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DIversification and Firm Performance

Diversification involves a firm entering new businesses, which can be related or unrelated to existing operations. It can be driven by factors such as economies of scope, lack of external capital, market failures, managerial motives, and regulatory measures. While related diversification tends to enhance profitability, unrelated diversification may decrease it, indicating that the impact of diversification on profitability is influenced by various factors.

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Vinay Jaddumahanthi
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3 views1 page

DIversification and Firm Performance

Diversification involves a firm entering new businesses, which can be related or unrelated to existing operations. It can be driven by factors such as economies of scope, lack of external capital, market failures, managerial motives, and regulatory measures. While related diversification tends to enhance profitability, unrelated diversification may decrease it, indicating that the impact of diversification on profitability is influenced by various factors.

Uploaded by

Vinay Jaddumahanthi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Diversification and firm performance:

Diversification is defined as a firm entering a new business other


than its existing businesses. These new businesses may or may not be
closely related to the existing business. If the new business is related to
the existing business, it is called related diversification while if the new
business is unrelated to the existing business, it is called unrelated
diversification.

A variety of reasons could prompt a firm to go for diversification.


Economies of scope to improve utilization rate of resources that can be
shared in production of different products (Panzar and Willig, 1981) could
be one reason. Lack of availability of external capital can force firms to
use internal capital resources for a new business leading to diversification
(Williamson, 1975). High external transactions leading to market failure
could be another reason (Chatterjee and Wernerfelt, 1988). In addition,
managerial motives to reduce their employment risk (Amihud and Lev,
1981) and increase executive compensation (Tosi and Gomez-Mejia, 1989)
could lead to diversification. Even policy measures like anti-trust laws in
USA during the 1960s could lead to diversification (Bhagat et al. (1990),
Hoskisson and Turk (1990), Shleifer and Vishny (1990, 1991)).

Given that firms have incentives to diversify, does diversification


improve profitability of firms? Related diversification seems to improve
profitability while unrelated diversification seems to reduce it (Rumelt,
1982). This might be due to benefits like economies of scope. Profitability
might also depend on the ability of top corporate management to adapt
their logic to new business (Prahalad et al, 1986). Additionally,
diversification may not lead to profitability improvement when it is
excessive (Markides, 1995), in which case diversification leads to decline
in profitability. Thus, the effect of diversification on firm profitability is
contingent on a lot of factors and a careful combination of these factors
could lead to successful diversification by improving profitability.

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