Diversification, Ricardian rents and Tobin’s q

Cynthia A. Montgomery Birger Wernerfelt

Presented by Carla Fernández-Corrales, Fall 2013

The RAND Journal of Economics (1988): 623-632

Northwestern University (now at HBS)

Northwestern University (now at MIT Sloan)

Motivation

• Although multimarket firms play an important role, the theory of diversification lacked empirical tests at the time of this article.

• Theory of diversification: if a firm presents excess of capacity of productive factors, diversification is an efficient choice (Penrose, 1959)

• The article considers the heterogeneity of factors and profit/maximizing decisions.

Ricardian rents

• Economics rents from unique factors (e.g., good manager, good location, patent).

• Rents also originate from imitable factors, when imitating them is an uncertain project for competitors (e.g. brand or reputation).

• Rents likewise can derive from shared factors (e.g., team of managers that cannot market themselves as a package, manager or supplier that makes an unanticipated investment).

Diversification

If a firm owns or share a factor with exceeded capacity, and this factor is subject to market imperfections, those are conditions for diversification. Assumptions:

1. The firm can dispose of excess capacity without affecting the rest of its operations.

2. If any firm in one industry will participate uniformly in other, those pair of industries are considered a single industry.

Diversification

Assumptions

3. Only firms that own or control rent-yielding factors

4. Static model of the case of a single diversification move in which a firm with excess capacity of a factor considers a marginal expansion of its scope.

Diversification

Hypotheses

Tobin’s q

• Accounting measures are not good proxies for rent because they don’t consider differences in systematic risk, temporary disequilibrium effects, tax laws, and arbitrary accounting conventions. • Tobin’s q Market

value

Replacement value of

physical assets

Value of intangible

assets

Value of collusive relationships with

competitors

Ricardian rents

Disequilibrium effects

Tobin’s qSpecificity

Opportunities

Diversification

Industry dummies

s and o are unobservables, therefore,

Data

• Sample of 167 firms (around 1976)

• q from Lindenberg and Ross (1981)• Domestic market share data and dollar sales from

Trinet/EIS • Replacement cost from 10 K's• Foreign sales estimates from EIS Directory• Industry estimates of marketing expenditures and

company sponsored R&D from Line-of-Business Report• Four-firm concentration ratios growth rates per SIC

code from the Census of Manufactures

Measures

Ai = firm i’s marketing expenditures (sales weighted)

Ri = firm i’s R&D (sales weighted)

Ci = concentration in firm /'s markets (sales weighted)Gi = growth of shipments in firm i’s markets (sales weighted)Si = firm i’s market share (sales weighted)

Fi = firm i’s foreign sales (in percent)

Vpi = replacement costs of firm i’s physical assets

Measures

• Diversification• Concentric index

Percentage of firm I’s sales in industry

0 if j and l have the same three-digit code

1 if they have identical two-digit code

2 if they have different two-digit code

Tests

After taking logs to reduce measurement error…

Results

Discussion

The farther firms must go to use their factors, the lower the marginal rents they extract (p 630).

Explanations1. Firms underestimate the effort to gain rents2. Free cash flow3. Firms diversify to overcome moral hazard

problems