Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Theory of the Firm
- Economics of Strategy III
Prof. Dr. Christian Ernst
Winter Semester 2009 / 2010
Contents
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
III. Firm Boundaries
III.III Organizing Vertical Boundaries
•
•
•
Technical vs. Agency Efficiency
Process Issues in Vertical Mergers
Alternatives to Vertical Integration
III.IV Diversification
•
•
•
•
A Brief History
Why do Firms Diversity
Managerial Reasons for Diversification
Performance of Diversified Firms
Theory of the Firm
2
Firm Boundaries
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Firm Boundaries:
ORGANIZING VERTICAL
BOUNDARIES
Theory of the Firm
3
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Technical vs. Agency Efficiency
Organization of the vertical chain is a matter of choice. Firms can organize exchange
around arm’s-length market transaction, or they can organize exchange internally
(vertical integration).
Factors that affect the relative efficiency of market exchanges versus vertical integration:
•
•
•
•
•
Scale economies
Incentives
Coordination
Leakage of private information
Transactions costs of market exchange
Now we systematically study how these factors trade off against one another in
particular circumstances.
Theory of the Firm
4
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Technical vs. Agency Efficiency
The costs and benefits of relying on the market can be classified as relating to either
technical efficiency or agency efficiency.
Technical Efficiency
•
•
Technical efficiency represents the degree to which a firm produces as much as it can
from a given combination of inputs
Technical efficiency indicates whether the firm is using the least-cost production
process
Agency Efficiency
Agency efficiency refers to the extent to which the exchange of goods and services in the
vertical chain has been organized to minimize the coordination, agency, and transaction
costs (compare Theory of the Firm II).
Theory of the Firm
5
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Technical Efficiency/ Agency Efficiency Tradeoff and Vertical Integration
The appropriate vertical organization of production must balance technical and agency
efficiencies. Oliver Williamson uses the term economizing to describe this balancing act.
TRADEOFF BETWEEN AGENCY AND TECHNICAL EFFICIENCY
• ΔT represents the minimum cost of production under
vertical integration minus the minimum cost of
production under arm’s-length market exchange;
that is, it reflects differences in technical efficiency.
• ΔA represents the transactions costs when production
is vertically integrated minus the transactions costs
when it is organized through an arm’s-length market
exchange. This curve reflects differences in agency
efficiency.
• ΔC is the vertical sum of ΔT and ΔA and represents the
overall cost difference between vertical integration and
market exchange.
• The horizontal axis measures asset specificity,
denoted by k.
Theory of the Firm
6
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Technical Efficiency/ Agency Efficiency Tradeoff and Vertical Integration
THE EFFECT ON INCREASED SCALE ON TRADEOFF BETWEEN
AGENCY EFFICIENCY AND TECHNICAL EFFICIENCY
As the scale of the transaction increases, the firm’s
demand for the input goes up, and a vertically
integrated firm can better exploit economies of scale
and scope in production.
• Its production cost disadvantage relative to a
market specialist firm will go down, so the curve
ΔT will shift downward.
• Increased scale accentuates the advantage of the
organizational mode with the lowest exchange
costs. Thus, curve ΔA twists clockwise through
point k*.
• The intersection of the ΔC curve with the
horizontal axis moves leftward, from k** to k***,
expanding the range in which vertical integration
is the least-cost organizational mode.
Theory of the Firm
7
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Technical Efficiency/ Agency Efficiency Tradeoff and Vertical Integration
Three powerful conclusions about vertical integration:
•
Scale and Scope Economies
If the firm is considering whether to make or buy an input requiring significant upfront setup
costs, and there is a large market outside the firm for the input, then the firm should buy the
input from outside market specialists.
•
Product Market Share and Scope
A firm with a larger share of the product market will benefit more from vertical integration
than a firm with a smaller share of the product market.
A firm with multiple product lines will benefit more from being vertically integrated in the
production of components for those products in which it can achieve significant market
scale.
•
Asset Specificity
A firm gains more from vertical integration when production of inputs involves investments in
relationship-specific assets.
Theory of the Firm
8
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Real-World Evidence
Evidence suggests that many real-world firms behave in accordance with these principles.
The evolution of the hierarchical firm discussed in “THE EVOLUTION OF THE MODERN
FIRM” is certainly consistent with the product market scale and the asset-specific effects.
A key step in the growth of the modern firm was forward integration by manufacturers into
marketing and distribution.
Statistical evidence on vertical integration from a variety of industries is also consistent
with the theory developed earlier. Consider these examples from strategy research:
•
Automobiles
Greater applications engineering effort is likely to involve greater human asset specificity.
It was hypothesized that car makers would be more likely to produce components that
required significant amounts of applications engineering effort and more likely to buy
components that required small amounts of applications engineering effort.
Analysis of the data confirmed this hypothesis
Monteverde, K. Teece, D. (1982): Supplier switching costs and vertical integration in the automobile industry, in: Bell Journal of Economics, Vol. 13, p. 206 – 213.
Theory of the Firm
9
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Real-World Evidence
•
Aerospace Industry
Consistent with the asset-specificity hypothesis, it was found that greater design specificity
increased the likelihood that production of these airplane components was vertically
integrated.
More complex components were more likely to be manufactured internally.
Masten, S.(1984): The organization production: evidence from the aerospace industry, in: Journal of Law and Economics, Vol. 27, p. 403 – 417.
•
Electric Utility Industry
Coal-burning electricity-generating plants are sometimes located next to coal mines (site and
physical-asset specificity).
It was found that Coal-burning plants/ utilities are much more likely to be vertically integrated
than other plants. Otherwise coal suppliers relied on long-term supply contracts to prevent
holdup.
Joskow, P. (1985): Vertical integration and long-term contracts: the case of coal-burning electric generating plants, in: Journal of Law and Economics, Vol. 33,
p. 32 – 80.
•
Electronic Components
It was found that greater asset specificity in the selling function was associated with a greater
likelihood firms rely on their own sales forces rather than manufacturers’ reps.
Anderson, E., Schmittlein, D.C. (1984): Integration of the sales force: an empirical examination, in: RAND Journal of Economics, Vol. 15, p. 385 – 395.
Theory of the Firm
10
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Vertical Integration and Asset Ownership / GHM
The basic argument of the preceding section is that the interplay of technical and agency
efficiency determines the relative desirability of vertical integration versus arm’s-length
market contracting. Grossman, Hart, and Moore have developed a different theory for
comparing vertical integration with market exchange (GHM-Theory).
GHM-Theory focuses on the importance of asset ownership and control and makes
the critical observation that the resolution of the make-or-buy decision determines
ownership rights. The owner of an asset may grant another party the right to use it,
but the owner retains all rights of control that are not explicitly stipulated in the
contract. These are known as residual rights of control. When ownership is
transferred, the residual rights of control are transferred as well.
Taking incomplete contracting as a starting point, the GHM theory establishes that the form
of integration affects the incentives of parties to invest in relationship-specific assets.
Theory of the Firm
11
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Vertical Integration and Asset Ownership / GHM
Three alternative ways to organize transactions:
•
•
•
•
Two units enter a transaction with each other (unit 1 being upstream from unit 2)
To carry out the transaction, the parties must jointly make an array of operating decisions
The parties cannot write a contract that specifies these operating decisions in advance
They must bargain over them once the transaction is underway
•
Nonintegration
The two units are independent firms, each with control over its own assets.
•
Forward Integration
Unit 1 owns the assets of unit 2 (i.e., unit 1 forward integrates into the function
performed by unit 2 by purchasing control over unit 2’s assets).
•
Backward Integration
Unit 2 owns the assets of unit 1 (i.e., unit 2 backward integrates into the function
performed by unit 1 by purchasing control over unit 1’s assets).
Theory of the Firm
12
Organizing Vertical Boundaries:
Technical vs. Agency Efficiency
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Vertical Integration and Asset Ownership /GHM
By having control over the other unit’s assets, a unit has a better bargaining position
when it negotiates with the other unit over the operating decisions that they could not
contract  it can capture more of the economics value/ (quasi) rent created by the
transaction  boosting its willingness to make relationship-specific investments.
What about the other one?
Examples (GHM-Theory):
General Motors and Ford often own their own specialized tooling and dies, even though an
independent firm produces body parts and components.
Similarly, in the glass bottle industry, large buyers will often retain ownership of specialized
molds, even though an independent manufacturer produces the jars and bottles.
 Quod vide Example 4.3 (Economics of Strategy; Besanko et al.)
Theory of the Firm
13
Organizing Vertical Boundaries:
Process Issues in Vertical Mergers
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Process Issues in Vertical Mergers
Merging on the vertical chain is not a clear make-or-buy decision, but more a matter of
“buying” an opportunity to “make”. Whether that opportunity will be productive depends
on how governance arrangements between the two merging firms develop.
•
Governance arrangements delegate decision rights and the control of assets within firms
(compare GHM-Theory)
•
If an integrated firm does not get the governance right, then the benefits of integration may be lost
•
Acquiring firms may gain governance rights over physical assets, but can never gain full
governance rights over human capital  a governance arrangement that does not grant acquired
workers decision-making rights commensurate with their control over specialized resources thus
risks being inefficient
Decision –Making rights for an activity should be given to those managers whose decisions will
have the greatest impact on the performance of the activity.
•
The process by which governance develops can also exhibit path dependence
Theory of the Firm
14
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Alternatives to Vertical Integration
This section poses the problem of the firm’s vertical boundaries rather starkly – the firm must
either make an input or purchase it from an independent firm through arm’s-length market
transaction. A variety of in-between alternatives may capture the best of both worlds.
Hybrid ways of organizing exchange:
•
Tapered Integration: Make and Buy
•
Strategic Alliances and Joint Ventures
•
Collaborative Relationships
•
Implicit Contracts and Long-Term Relationships
Theory of the Firm
15
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Tapered Integration: Make and Buy
Tapered integration represents a mixture of vertical integration and market exchange.
A manufacturer might produce some quantity of an input itself and purchase the remaining
portion from independent firms.
Examples:
•
Coca Cola and Pepsi
 have their own bottling subsidiaries, but also rely on independently owned bottlers to produce
and distribute their soft drinks in some markets
•
General Motors
 had its own market research division but also purchases market research from independent
firms
Tapered integration offers three benefits:
•
Expands the firm’s input and/or output channels without requiring substantial capital outlays
•
The Firm can use information about the cost and profitability of its internal channels to help
negotiate contracts with independent channels
•
The firm may also develop internal input supply capabilities to protect itself against holdup
Any potential Problems?
Theory of the Firm
16
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Strategic Alliances and Joint Ventures
Since the 1970s, firms have increasingly turned to strategic alliances as a way to organize
complex business transactions collectively without sacrificing autonomy.
Theory of the Firm
17
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Strategic Alliances and Joint Ventures
In a strategic alliance, two or more firms agree to collaborate on a project or to share
information or productive resources. Firms may rely on a contract to spell out specific
responsibilities for investing in assets as well as the distribution of earnings, but the
contracts may be largely silent about the details of the collaborative effort.
A joint venture is a particular type of strategic alliance in which two or more firms create,
and jointly own, a new independent organization. The new organization may be staffed and
operated by employees of one or more parent firms, or it may be staffed independently of
either.
Theory of the Firm
18
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Strategic Alliances and Joint Ventures
The most natural candidates for alliances are transactions for which there are compelling
reasons to both make and buy. Specifically, transactions that are natural candidates for
alliances have all or most of the following features:
•
The transaction involves impediments to comprehensive contracting
•
The transaction is complex, not routine
•
The transaction involves the creation of relationship-specific assets by both parties in the
relationship, and each party to the transaction could hold up the other
•
It is excessively costly for one party to develop all of the necessary expertise to carry out all of the
activities itself
•
The market opportunity that creates the need for the transaction is either transitory, or it is
uncertain that it will continue on an ongoing basis
•
The transaction or market opportunity occurs in a contracting or regulatory environment with
unique features that require a local partner who has access to relationship s in that environment
Theory of the Firm
19
Organizing Vertical Boundaries:
Problems with joint ventures
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Firm A and Firm B are considering a joint venture. Both need to invest a specific amount of money
MA: Measured Value of Investment in JV Firm A (Accounting value)
MB: Measured Value of Investment in JV Firm B (Accounting value)
VA: True value of firm A‘s investment in JV (unobservable)
VB: True value of firm B‘s investment in JV (unobservable)
Why do we have M A ≠ VA [ M B ≠ VB ] ?
- Historical cost - depreciation often ≠ V
- Salary of an employee delegated to JV does not measure her true capability
Formal Contarcts on JV can only state specifics for M
→ Scope for manipulation
Theory of the Firm
20
Organizing Vertical Boundaries:
Problems with joint ventures
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
(Gross-)Payoff-function:
=
Ü (VA ,VB ) 1 , 5 (VA ,VB ) − 600
(Net-)Payoff-function:
Ü (VA ,V=
1 , 5 (VA + VB ) − 600 − VA − VB
B)
Both firms "agree" to invest VA =VB = $ 1.000k,
Agreement can only specify M A and M B .
Further Agreement: A and B split JVprofits 50:50
Case 1: Adhere to agreement (co-operate):
Ü (VA=
,VB ) 1 , 5 ( 2.000 ) − 600 − 1.000 − 1.000 = 400
A and B will both make 200 from the agreement.
Is this a realistic assumption?
Theory of the Firm
21
Organizing Vertical Boundaries:
Problems with joint ventures
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
CASE 2: Firm plays Accounting tricks:
if M = 1.000, V = 500, → VMin =
500 (you can only cheat so much)
Firm A's strategy given any strategy VB :
Max
π A 0 , 5 1 , 5 (VA + VB ) − 600  − VA
=
V
A
=
−0 , 25 ⋅ VA + 0 , 75 ⋅ VB
dπ A
=
−0 , 25 < 0 → VA* = VAMin = 500 → Free Rider Problem
dVA
B does the same → Dominant Strategy Equilibrium
*
*
500
V=
V=
A
B
1 , 5 ( 1000 ) − 600 − 500 − 500 =
Ü (VA ,VB ) =
−100
Even though JVwould be profitable, no agreement can be reached!
Theory of the Firm
22
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Collaborative Relationships
In the past few years, large firms throughout North America and Europe have increasingly
focused on a core set of activities, outsourcing the rest to specialized trading partners in
the vertical chain. These companies are following the lead of their East Asian counterparts
for whom vertical disintegration has been the normal way of doing business for decades.
Firms relay on a labyrinth of long-term, semiformal relationships
between firms up and down the vertical chain
•
Subcontractor Networks
Manufacturers make extensive use of networks of independent subcontractors with whom they
maintain close long-term relationships
These relationships typically involve a much higher degree of collaboration between the
manufacturer and the subcontractors and the delegation of a more sophisticated set of
responsibilities to the subcontractor.
•
Keiretsu
These systems are closely related to subcontractor networks, but they supposedly involve more
formalized institutional linkages.
Theory of the Firm
23
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Dept, Equity, and Trade Linkages in Japanese Keiretsu
•
•
•
•
•
•
•
Theory of the Firm
Members with strong institutional linkages
Links further strengthened by social affiliation
and personal relationship among executives
Easy coordination and no holdups when
vertical chain activities are performed by
keiretsu members
Recent research indicates that Keiretsus are not
what they were thought to be
Members borrow from their central banks as
well as from outside banks
Members have extensive business dealings
outside their Keiretsus
Profitability of Keiretsus have always been
average
24
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Implicit Contracts and Long-Term Relationships
An implicit contract is an unstated understanding between parties in a business relationship.
But implicit contracts are generally not enforceable in court, so parties to an implicit contract
must rely on alternative mechanisms to make the understanding viable.
A powerful mechanism that makes implicit contracts viable is the threat
of losing future business if one party breaks the implicit contract for its
own gain.
Theory of the Firm
25
Organizing Vertical Boundaries:
Alternatives to Vertical Integration
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Example (p. 159)
Firm 1 and Firm 2 coordinate efforts and make each an annual profit of $
1 mio. $. If they deal with another partner, annual profits decline to 0.9
mio. Both have an incentive to shirk on the commitment, boosting profits
in one year to $ 1.2 mio for the shirker. Other firm will end relationship.
Discount rate: 5%.
Shirking yields one time profits of $ 200.000 (1.2 mio. -1 mio.)
Value of the continued relationship $ 100.000/0.05 = 2 mio. (!) (1-0.9)
 Problem: Is the threat to end the relationship credible?
Theory of the Firm
26
Firm Boundaries
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Firm Boundaries:
DIVERSIFICATION
Theory of the Firm
27
Diversification: A Brief History
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
A Brief History
Many well-known firms are diversified – that is, they produce for numerous markets.
Through diversification within their areas of business, firms hope to reduce costs and
improve market effectiveness by exploiting economies of scale and scope.
To measure how diversified a firm is at a given point in time, Richard Rumelt developed the
notion of relatedness*. This measure depends on how much of a firm’s revenues are attributable to
product market activities that have shared technological characteristics, production characteristics,
or distribution channels.
Rumelt focused three characteristics of firms:
•
The proportion of a firm’s revenues derived from its largest business
•
The proportion of a firm’s revenues derived from its largest group or related businesses
•
The stages of a vertically integrated production process
* Rumelt, R. (1974): Strategy, Structure, and Economics Performance, Boston.
Theory of the Firm
28
Diversification: A Brief History
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
A Brief History
Relatedness (Classification)
A single-business firm derives more than 95 percent of its revenues from a
single activity
A dominant business firm derives 70 to 95 percent of its revenues from its
principal activity
A related business firm derives less than 70% of its revenue from its primary
activity, but its other lines of business are related to the primary one
An unrelated business firm or a conglomerate derives less than 70% of its
revenue from its primary area and has few activities related to the primary
area
Theory of the Firm
29
Diversification: A Brief History
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
A Brief History
Conglomerate Growth After WW II
•
•
From 1949 to 1969, the proportion of single and dominant firms dropped from 70 percent to 36
percent
Over the same period, the proportion of conglomerates increased from 3.4 percent to 19.4 percent
But:
Entropy Measure of Diversification
• If a firm is exclusively in one line of business (pure play), its entropy is 0
• For a firm spread out into 20 different lines equally, the entropy is about 3
Entropy Decline in the 1980s
•
•
•
During the 80s, the average entropy of Fortune 500 firms dropped form 1.0 to 0.67
Fraction of U.S. businesses in single business segments increased from 36.2% in 1978 to 63.9%
in 1989
Firms have become more focused in their core businesses
Theory of the Firm
30
Diversification: A Brief History
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
A Brief History
Merger Waves in U.S. History
•
First wave that created monopolies like standard oil and U.S. Steel (1880s to early 1900s)
•
The merger wave of the 1920s that created oligopolies and vertically integrated firms
•
The merger wave of the 1960s that created diversified conglomerates
•
The merger wave of the 1980s when undervalued firms were bought up in the market place
•
The most recent wave of the mid 1990s in which firms were pursuing increased market share and
increased global presence by merging with “related” businesses
Firms can diversify in different ways:
• They can develop new lines of business internally
• They can form joint ventures in new areas of business
• They can acquire firms in unrelated lines of business
Theory of the Firm
31
Diversification: Why do Firms Diversity
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Efficiency-based Reasons for Diversification
Economies of Scale and Scope
•
Evidence of Scale Economies
•
•
If a merger is motivated by scale economies, the market share of the merged firm should
increase immediately following the merger
Data from manufacturing industries show that changes in market share were as expected*
* Brush, T. H. (1996): Predicted change in operational synergy and post-acquisition performance of acquired businesses, in: Strategic Management Journal,
Vol. 17, p. 1 - 24.
•
Evidence Regarding Scope
•
•
•
If firms pursue economies of scope through diversification, large firms should be expected
to sell related set of products in different markets
Evidence indicates that this happens only occasionally * *
Several firms produced unrelated products and served unrelated consumer groups
* * Nathanson, D./ Cassano, J. (1982): Organization, diversity, and performance, in: The Wharton Magazine, Summer 1982, p. 19 - 26.
Theory of the Firm
32
Diversification: Why do Firms Diversity
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Efficiency-based Reasons for Diversification
Economies of Scale and Scope
•
Scope Economies Outside of Technology and Markets
•
•
Firms that produce unrelated products and serve unrelated markets could be pursuing
scope economies in other dimensions
Two explanations that take this approach are
− Resource based view of the firm (Penrose)
− Dominant general management logic* (Prahalad and Bettis)
* Prahalad, C. K./ Bettis, R. A. (1986): The dominant logic: A new linkage between diversity and performance, in: Strategic Management Journal,
Vol. 7, p. 485 - 501.
Theory of the Firm
33
Diversification: Why do Firms Diversity
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Efficiency-based Reasons for Diversification
Economizing on Transaction Costs
•
•
•
If transactions costs complicate coordination, merger may be the answer
Transactions costs can be a problem due to specialized assets such as human capital
Market coordination may be superior in the absence of specialized assets
Internal Capital Markets
•
•
•
In a diversified firm, some units generate surplus funds that can be channeled to units
that need the funds (Internal capital market)
The key issue is whether the firm can do a better job of evaluating its investment
opportunities than an outside banker can do
Internal capital market also engenders influence costs
Theory of the Firm
34
Diversification: Why do Firms Diversity
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Efficiency-based Reasons for Diversification
Diversifying Shareholders’ Portfolios
•
•
•
Diversification reduces the firm’s risk and smoothens the earnings stream
But the shareholders do not benefit from this since they can diversify their portfolio at
near zero cost.
Only when shareholders are unable to diversify (as in the case of owners of a large
fraction of the firm) do they benefit from such risk reduction
Identifying Undervalued Firms
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•
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When the target firm is in an unrelated business, the acquiring firm is more likely to
have overvalued the target
The key question is: “Why did other potential acquirers not bid as high as the
‘successful’ acquirer?”
Winner’s curse could wipe out any gains from financial synergies
Theory of the Firm
35
Diversification: Why do Firms Diversity
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Potential Costs of Diversification
•
Diversified firms may incur substantial influence costs
•
Diversified firms may need elaborate control systems to reward and punish managers
•
Internal capital markets may not function well
Example: Internal Capital Market in Oil Companies*
To examine the efficacy of cross-subsidization (nonoil subsidiaries),
it was examined how investment in the nonoil subsidiaries changed
when the price of oil fell dramatically in the mid-1980s.
Investment in nonoil subsidiaries fell sharply after the drop
in oil prices.
−
−
If internal capital markets worked well, non-oil investments should
not be affected by the price of oil
Managerial reasons may dominate the investment decisions
* Lamont, O. (1997): Cash flow and investment: Evidence from internal capital markets, in: Journal of Finance, Vol. 52, p. 83 – 109.
Theory of the Firm
36
Diversification:
Managerial Reasons for Diversification
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Benefits to Managers from Acquisitions
•
•
•
•
•
•
•
Growth may benefit managers even when it does not add value for the shareholders
When growth cannot be achieved through internal development, diversification may
be an attractive route to growth
When related mergers were made difficult by law conglomerate mergers became
popular
Managers may feel secure if the firm performance mirrors the performance of the
economy (which will happen with diversification)
Diversification will offer managers room for lateral movement and allow them to invest
in firm specific skills
Unrelated diversification may make it easier to motivate managers with pay for
performance incentives
Managers could be engaged in empire building and enhancing their status in their
network at the expense of the shareholders
Theory of the Firm
37
Diversification:
Managerial Reasons for Diversification
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Problems of Corporate Governance
All managerial motives for diversification rely on the existence of some failure of corporate
governance – that is the mechanisms through which corporations and their managers are
controlled by shareholders. If shareholders could (1) determine which acquisitions will lead
to increased profits and which one will not and (2) direct management to undertake only
those that will increase shareholder value, the possibility of managerially driven
acquisitions would disappear.
But:
•
•
•
•
Shareholders are not knowledgeable regarding the value of an acquisition to the firm
Shareholders have weak incentive to monitor the management
Shareholders may find it difficult to change management’ s decisions
Acquiring firms tend to experience loss of value
Theory of the Firm
38
Diversification:
Managerial Reasons for Diversification
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Market for Corporate Control and Recent Changes in Corporate Governance
•
•
Publicly traded firms are vulnerable to hostile takeovers
If managers undertake unwise acquisitions, the stock price drops, reflecting
−
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Overpayment for the acquisition
Potential future overpayment by the incumbent management
•
•
•
Free cash flow (FCF) = cash flow in excess of profitable investment opportunities
Managers tend to use FCF to expand their empires
Shareholders will be better off if FCFs were used to pay dividends
•
•
•
In an LBO (Leveraged Buy-out), debt is used to buy out most of the equity
Future free cash flows are committed to debt service
Debt burden limits manager’s ability to expand the business
Theory of the Firm
39
Diversification:
Managerial Reasons for Diversification
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Market for Corporate Control and Recent Changes in Corporate Governance
Market for Corporate Control - Evidence
•
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Hostile takeovers tend to occur in declining industries and industries experiencing
drastic changes where managers have failed to readjust scale and scope of
operations
Corporate raiders have profited handsomely for taking over and busting up firms that
pursued unprofitable diversification
• LBOs may hurt other stakeholders
− Employees
− Bondholders
− Suppliers
• Wealth created by LBO may be quasi-rents extracted from stakeholders
• Redistribution of wealth may adversely affect economic efficiency
Theory of the Firm
40
Diversification:
Managerial Reasons for Diversification
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
The Market for Corporate Control and Recent Changes in Corporate Governance
Redistribution and Long Run Efficiency
•
•
•
Takeovers that simply redistribute wealth are rational from the point of view of the
acquirers but sacrifice long run efficiency
Employees and other stakeholders will be reluctant to invest in relationship specific
assets
Purely redistributive takeovers will create an atmosphere of distrust and harm the
economy as a whole
• Possible reasons for the end of the LBO merger wave
− Use of performance measures such as EVA
− Increased ownership stakes by the CEO
− Monitoring by large shareholders
Theory of the Firm
41
Diversification: Performance of Diversified Firms
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Studies of Operating Performance
•
•
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Unrelated diversification harms productivity
Diversification into narrow markets does better than diversification into broad markets
Improvements in newly acquired plants may come at the expense of performance at
the existing plants
Valuation and Event Studies
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•
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“Diversification discount” in valuation
Discounts may have existed prior to acquisition for acquisition candidates
Market for corporate control counteracts the diversification discount
Firms with the largest discounts get taken over
Theory of the Firm
42
Diversification: Performance of Diversified Firms
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Diversifying Acquisitions
•
•
Shareholders of the acquiring firms do not benefit from the acquisitions
Negative effects on the acquiring firms are more severe when:
−
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the managers of the acquiring firms were performing poorly before the acquisition
the CEOs of the acquiring firms hold smaller share of the firms’ equity
Diversification and Performance
•
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Gains from diversification depends on specialized resources of the firm
Gains to unrelated acquirers get bid away in the auction for the target
Theory of the Firm
43
Diversification: Performance of Diversified Firms
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Long-Term Performance of Diversified Firms
•
Long term performance of diversified firms appear to be poor
•
One third to one half of all acquisitions and over half of all new business acquisitions
are eventually divested
•
Corporate refocusing of the 1980s could be viewed as a correction to the
conglomerate merger wave of the 1960s
•
Another view is that both the conglomerate diversification of the 60s and the
refocusing of the 80s could be value creating
•
Conditions in the 60s could have favored unrelated diversification and these
conditions could since have changed (Example: Anti-trust climate)
Theory of the Firm
44
Literature and further Reading
Institut für Haushalts- und Konsumökonomik
Fg. Ökonomik und Management sozialer Dienstleistungen
Prof. Dr. Christian Ernst
Besanko, David et al. (2007): Economics of Strategy, 4th Ed., Evanston, Illinois.
• Organizing Vertical Boundaries: Vertical Integration and its Alternatives (p. 136– 162)
• Diversification (p. 163 – 188)
• Examples 4.1 – 5.4 (see HOMEPAGE → STUDENTEN/- INNEN LOGIN
→ Masterstudiengänge)
Theory of the Firm
45