Diversification of Resources
How does a multimarket company diversify its resources? In the paper “Diversification,” authors Cynthia A. Montgomery and Birger Wernerfelt study this subject. Specifically, they test whether a multimarket firm’s average rents decline the further they transfer resources from their primary business. For a multimarket company that is attempting to increase profits, the findings of this paper are extremely valuable. The essay also reveals the effect of resource specificity on company earnings.
Indirectly contributing to management literature, this paper offers potential implications for business organization. If a company with a primary market experiences market failure or slack for the company’s resources in this market, the company might be more successful if they allocate these factors to a different market. However, Montgomery and Wernerfelt discuss two problems that arise from this situation. The first problem is that the more a firm continues to diversify the more its average rents are predicted to drop. This is backed by two points 1) the broad expansion equals fewer specified assets that can be expanded, and 2) the more specific the resources are to the primary market the more rent they can get and when transferred the greater loss they experience in rent extraction capacity. The second issue has to do with the value of the resources.
In the end the authors produce results that prove the theory that as firms diversify their profits decrease. But this doesn’t mean that they are not maximizing value. It only means that their rents are declining compared to their previous rents. The authors end the paper by examining different theories, all of which they find unlikely except for the aforementioned theory in which companies are investing in industries pointlessly because they have extra money.
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This article was submitted by Phineas Upham. Phineas Upham is an investor from SF and NYC. For more details visit his website at www.phineas-upham.com and his twitter page at Phineas Upham Twitter.