Montgomery, C. & Wernerfelt, B. Diversification, Ricardian rents, and Tobin’s q RAND Journal of Economics, 1988 Eva Herbolzheimer University of Illinois at Urbana-Champaign

Objective  Testing prevailing theory: diversification is based on excess capacity of productive factors (Penrose, Teece…)  Extending this theory by considering heterogeneity of factors and profit-maximization considerations of firms  Showing how Ricardian rents are reflected in Tobin’s q  Main Hypothesis: Rents decrease as large companies diversify more widely Diversification, Ricardian rents, and Tobin’s q

Sources of Rents  Collusive relationships with competitors  Disequilibrium effects (luck)  Unique factors = Ricardian Rent  focus of paper Diversification, Ricardian rents, and Tobin’s q

Diversification as a way to appropriate Ricardian rents  If factor is subject to market imperfections, firm can use capacity internally instead of selling or renting it, this circumstance leads to diversification (Williamson, 1985)  Four Assumptions: - Firm can dispose of excess capability without affecting its other operations - Cases with natural economies of scope are not considered - Firms own or control rent-yielding factors - Static model evaluating a single diversification move of a firm with excess capacity, marginal expansion of scope Diversification, Ricardian rents, and Tobin’s q

Less specific factors: lose less efficiency as they are applied farther from their origin, but are in wider supply, and therefore yield less advantage.

Diversification, Ricardian rents, and Tobin’s q Prediction: as optimal diversification increases, average rents decline

Tobin’s q as a measure of rents  Tobin’s q: ratio of market value to the replacement cost of the firm  The extent to which q differs from 1 is a measure of the extent to which a firm’s capitalized rents differ from the fair market price of its physical assets Diversification, Ricardian rents, and Tobin’s q

Data, measures, and tests (I)  Sample of 167 firms (data from different researchers / institutions)  Montgomery and Wernerfelt constructed the following variables from the data Diversification, Ricardian rents, and Tobin’s q

Data, measures, and tests (II)  Prediction of ßs: -ß(0) should be roughly 1 (value of q under perfect competition) -ß(1) should be 10/3 and ß(2) should be 10 (iSalinger, intangible assets) -ß(3) is unlikely to be significantly different from 0 (Smirlock, concentration) -ß(4) expected to be positive (sign of Ricardian rent) -ß(5) predicted negative (wide diversification  low rent) -ß(6) difficult to predict (foreign sales) -ß(7) expected to be positive (disequilibrium effects, Salinger) Diversification, Ricardian rents, and Tobin’s q

Results (I) Diversification, Ricardian rents, and Tobin’s q

Results (II)  R^2 similar to other studies (Salinger)  As expected: -Intercept close to 1 -A/V and R/V consistent with Salinger results and predictions -S (market share) is positive while C (concentration) has a negative effect -D (diversification) negative & significant  Large firms in otherwise fragmented industries reap high Ricardian rents  As firms diversify more widely, their rents decline -F (foreign sales) is positive  foreign sales are more similar to domestic sales than diversification Diversification, Ricardian rents, and Tobin’s q

Conclusion  Firms earn decreasing average rents as they diversify more widely  Consistent with idea that diversification is prompted by excess capacity of factors that are subject to market failure  The farther a firm must go to use these factors, the lower the marginal rent  Discussion: -“Free-Cash-Flow” Hypothesis: Firms may undertake diversification against interest of shareholders  argue that firm will begin with the most profitable opportunities and move towards the least profitable ones Diversification, Ricardian rents, and Tobin’s q