Diversification and Performance: Linking Relatedness, Market Structure and the Decision to Diversify
41 Pages Posted: 22 Mar 2006
Date Written: February 24, 2006
An extensive empirical literature in strategy and finance studies the performance implications of corporate diversification. Two core debates in the literature concern the existence of a diversification discount and the relative importance of industry relatedness and market structure for the performance of diversifiers. We address these debates by building a formal model in which the extent of diversification is endogenous and depends on the degree of industry relatedness. Firms' diversification choices affect both their own competitiveness and market structure. We find a non-monotonic effect of relatedness on performance: while greater relatedness increases the competitiveness of diversified firms, it can also spur additional diversification, thereby eroding market structure and performance. In addition, our model elucidates the emergence of heterogeneity in firm scope strategies. We use the model to generate data and show how the negative effect of relatedness on market structure can give rise to spurious inference of a diversification discount in cross-sectional regressions.
Keywords: diversification discount, horizontal scope of the firm, formal foundations of strategy
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