Diversification, Ricardian rents and Tobin’s q Cynthia A. MontgomeryBirger Wernerfelt Presented by Carla Fernández-Corrales, Fall 2013 The RAND Journal of Economics (1988): Northwestern University (now at HBS) Northwestern University (now at MIT Sloan)

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.

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).

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.

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.

Diversification

Hypotheses

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

Tobin’s q Specificity Opportunities Diversification Industry dummies s and o are unobservables, therefore,

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

Measures A i = firm i’s marketing expenditures (sales weighted) R i = firm i’s R&D (sales weighted) C i = concentration in firm /'s markets (sales weighted) G i = growth of shipments in firm i’s markets (sales weighted) S i = firm i’s market share (sales weighted) F i = firm i’s foreign sales (in percent) V pi = replacement costs of firm i’s physical assets

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

Tests After taking logs to reduce measurement error…

Results

Discussion The farther firms must go to use their factors, the lower the marginal rents they extract (p 630). Explanations 1.Firms underestimate the effort to gain rents 2.Free cash flow 3.Firms diversify to overcome moral hazard problems