Diversification, Ricardian rents and Tobin’s q
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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)
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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.
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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).
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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.
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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.
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Diversification
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Hypotheses
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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
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Tobin’s qSpecificity
Opportunities
Diversification
Industry dummies
s and o are unobservables, therefore,
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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
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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
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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
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Tests
After taking logs to reduce measurement error…
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Results
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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