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Firm Level

Firms diversify for many reasons. Diversification may generate economies of scale and scope by transferring capabilities and competencies developed in one business to a new business without significant additional costs.16 This will primarily motivate related diversification, where activities can be shared across multiple business units. Two operational economies allow firms to create value from economies of scope: the sharing of activities and the transferring of core competencies. When related businesses share activities, they may, for example, have a joint production facility or share sales and distribution networks. Research has shown that when related businesses have the potential to share activities, higher returns may be obtained,17 and the firm may have lower risk since if one unit does poorly, resources can still be utilized and leveraged by another.18 The transferring of core competencies, however, deals not with tangible assets or established business functions, but with complex sets of capabilities that link businesses primarily through managerial and technological knowledge, experience, and expertise.19 Disney, for example, has developed a core competency in innovation and invention, which they have leveraged across a diverse range of businesses, including movies, theme parks, television, toys, book and magazine publishing, department stores, and even fast-food restaurants. Developing core competencies is an investment-intensive process that is difficult for competitors to understand or imitate. The ability of a firm to transfer its core competencies from one business unit to another can thus enhance its strategic competitiveness.20

Firms may also use related diversification to gain market power and competitive advantage through vertical integration.21 Vertical integration occurs when a company produces its own inputs (backward integration) or owns sources of distribution for outputs (forward integration). Vertical integration thus allows a firm to better control its own supply chain by owning downstream suppliers and upstream buyers. Exxon Mobil engages in the exploration and extraction of crude oil, thus supplying its own refineries with raw materials. The products of its refineries often find their way to Exxon or Mobil service stations where the end-consumer purchases gasoline. Additional integration occurs by way of Exxon Mobil's other businesses, including, chemicals, plastics, and business services. Vertical integration often results in savings in operations costs, the avoidance of market costs, better control of quality, and the protection of technology, and it enables a company to strengthen its position and gain market power.22 There are, however, limits to vertical integration. When outside suppliers can produce an input at a lower cost, transaction costs arising from vertical integration may be expensive in comparison. In addition, costs associated with bureaucracy are incurred when creating new, integrated units within a firm. Vertical integration can require substantial amounts of capital to be invested in specific technologies, creating problems when the technology changes and is rendered obsolete. In summary, whereas vertical integration may create value and increase a firm's strategic competitiveness, it does not come without its costs and risks.

Overall, firms diversify to improve performance. Firms plagued by poor performance often seek to increase their diversification, hoping that growth will occur as a result of the discovery of new, varied, and heterogeneous uses for a firm's resources.23 This growth, however, should not be perceived as being random, but rather directed to the growth of related resources and uses.24


Managerial motives for diversification are sometimes quite different from those of the firm, and may have little to do with firm performance and resources. These include managerial risk reduction and a desire for increased compensation.25 When a corporation possesses a diverse group of businesses, corporate-level risk is lower than that of a single-business company. If one business fails, the remaining businesses are typically able to ensure the survival of the parent corporation. In contrast, single-business firms are frequently unable to survive when confronted with the failure of the business unless they can make radical changes in strategy. Since the survival of a firm affects the employment of corporate executives, they often diversify the firm to diversify their own employment risk, assuming in doing so that the profitability of the corporation will not suf-fer.26 Diversification and firm size are also highly correlated and executive compensation increases with firm size.27 Large firms are more complex and difficult to manage than small firms; thus managers of large firms are compensated more highly.28 Corporate executives may choose to diversify simply as an avenue for increased personal compensation.

The governance literature addresses the "agency problem" involving conflicts of interest between owners and managers over potentially conflicting goals of growth and profit.29 The agency problem occurs when shareholders hire a manager or executive, the agent, to act in the best interests of the shareholders. Shareholders, however, are not always able to observe the actions of the agent directly; thus the agents may act to pursue their own best interests even when these are divergent from shareholder interests. Agency theorists contend that managers seek to diversify to increase the sales growth rate to levels that are not optimal for shareholder profit maximization.30 By doing so, they are able to earn higher pay, power, status, and prestige for themselves at the expense of shareholder returns.31 Agency problems are frequently addressed by increased monitoring of the agents and providing them with incentives (e.g., stock options) that align their personal interests with those of shareholders.

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