifying are able to overcome many barriers to entry and may promote competition by their entry. Diversification may be the only means by which firms may grow large enough to reap pecuniary economies of scale, without becoming too dominant in a single market. It is also argued that the diversity of products, as well as large size, brings a greater potential benefit from research. Therefore large, diversified firms may be more likely to engage in intensive research and development, to the benefit of the whole economy. The associated introduction of the M-form organization is argued to lead to improved internal efficiency of the firm as divisions strive to meet profit targets and compete for funds. It is also argued that the internalizing of the capital market within the large, diversified firm can lead to improved allocative efficiency. This is created by top management, who hold better information than investors, allocating funds to their most profitable use. On the other hand there are several arguments which suggest that the growth of the diversified firm has the potential to create reduced competition and efficiency. It was noted earlier that there has been a high proportion of narrow spectrum diversification.
At least one possible interpretation of this finding is that the diversification that has led to relatively rapid rates of corporate growth (or has accompanied it) has not in general been to markets where the entering firm is a new and potentially competitive force. Rather, that ‘diversification’ has been to markets that are related to – and potentially if not actively competitive with – those in which the entering firm will frequently share what ever market power already exists. This kind of diversification is only one small step removed from the consolidation of market power through horizontal acquisition (Berry 1975, pp. 74–5).
Furthermore, the internalizing of capital markets has led to the removal of information and decision-making from the investor and led to a concentration of economic power. ‘This means that the diversified, divisionalized firm is increasingly becoming the arbiter of intersectional shifts in funds’ (Rumelt 1974, p. 155). Another focus of concern has been the potential for predatory pricing behaviour in which the diversified firm uses cross-subsidization between divisions to eliminate, or discipline, more specialized rivals and so achieve higher long-run profits. A further possibility is reciprocal purchasing agreements when a firm is significant both as a seller to and buyer from another firm. It is argued that such practices are more likely to be found amongst large, diversified firms, but there is little evidence for the widespread existence of either predatory pricing, or reciprocal purchasing behaviour. Finally there is the spheres of influence hypothesis which recognizes the pervasive influence of large, diversified firms in almost all markets. Conglomerates might recognize that aggressive behaviour against another conglomerate in one market would have adverse consequences in other markets. It is possible that a symmetry of market power might emerges which would blunt competition. The answer to many of the empirical issues concerning diversification are as yet unresolved. This is in part due to a lack of sufficient research, but also in part due to the fact that the process of diversification is continuing. When, and if, a more stable period emerges the uncompetitive consequences outlines above may become more apparent.
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Cosh, A. (2018). Diversification of Activities. In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-349-95189-5_282
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