CHAPTER

9 Corporate
Diversification

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

9.1 Define corporate diversification and describe five types of corporate diversification.
9.2 Specify the two conditions that a corporate diversification strategy must meet to
­create economic value.
a. Define the concept of “economies of scope” and identify nine potential economies
of scope a diversified firm might try to exploit.
b. Identify which of these economies of scope a firm’s outside equity investors can
realize on their own at low cost.
9.3 Specify the circumstances under which a firm’s diversification strategy will be a
source of sustained competitive advantage.
a. Explain which of the economies of scope identified in this chapter are more likely
to be subject to low-cost imitation and which are less likely to be subject to low-
cost imitation.
b. Identify two potential substitutes for corporate diversification.

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The Worldwide Leader

The breadth of ESPN’s diversification has even caught the attention of Hollywood
­writers. In the 2004 movie Dodgeball: A True Underdog Story, the championship game
between the underdog Average Joes and the bad guy Purple Cobras is broadcast on
the fictitious cable channel ESPN8. Also, known as “the Ocho,” ESPN8’s theme is “If it’s
almost a sport, we’ve got it.”
Here’s the irony: ESPN has way more than eight networks currently in operation.
ESPN was founded in 1979 by Bill and Scott Rasmussen after the father and son
duo was fired from positions with the New England Whalers, a National Hockey League
team now playing in Raleigh, North Carolina. Their initial idea was to rent satellite
space to broadcast sports from Connecticut—the University of Connecticut’s basketball
games, Whaler’s hockey games, and so forth. But they found that it was cheaper to rent
satellite space for 24 hours straight than to rent space a few hours during the week,
and thus a 24-hour sports channel was born.
ESPN went on the air September 7, 1979. The first event broadcast was a
228 slow-pitch softball game. Initially, the network broadcast sports that, at the time,
were not widely known to U.S. consumers—Australian rules
football, Davis Cup tennis, professional wrestling, minor
league bowling. Early on, ESPN also gained the rights to
broadcast early rounds of the NCAA basketball tournament.
At the time, the major networks did not broadcast these

Web Pix/Alamy Stock Photo

early round games, even though we now know that some
of these early games are among the most exciting in the
entire tournament.
The longest-running ESPN program is, of course,
SportsCenter. Although the first SportsCenter contained no
highlights and a scheduled interview with the football coach
at the University of Colorado was interrupted by technical dif-
ficulties, SportsCenter and its familiar theme have become icons in American p
­ opular
culture. The 50,000th episode of SportsCenter was broadcast on September 13,
2012.
ESPN was “admitted” into the world of big-time sports in 1987 when it signed
with the National Football League to broadcast Sunday Night Football. Since then, ESPN
has broadcast Major League Baseball, the National Basketball Association, and, at vari-
ous times, the National Hockey League. These professional sports have been augmented
by college football, basketball, and baseball games.
ESPN’s first expansion was modest—in 1993, it introduced ESPN2. Originally, this
station played nothing but rock music and scrolled sports scores. Within a few months,
however, ESPN2 was broadcasting a full program of sports.
After this initial slow expansion, ESPN began to diversify its businesses rapidly. In
1996, it added ESPN News (an all-sports news channel); in 1997, it acquired a company
and opened ESPN Classics (this channel shows old sporting events); and in 2005, it
started ESPNU (a channel dedicated to college athletics).
However, these five ESPN channels represent only a fraction of ESPN’s diverse
business interests. In 1998, ESPN opened its first restaurant, the ESPN Zone. This chain
has continued to expand around the world. Also, in 1998, it started a magazine to
compete with the then-dominant Sports Illustrated. Called ESPN The Magazine, it now
has more than 2 million subscribers. In 2001, ESPN went into the entertainment produc-
tion business when it founded ESPN Original Entertainment. In 2005, ESPN started ESPN
Deportes, a Spanish-language 24-hour sports channel. And, in 2006, it founded ESPN on
ABC, a company that manages much of the sports content broadcast on ABC. (In 1984,
ABC purchased ESPN. Subsequently, ABC was purchased by Capital Cities Entertainment,
and most of Capital Cities Entertainment was then sold to Walt Disney Corporation.
Currently, 80 percent of ESPN is owned by Disney.) 229
230    Part 3: Corporate Strategies

And none of this counts ESPN HD; ESPN2 HD; ESPN Pay Per View; ESPN3; ESPN
Films; ESPN Plus; ESPN America; The Longhorn Network; the SEC Network; the ESPN
Web site; city-based ESPN Web sites in Boston, New York, Chicago, and Los Angeles;
ESPN Radio; and ESPN’s retail operations on the Web—ESPN.com. In addition, ESPN
owns 27 international sports networks that reach 190 countries in 11 languages.
Of course, this expansion has not proceeded without challenges. For example,
over the last few years, NBC, CBS, and Fox have all redoubled their commitment to
24-hour sports broadcasting and a variety of specialty sports channels—including the
NFL Network, the Golf Channel, NBA TV, MLB Network, and the Tennis Channel—have
emerged. ESPN programming costs have continued to rise while at the same time the
number of people subscribing to and watching ESPN have fallen. In 2016, ESPN was the
cause of Disney’s 11% drop in cable operating income.
ESPN’s proposed solution to these challenges? ESPN is planning to introduce
another new sports broadcasting business—a direct to consumer sports service that
will carry events not on traditional ESPN networks. It has also signed agreements with
several digital media companies that will create more focused bundles of cable chan-
nels, bundles that will include ABC, Disney channels, and ESPN channels. Which of those
numerous enterprises will be called “the Ocho” is hard to tell.1

E
SPN is like most large firms in the United States and the world: It has diversi-
fied operations. Indeed, virtually all the 500 largest firms in the United States
and the 500 largest firms in the world are diversified, either by product or
geographically. Large single-business firms are very unusual. However, like most
of these large diversified firms, ESPN has diversified along some dimensions but
not others.

Objective 9.1  Define cor- What is Corporate Diversification?

porate diversification and
describe five types of cor- A firm implements a corporate diversification strategy when it operates in multiple
porate diversification. industries or markets simultaneously. When a firm operates in multiple industries
simultaneously, it is said to be implementing a product diversification strategy.
When a firm operates in multiple geographic markets simultaneously, it is said to
be implementing a geographic market diversification strategy. When a firm imple-
ments both types of diversification simultaneously, it is said to be implementing a
product-market diversification strategy.
We have already seen glimpses of these diversification strategies in the dis-
cussion of vertical integration strategies in Chapter 8. Sometimes, when a firm
vertically integrates backward or forward, it begins operations in a new product or
geographic market. This happened to computer software firms when they began
manning their own call centers. These firms moved from the “computer software
development” business to the “call-center management” business when they verti-
cally integrated forward. In this sense, when firms vertically integrate, they may
also be implementing a diversification strategy. However, the critical difference
between the diversification strategies studied here and vertical integration (dis-
cussed in Chapter 8) is that in this chapter, product-market diversification is the
primary objective of these strategies, whereas in Chapter 8, such diversification was
often a secondary consequence of pursuing a vertical integration strategy.
 Chapter 9:  Corporate Diversification     231

Types of Corporate Diversification

Firms vary in the extent to which they have diversified the businesses within which
they operate. These strategies fall into three broad categories presented in Figure 9.1:
limited corporate diversification, related corporate diversification, or unrelated
corporate diversification.

Limited Corporate Diversification

A firm has implemented a strategy of limited corporate diversification when all
or most of its business activities fall within a single industry and geographic mar-
ket (see Panel A of Figure 9.1). Two kinds of firms are included in this corporate
diversification category: single-business firms (firms with greater than 95 percent
of their total sales in a single-product market) and dominant-business firms (firms
with between 70 and 95 percent of their total sales in a single-product market).
Differences between single-business and dominant-business firms are rep-
resented in Panel A of Figure 9.1. The firm pursuing a single-business corporate
diversification strategy engages in only one business, Business A. An example of a
single-business firm is the WD-40 Company of San Diego, California. This company
manufactures and distributes only one product: the spray lubricant WD-40.
The dominant-business firm pursues two businesses, Business E and a smaller
Business F. An example of a dominant-business firm is Donato’s Pizza. Donato’s
Pizza does the vast majority of its business in a single product—pizza—in a single
market—the United States. However, Donato’s has begun selling non-pizza food
products, including sandwiches, and owns a subsidiary that makes a machine that
automatically slices and puts pepperoni on pizzas. Not only does Donato’s use this
machine in its own pizzerias, it also sells this machine to food manufacturers that
make frozen pepperoni pizza.
In an important sense, firms pursuing a strategy of limited corporate diversifi-
cation are not leveraging their resources and capabilities beyond a single product or

Figure 9.1  Levels and

Single business firms Types of Diversification
( 95% of revenues in one business) A

Dominant business firms

(70-95% of revenues in one business) B C

A. Limited Corporate Diversification

Related-constrained diversified firms
( 70% ofrevenues in one business, all
businesses in the portfolio share the same D E F G
economies of scope)

Related-link diversified firms

( 70% of revenues in one business,
businesses in the portfolio share different Q R S T
economies of scope)

B. Related Corporate Diversification

Unrelated diversified corporation
( 70% of revenues in one business, no or U V W X
very limited economies of scope realized
across the portfolio of businesses)
C. Unrelated Corporate Diversification
232    Part 3: Corporate Strategies

market. Thus, the analysis of limited corporate diversification is logically equivalent

to the analysis of business-level strategies (discussed in Part 2 of this book). Because
these kinds of strategies have already been discussed, the remainder of this chapter
focuses on corporate strategies that involve higher levels of diversification.

Related Corporate Diversification

As a firm begins to engage in businesses in more than one product or market, it
moves away from being a single-business or dominant-business firm and begins
to adopt higher levels of corporate diversification. When less than 70 percent of
a firm’s revenue comes from a single-product market and these multiple lines of
business share important economies of scope, the firm has implemented a strategy
of related corporate diversification. An economy of scope exists when the value
created by several businesses operated together is greater than the value of these
businesses operated separately. Potential sources of economies of scope are dis-
cussed later in this chapter.
The multiple businesses that a diversified firm pursues can realize economies
of scope in at least at least two ways (see Panel B in Figure 9.1). If all the businesses
in which a firm operates share the same economies of scope, then this corporate
diversification strategy is called related-constrained. This strategy is related because
of the economies of scope that exist among a firm’s businesses; it is constrained
because all (or at least most) of the businesses in a firm’s portfolio share the same
economies of scope.
PepsiCo is an example of a related-constrained diversified firm. Although
PepsiCo operates in multiple businesses around the world, all its businesses focus
on providing snack-type products, either food or beverages. This enables PepsiCo
to exploit at least two economies of scope across all its businesses: common distri-
bution processes and an emphasis on brands.
Regarding distribution, almost all of PepsiCo’s products are sold in similar
outlets—grocery stores, convenience stores, sandwich shops, fast food and other
restaurants, and so forth. Supplying these different outlets with PepsiCo’s products
can be a challenge, but this firm has developed a variety of distribution capabilities
that it applies to each of its businesses.
Also, PepsiCo uses its ability to build and exploit brands in most of its busi-
nesses. Whether it’s Pepsi, Doritos, Mountain Dew, or Big Red, PepsiCo is all about
building, and then exploiting, brand names. In fact, PepsiCo has 22 brands that
each generate well over $1 billion or more in revenues a year.2
Both distribution capabilities and branding capabilities are economies of
scope. Since almost all of PepsiCo’s businesses build on these two capabilities,
PepsiCo is pursuing a related constrained diversification strategy.
If the different businesses that a single firm pursues realize different types of
economies of scope, this corporate diversification strategy is called related-linked.
For example, Business Q and Business R may share production-based economies
of scope, Business R and Business S may share sales and distribution economies of
scope, and Business S and Business T may share supply economies of scope. This
strategy is represented in the related-linked section of Figure 9.1 by businesses
within a firm sharing different kinds of economies of scope (i.e., straight lines and
curved lines).
An example of a related-linked diversified firm is Disney. Disney has evolved
from a single-business firm (when it did nothing but produce animated motion pic-
tures), to a dominant business firm (when it produced family-oriented motion pictures
 Chapter 9:  Corporate Diversification     233

and operated a theme park), to a related-constrained diversified firm (where it lever-

aged its ability to create and market animated characters in its family-oriented motion
production business, in its multiple theme parks, and through selling products in its
Disney Stores). Recently, it has become so diversified that it has taken on the attributes
of related-linked diversification. Although much of the Disney empire still builds on
animated characters, it also owns and operates businesses—including a television
network (ABC) that broadcasts non-Disney-produced content—that are less directly
linked to these characters. This is not to suggest that Disney is pursuing an unrelated
diversification strategy. After all, most of its businesses are in the entertainment indus-
try, broadly defined, and share a variety of economies of scope. Rather, this is only to
suggest that it is no longer possible to find a single economy of scope—like a Mickey
Mouse or a Lion King—that connects all of Disney’s business enterprises. In this sense,
Disney has become a related-linked diversified firm.3

Unrelated Corporate Diversification

Firms that pursue a strategy of related corporate diversification have some type of
economy of scope that benefits the different businesses they pursue. However, it is
possible for firms to pursue numerous different businesses and for there to be no
such economies of scope (see Panel C of Figure 9.1). When less than 70 percent of
a firm’s revenues is generated in a single-product market and when the businesses
in a firm’s portfolio share few, if any, economies of scope, then that firm is pursuing
a strategy of unrelated corporate diversification.
As will be discussed shortly, there is little economic justification for firms
pursuing multiple businesses that do not share economies of scope. For this reason,
there are relatively few examples of such firms in the modern economy—although
such diversification has existed in the past.

The Value of Corporate Diversification Objective 9.2  Specify

the two conditions that a
For corporate diversification to be economically valuable, two conditions must corporate diversification
hold. First, there must be some valuable economy of scope among the multiple strategy must meet to cre-
businesses in which a firm is operating. Second, it must be less costly for managers ate economic value.
in a firm to realize these economies of scope than for outside equity holders on their
own. If outside investors could realize the value of an economy of scope on their
own and at low cost, then they would have few incentives to “hire” managers to
realize this economy of scope for them. Each of these requirements for corporate
diversification to add value for a firm will now be considered.

What Are Valuable Economies of Scope?

As suggested earlier, economies of scope exist when the value created by operating
several businesses simultaneously is greater than the value of operating these busi-
nesses separately. In this definition, the term scope refers to the range of businesses
in which a diversified firm operates. Economies refer to the lower costs or higher rev-
enues associated with operating multiple businesses. Thus, only diversified firms
can exploit economies of scope. Economies of scope are valuable to the extent that
they do, in fact, increase a firm’s revenues or decrease its costs, compared with what
would be the case if these economies of scope did not exist, or had the potential to
exist but were not exploited.
234    Part 3: Corporate Strategies

A wide variety of potentially valuable sources of economies of scope have

been identified in the literature. Some of the most important of these are listed in
Table 9.1 and discussed in the following text. How valuable economies of scope
actually are, on average, has been the subject of a great deal of research, which is
summarized in the Research Made Relevant feature.

Diversification to Exploit Shared Activities

In Chapter 3, it was suggested that value-chain analysis can be used to describe
the specific business activities of a firm. This same value-chain analysis can also be
used to describe the business activities that may be shared across several different
businesses within a diversified firm. These shared activities are potential sources
of operational economies of scope for diversified firms.

TABLE 9.1  Different Types

1. Shared activities as an economy of scope
of Economies of Scope
2. Core competencies as an economy of scope
• Shared business level competencies
• Corporate competencies
3. Financial economies of scope
• Internal capital allocation
• Risk reduction
• Tax advantages
4. Anticompetitive economies of scope
• Multipoint competition
• Exploiting market power
5. Maximizing management compensation

Research Made Relevant

I n 1994, Lang and Stulz published

a sensational article that suggested
that, on average, when a firm began
higher than the market performance
of a single diversified firm operating
in all the businesses included in this
implementing a corporate diversi- portfolio. These results suggested that
fication strategy, it destroyed about not only were economies of scope not
25 percent of its market value. Lang valuable, but, on average, efforts to
and Stulz came to this conclusion by realize these economies destroyed
comparing the market performance of economic value. Similar results were
firms pursuing a corporate diversifica- published by Comment and Jar-
tion strategy with portfolios of firms rell using different measures of firm
pursuing a limited diversification performance.
strategy. Taken together, the market Not surprisingly, these results
performance of a portfolio of firms generated quite a stir. If Lang and
that were pursuing a limited diversi- Stulz were correct, then diversi-
How Valuable Are Economies
fication strategy was about 25 percent fied firms—no matter what kind of
of Scope?
 Chapter 9:  Corporate Diversification     235

diversification strategy they engaged Second, Miller found that firms smaller increments as it continues to
in—destroyed an enormous amount that find it in their self-interest to diversify.
of economic value. This could lead diversify do so in a very predictable All the results examine returns
to a fundamental restructuring of the pattern. These firms tend to diversify to diversification, on average. But
U.S. economy. into the most profitable new business returns to diversification depend on
However, several researchers first, the second-most profitable busi- the specific resources and capabilities
questioned Lang and Stulz’s conclu- ness second, and so forth. Not surpris- a firm possess and whether those can
sions. Two new findings suggest that, ingly, the fiftieth diversification move be used to create value through diver-
even if there is a 25-percent discount, made by these firms might not gener- sification. So, for example, a firm—
diversification can still add value. ate huge additional profits. However, like WD-40—that can generate value
First, Villalonga and others found that these profits—it turns out—are still, by remaining focused (i.e., not diver-
firms pursuing diversification strate- on average, positive. Because multi- sifying) should not diversify at all. A
gies were generally performing more ple rounds of diversification increase firm that can use shared activities to
poorly before they began diversifying profits at a decreasing rate, the over- generate value—like ESPN—should
than firms that never pursued diver- all average profitability of diversified engage in related diversification.
sification strategies. Thus, although firms will generally be less than the Finally, a firm that can use corporate
it might appear that diversification overall average profitability of firms core competencies, without shared
leads to a significant loss of economic that do not pursue a diversification activities, to generate value—like
value, that loss of value occurred strategy—thus, a substantial differ- Berkshire Hathaway—should engage
before these firms began implement- ence between the market value of in unrelated diversification. A recent
ing a diversification strategy. Indeed, non-diversified and diversified firms paper by Mackey, Barney, and Dotson
some more recent research suggests might exist. However, this discount, shows that all forms of diversification
that these relatively poor-performing per se, does not mean that the diver- can create value for firms, and that
firms may increase their market value sified firm is destroying economic over 90% of firms choose that form of
over what would have been the case if value. Rather, it may mean only that diversification that creates the most
they did not diversify. a diversifying firm is creating value in value for their shareholders.4

Consider, for example, the hypothetical firm presented in Figure 9.2. This
diversified firm engages in three businesses: A, B, and C. However, these three
businesses share a variety of activities throughout their value chains. For example,
all three draw on the same technology development operation. Product design and
manufacturing are shared in Businesses A and B and separate for Business C. All
three businesses share a common marketing and service operation. Business A has
its own distribution system.
These kinds of shared activities are quite common among both related-con-
strained and related-linked diversified firms. At Texas Instruments, for example,
a variety of electronics businesses share some research and development activities,
and many share common manufacturing locations. Procter & Gamble’s numerous
consumer products businesses often share common manufacturing locations and
rely on a common distribution network (through retail grocery stores).5 Some of the
most common shared activities in diversified firms and their location in the value
chain are summarized in Table 9.2.
Many of the shared activities listed in Table 9.2 can have the effect of reduc-
ing a diversified firm’s costs. This is especially the case if these shared activities are
subject to economies of scale. For example, if a diversified firm has a purchasing
function that is common to several of its different businesses, it can often obtain
volume discounts on its purchases that would otherwise not be possible. Also, by
manufacturing products that are used as inputs into several of a diversified firm’s
236    Part 3: Corporate Strategies

Figure 9.2  A Hypotheti-

cal Firm Sharing Activities
Technology Development
Among Three Businesses A, B, C

Product Design Product Design

A, B C

Manufacturing Manufacturing
A, B C

Marketing
A, B, C

Distribution Distribution
A B, C

Service
A, B, C

TABLE 9.2  Possible Shared

Value Chain Activity Shared Activities
Activities and Their Place in
the Value Chain Input activities Common purchasing
Common inventory control system
Common warehousing facilities
Common inventory delivery system
Common quality assurance
Common input requirements system
Common suppliers
Production activities Common product components
Common product components manufacturing
Common assembly facilities
Common quality control system
Common maintenance operation
Common inventory control system
Warehousing and distribution Common product delivery system
Common warehouse facilities
Sales and marketing Common advertising efforts
Common promotional activities
Cross-selling of products
Common pricing systems
 Chapter 9:  Corporate Diversification     237

Value Chain Activity Shared Activities

TABLE 9.2 Continued

Common marketing departments

Common distribution channels
Common sales forces
Common sales offices
Common order processing services
Dealer support and service Common service network
Common guarantees and warranties
Common accounts receivable management systems
Common dealer training
Common dealer support services
Sources: M. E. Porter (1985). Competitive advantage. New York: Free Press; R. P. Rumelt (1974). Strategy,
structure, and economic performance. Cambridge, MA: Harvard University Press; H. I. Ansoff (1965).
Corporate strategy. New York: McGraw-Hill.

businesses, the total costs of producing these products can be reduced. A single
sales force representing the products or services of several different businesses
within a diversified firm can reduce the cost of selling these products or services.
Firms such as IBM, HP, and General Motors (GM) have all used shared activities
to reduce their costs in these ways.
Failure to exploit shared activities across businesses can lead to out-of-control
costs. For example, Kentucky Fried Chicken, when it was a division of PepsiCo,
encouraged each of its regional business operations in North America to develop
its own quality improvement plan. The result was enormous redundancy and at
least three conflicting quality efforts—all leading to higher-than-necessary costs.
In a similar way, Levi Strauss’s unwillingness to centralize and coordinate order
processing led to a situation where six separate order-processing computer systems
operated simultaneously. This costly redundancy was ultimately replaced by a
single, integrated ordering system shared across the entire corporation.6
Shared activities can also increase the revenues in diversified firms’ busi-
nesses. This can happen in at least two ways. First, it may be that shared product
development and sales activities may enable two or more businesses in a diversi-
fied firm to offer a bundled set of products to customers. Sometimes, the value of
these “product bundles” is greater than the value of each product separately. This
additional customer value can generate revenues greater than would have been the
case if the businesses were not together and sharing activities in a diversified firm.
These bundles of products are what has led firms like AT&T—initially a pro-
vider of mobile telephone services—to acquire first a variety of cable television
companies, and more recently, DirectTV—a supplier of satellite television services.
Now AT&T customers can watch television programs on any of their devices—TV,
tablets, mobile phones—receive a single bill, and interact with a single company. If
consumers find these linkages valuable, these shared activities are likely to create
value for AT&T’s shareholders.7
Such product bundles are important in other firms as well. Many grocery
stores now sell prepared foods alongside traditional grocery products in the belief
that busy customers want access to all kinds of food products in the same location.8
Second, shared activities can enhance business revenues by exploiting the
strong, positive reputations of some of a firm’s businesses in other of its businesses.
238    Part 3: Corporate Strategies

For example, if one business has a strong positive reputation for high-quality man-
ufacturing, other businesses sharing this manufacturing activity will gain some
of the advantages of this reputation. And, if one business has a strong positive
reputation for selling high-performance products, other businesses sharing sales
and marketing activities with this business will gain some of the advantages of this
reputation. In both cases, businesses that draw on the strong reputation of another
business through shared activities with that business will have larger revenues than
they would were they operating on their own.
The Limits of Activity Sharing  Despite the potential of activity sharing to be the
basis of a valuable corporate diversification strategy, this approach has three
important limits.9 First, substantial organizational issues are often associated with
a diversified firm’s learning how to manage cross-business relationships. Managing
these relationships effectively can be very difficult, and failure can lead to excess
bureaucracy, inefficiency, and organizational gridlock. These issues are discussed
in detail in Chapter 10.
Second, sharing activities may limit the ability of a business to meet its specific
customers’ needs. For example, if two businesses share manufacturing activities,
they may reduce their manufacturing costs. However, to gain these cost advan-
tages, these businesses may need to build products using somewhat standardized
components that do not fully meet their individual customers’ needs. Businesses
that share distribution activities may have lower overall distribution costs but be
unable to distribute their products to all their customers. Businesses that share sales
activities may have lower overall sales costs but be unable to provide the special-
ized selling required in each business.
One diversified firm that has struggled with the ability to meet the specialized
needs of customers in its different divisions is GM. To exploit economies of scope
in the design of new automobiles, GM shared the design process across several
automobile divisions. The result over many years was “cookie-cutter” cars where
the traditional distinctiveness of several GM divisions, including Oldsmobile and
Cadillac, was all but lost.10
Third, if one business in a diversified firm has a poor reputation, sharing
activities with that business can reduce the quality of the reputation of other busi-
nesses in the firm.
Taken together, these limits on activity sharing can more than offset any pos-
sible gains. Indeed, over the past decade more and more diversified firms have
been abandoning efforts at activity sharing in favor of managing each business’s
activities independently. For example, ABB, Inc. (a Swiss engineering firm) and
CIBA-Geigy (a Swiss chemical firm) have adopted explicit corporate policies that
restrict almost all activity sharing across businesses.11 Other diversified firms,
including Nestlé and GE, restrict activity sharing to just one or two activities (such
as research and development or management training). However, to the extent
that a diversified firm can exploit shared activities while avoiding these problems,
shared activities can add value to a firm.

Core Competencies as an Economy of Scope

A second potential economy of scope in a diversified corporation is called a core
competence. Core competence has been defined by Prahalad and Hamel as, “the
collective learning in the organization, especially how to coordinate diverse pro-
duction skills and integrate multiple streams of technologies.” 12 Core competen-
cies are complex sets of resources and capabilities that link different businesses
 Chapter 9:  Corporate Diversification     239

in a diversified firm through managerial and technical know-how, experience,

and wisdom.13
Shared Business and Transnational Core Competencies  At least two types of
core competencies have been described in the literature. The first focuses on learn-
ing, know-how, and experience that develops in a business within a ­diversified
firm that can then be leveraged in other businesses within that firm. This
shared business level competence may or may not be accompanied by shared
activities. When the business within a diversified firm that develops and then
shares this core competence with other businesses in the firm in a non-domestic
market, this core competence is the basis of what is called a transnational
strategy.14
One firm that has exploited a transnational core competence as an economy
of scope is General Electric in its medical imaging business. Originally, GE entered
China to source costly parts for its MRI and related medical imaging machines.
Those parts were then shipped out of China and incorporated into imaging prod-
ucts that were sold back into the Chinese market and elsewhere around the world.
Unfortunately, the imaging devices that were designed to work in the West were
not as reliable in China. In particular, MRI’s in the United States are typically used
five or six times a day, whereas the same units in China were often used 25 to 30
times a day. GE’s imaging machines were not designed to be used that many times
a day, and their reliability in China was low.
GE’s Chinese division became aware of this problem and began designing a
new type of imaging machine that could be used much more frequently each day.
Once built, this machine became very popular in the Chinese market. However,
what is particularly interesting about this example is that non-Chinese GE business
started to sell the Chinese imaging machine outside of China. That is, the compe-
tence that GE’s Chinese division had developed and incorporated into its imaging
technology was valuable in non-Chinese markets serviced by other GE divisions.
These other divisions leveraged the Chinese division’s competence in a way that
generated value for the entire corporation. The Chinese division’s products are now
among GE’s most successful imaging technologies.15
Corporate Competencies  A second type of core competence is called a corporate
competence. This kind of competence exists when a firm develops managerial
skills, technical knowhow, experience, and wisdom in managing a diversified cor-
poration. This type of competence usually exists at a firm’s corporate headquarters,
and may or may not be associated with shared activities.
One example of a firm with this corporate competence, with no shared
­activities, is Berkshire Hathaway. With sales more than $210 billion, Berkshire
Hathaway operates in four large segments: insurance; railroads; utilities and
energy; and manufacturing, services, and retail. However, its businesses are run
through literally hundreds of wholly owned subsidiaries. Some of these subsid-
iaries are relatively obscure and sell only to other companies, e.g., TTI, a Texas
company that distributes components to electronics manufacturing firms. Other
subsidiaries are well-known in consumer markets, e.g., GEICO, Fruit of the Loom,
Justin Brands, Benjamin Moore, Dairy Queen, RC Wiley, and Helzberg Diamonds
to name just a few.
In addition to owning hundreds of businesses outright, Berkshire Hathaway
also invests cash from its businesses to take substantial, but not controlling, inter-
ests in a variety of other companies, including Mars, American Express, Coca-Cola,
Wells Fargo, and IBM.
240    Part 3: Corporate Strategies

However, unlike firms that exploit shared activities as an economy of scope,

the businesses Berkshire Hathaway owns have very few, if any, shared activities.
In fact, perhaps the only thing that all these businesses have in common is that
Berkshire Hathaway likes them to generate positive cash flows.
However, that Berkshire Hathaway does not have shared activities does not
mean they do not realize economies of scope. Instead of shared activities, Berkshire
Hathaway has developed significant skills in managing this type of corporation.
Consider how Berkshire Hathaway describes that competence in their 2012 10K
report, “Berkshire’s operating businesses are managed on an unusually decentral-
ized basis. There are essentially no centralized or integrated business functions
(such as sales, marketing, purchasing, legal, or human resources) and there is mini-
mal involvement by Berkshire’s corporate headquarters in the day to day business
activities of the operating businesses.”
In describing Berkshire’s operating principles, founder and chair, Warren
Buffett, has written, “Although our form is corporate, our attitude is partnership.
Charlie Munger (Vice Chair of the Board) and I think of our shareholders as owner-
partners, and ourselves as managing partners . . . We do not view the company as
the ultimate owner of our business assets but instead view the company as a con-
duit through which our shareholders own the assets . . . Our long term economic
goal is to maximize Berkshire’s average annual rate of gain in intrinsic business
value on a per-share basis. We do not measure the economic significance or perfor-
mance of Berkshire by its size; we measure by per-share progress.”16
Core Competencies and Shared Activities  Of course, core competencies and shared
activities are not mutually exclusive. Diversified firms can exploit both these kinds
of economies of scope at the same time. Danaher Corporation is a firm that exploits
both these economies of scope simultaneously. With over $20 billion in sales, Dana-
her is a widely diversified manufacturing firm that has developed a corporate
competence in applying lean manufacturing capabilities to a wide variety of busi-
ness processes. While most operating decisions in this corporation are delegated
to operating divisions, the corporate office trains leaders from all over the corpora-
tion in lean manufacturing techniques.17 Thus, Danaher’s commitment to use lean
manufacturing processes in all its businesses is an example of a core competence
as an economy of scope, and the processes it uses to train employees in its different
businesses how to apply these lean manufacturing techniques is an example of a
shared activity.
Limits of Core Competencies  Just as there are limits to the value of shared activi-
ties as sources of economies of scope, so there are limits to core competencies as
sources of these economies. The first of these limitations stems from important
organizational issues to be discussed in Chapter 11. The way that a diversified firm
is organized can either facilitate the exploitation of core competencies or prevent
this exploitation from occurring.
A second limitation of core competencies is a result of the intangible nature
of these economies of scope. Whereas shared activities are reflected in tangible
operations in a diversified firm, core competencies may be reflected only in shared
knowledge, experience, and wisdom across businesses. The intangible character of
these relationships is emphasized when they are described as a dominant logic in
a firm, or a common way of thinking about strategy across different businesses.18
The intangibility of core competencies can lead diversified firms to make two
kinds of errors in managing relatedness. First, intangible core competencies can
be illusory inventions by creative managers who link even the most completely
 Chapter 9:  Corporate Diversification     241

unrelated businesses and thereby justify their diversification strategy. A firm that
manufactures airplanes and running shoes can rationalize this diversification by
claiming to have a core competence in managing transportation businesses. A firm
operating in the professional football business and the movie business can rationalize
this diversification by claiming to have a core competence in managing entertainment
businesses. Such invented competencies are not real sources of economies of scope.
Second, a diversified firm’s businesses may be linked by a core competence,
but this competence may affect these businesses’ costs or revenues in a trivial way.
Thus, for example, all a firm’s businesses may be affected by government actions,
but the impact of these actions on costs and revenues in different businesses may
be quite small. A firm may have a core competence in managing relationships
with the government, but this core competence will not reduce costs or enhance
revenues for these businesses very much. Also, each of a diversified firm’s busi-
nesses may use some advertising. However, if advertising does not have a major
impact on revenues for these businesses, core competencies in advertising are not
likely to significantly reduce a firm’s costs or increase its revenues. In this case, a
core competence may be a source of economies of scope, but the value of those
economies may be very small.

Diversification to Exploit Financial Economies of Scope

A third class of motivations for diversification focuses on financial advantages
associated with diversification. Three financial implications of diversification have
been studied: diversification and capital allocation, diversification and risk reduc-
tion, and tax advantages of diversification.

Diversification and Capital Allocation  Capital can be allocated to businesses in one

of two ways. First, businesses operating as independent entities can compete for
capital in the external capital market. They do this by providing a sufficiently high
return to induce investors to purchase shares of their equity, by having a sufficiently
high cash flow to repay principal and interest on debt, and in other ways. Alterna-
tively, a business can be part of a diversified firm. That diversified firm competes
in the external capital market and allocates capital among its various businesses.
In a sense, diversification creates an internal capital market in which businesses
in a diversified firm compete for corporate capital.19
For an internal capital market to create value for a diversified firm, it must
offer some efficiency advantages over an external capital market. It has been sug-
gested that a potential efficiency gain from internal capital markets depends on the
greater amount and quality of information that a diversified firm possesses about
the businesses it owns, compared with the information that external suppliers of
capital possess. Owning a business gives a diversified firm access to detailed and
accurate information about the actual performance of the business, its true future
prospects, and thus the actual amount and cost of the capital that should be allo-
cated to it. External sources of capital, in contrast, have relatively limited access to
information and thus have a limited ability to judge the actual performance and
future prospects of a business.
Some have questioned whether a diversified firm, as a source of capital, has
more and better information about a business it owns, compared with external
sources of capital. After all, independent businesses seeking capital have a strong
incentive to provide sufficient information to external suppliers of capital to obtain
required funds. However, a firm that owns a business may have at least two infor-
mational advantages over external sources of capital.
242    Part 3: Corporate Strategies

First, although an independent business has an incentive to provide infor-

mation to external sources of capital, it also has an incentive to downplay or even
not report any negative information about its performance and prospects.20 Such
negative information would raise an independent firm’s cost of capital. External
sources of capital have limited ability to force a business to reveal all information
about its performance and prospects and thus may provide capital at a lower cost
than they would if they had full information. Ownership gives a firm the right to
compel more complete disclosure, although even here full disclosure is not guaran-
teed. With this more complete information, a diversified firm can allocate just the
right amount of capital, at the appropriate cost, to each business.
Second, an independent business may have an incentive not to reveal all the
positive information about its performance and prospects. In Chapter 3, the ability
of a firm to earn economic profits was shown to depend on the imitability of its
resources and capabilities. An independent business that informs external sources
of capital about all of its sources of competitive advantage is also informing its
potential competitors about these sources of advantage. This information sharing
increases the probability that these sources of advantage will be imitated. Because
of the competitive implications of sharing this information, firms may choose not
to share it, and external sources of capital may underestimate the true performance
and prospects of a business.
A diversified firm, however, may gain access to this additional information
about its businesses without revealing it to potential competitors. This information
enables the diversified firm to make more informed decisions about how much
capital to allocate to a business and about the cost of that capital, compared with
the external capital market.21
Over time, there should be fewer errors in funding businesses through inter-
nal capital markets, compared with funding businesses through external capital
markets. Fewer funding errors, over time, suggest a slight capital allocation advan-
tage for a diversified firm, compared with an external capital market. This advan-
tage should be reflected in somewhat higher rates of return on invested capital
for the diversified firm, compared with the rates of return on invested capital for
external sources of capital.
However, the businesses within a diversified firm do not always gain cost-of-
capital advantages by being part of a diversified firm’s portfolio. Several authors
have argued that because a diversified firm has lower overall risk (see the follow-
ing discussion), it will have a lower cost of capital, which it can pass along to the
businesses within its portfolio. Although the lower risks associated with a diver-
sified firm may lower the firm’s cost of capital, the appropriate cost of capital to
businesses within the firm depends on the performance and prospects of each of
those businesses. The firm’s advantages in evaluating its businesses’ performances
and prospects result in more appropriate capital allocation, not just in lower cost
of capital for those businesses. Indeed, a business’s cost of capital may be lower
than it could have obtained in the external capital market (because the firm can
more fully evaluate the positive aspects of that business), or it may be higher than
it could have obtained in the external capital market (because the firm can more
fully evaluate the negative aspects of that business).
Of course, if these businesses also have lower cost or higher revenue expecta-
tions because they are part of a diversified firm, then those cost/revenue advan-
tages will be reflected in the appropriate cost of capital for these businesses. In this
sense, any operational economies of scope for businesses in a diversified firm may
be recognized by a diversified firm exploiting financial economies of scope.
 Chapter 9:  Corporate Diversification     243

Limits on Internal Capital Markets  Although internal capital allocation has several
potential advantages for a diversified firm, this process also has several limits.
First, the diversification strategy that a firm pursues can affect the efficiency of this
allocation process. A firm that implements a strategy of unrelated diversification,
and does not develop a corporate competence, requires managers to evaluate the
performance and prospects of numerous very different businesses. This can put a
greater strain on the capital allocation skills of its managers.
Second, the increased efficiency of internal capital allocation depends on man-
agers in a diversified firm having better information for capital allocation than the
information available to external sources. However, this higher-quality informa-
tion is not guaranteed. The incentives that can lead managers to exaggerate their
performance and prospects to external capital sources can also lead to this behavior
within a diversified firm. Indeed, several examples of business managers falsifying
performance records to gain access to more internal capital have been reported.22
Research suggests that capital allocation requests by managers are routinely dis-
counted in diversified firms to correct for these managers’ inflated estimates of the
performance and prospects of their businesses.23
Finally, not only do business managers have an incentive to inflate the perfor-
mance and prospects of their business in a diversified firm, but managers in charge
of capital allocation in these firms may have an incentive to continue investing in a
business despite its poor performance and prospects. The reputation and status of
these managers often depend on the success of these business investments because
often they initially approved them. These managers often continue throwing good
money at these businesses in hope that they will someday improve, thereby justify-
ing their original decision. Organizational psychologists call this process escalation
of commitment and have presented numerous examples of managers becoming
irrationally committed to an investment.24
Indeed, research on the value of internal capital markets in diversified firms
suggests that, on average, the limitations of these markets often outweigh their
advantages. For example, even controlling for firm size, excessive investment in
poorly performing businesses in a diversified firm reduces the market value of
the average diversified firm.25 However, the fact that many firms do not gain the
advantages associated with internal capital markets does not necessarily imply that
no firms gain these advantages. If only a few firms can obtain the advantages of
internal capital markets while avoiding their limitations, this financial economy of
scope may be a source of at least a temporary competitive advantage.

Diversification and Risk Reduction  Another possible financial economy of scope

for a diversified firm has already been briefly mentioned—the riskiness of the cash
flows of diversified firms is lower than the riskiness of the cash flows of undiversi-
fied firms. Consider, for example, the riskiness of two businesses operating sepa-
rately compared with the risk of a diversified firm operating in those same two
businesses simultaneously. If both these businesses are very risky on their own
and the cash flows from these businesses are not highly correlated over time, then
combining these two businesses into a single firm will generate a lower level of
overall risk for the diversified firm than for each of these businesses on their own.
This lower level of risk is due to the low correlation between the cash flows
associated with these two businesses. If Business I is having a bad year, Business II
might be having a good year, and a firm that operates in both of these businesses
simultaneously can have moderate levels of performance. In another year, Business
II might be off, while Business I is having a good year. Again, the firm operating in
244    Part 3: Corporate Strategies

both these businesses can have moderate levels of performance. Firms that diver-
sify to reduce risk will have relatively stable returns over time, especially as they
diversify into many different businesses with cash flows that are not highly cor-
related over time.
Tax Advantages of Diversification  Another financial economy of scope from diver-
sification stems from possible tax advantages of this corporate strategy. These pos-
sible tax advantages reflect one or a combination of two effects. First, a diversified
firm can use losses in some of its businesses to offset profits in others, thereby
reducing its overall tax liability. Of course, substantial losses in some of its busi-
nesses may overwhelm profits in other businesses, forcing businesses that would
have remained solvent if they were independent to cease operation. However, if
business losses are not too large, a diversified firm’s tax liability can be reduced.
Empirical research suggests that diversified firms do, sometimes, offset profits in
some businesses with losses in others, although the tax savings of these activities
are usually small.26
Second, because diversification can reduce the riskiness of a firm’s cash flows,
it can also reduce the probability that a firm will declare bankruptcy. This can
increase a firm’s debt capacity. This effect on debt capacity is greatest when the
cash flows of a diversified firm’s businesses are perfectly and negatively correlated.
However, even when these cash flows are perfectly and positively correlated, there
can still be a (modest) increase in debt capacity.
Debt capacity is particularly important in tax environments where interest
payments on debt are tax deductible. In this context, diversified firms can increase
their leverage up to their debt capacity and reduce their tax liability accordingly.
Of course, if interest payments are not tax deductible or if the marginal corporate
tax rate is relatively small, then the tax advantages of diversification can be quite
small. Empirical work suggests that diversified firms do have greater debt capacity
than undiversified firms.27

Diversification to Exploit Anticompetitive Economies of Scope

A third group of motivations for diversification is based on the relationship between
diversification strategies and various anticompetitive activities by firms. Two spe-
cific examples of these activities are: (1) multipoint competition to facilitate mutual
forbearance and tacit collusion; and (2) exploiting market power.
Multipoint Competition  Multipoint competition exists when two or more
­ iversified firms simultaneously compete in multiple markets. For example, HP and
d
Dell ­compete in both the personal computer market and the market for ­computer
­printers. Michelin and Goodyear compete in both the U.S. automobile tire market
and the European automobile tire market. Disney and AOL/Time Warner compete
in both the movie production and book publishing businesses.
Multipoint competition can serve to facilitate a type of tacit collusion called
mutual forbearance. As suggested in Chapter 7, firms engage in tacit collusion
when they cooperate to reduce rivalry below the level expected under perfect
competition. Consider the situation facing two diversified firms, A and B. These
two firms operate in the same businesses, I, II, III, and IV (see Figure 9.3). In this
context, any decisions that Firm A might make to compete aggressively in Busi-
nesses I and III must consider the possibility that Firm B will respond by competing
aggressively in Businesses II and IV and vice versa. The potential loss that each of
these firms may experience in some of its businesses must be compared with the
potential gain that each might obtain if it exploits competitive advantages in other
 Chapter 9:  Corporate Diversification     245

of its businesses. If the present value of gains does not outweigh the present value
of losses from retaliation, then both firms will avoid competitive activity. Refraining
from competition is mutual forbearance.28
Mutual forbearance because of multipoint competition has occurred in sev-
eral industries. For example, this form of tacit collusion has been described as exist-
ing between Michelin and Goodyear, Maxwell House and Folger’s, Caterpillar and
John Deere, and BIC and Gillette.29 Another clear example of such cooperation can
be found in the airline industry. For example, America West (now part of American
Airlines through its merger with U.S. Air) began service into the Houston Inter-
continental Airport with very low introductory fares. Continental Airlines (now
part of United Airlines), the dominant firm at Houston Intercontinental, rapidly
responded to America West’s low Houston fares by reducing the price of its flights
from Phoenix, Arizona, to several cities in the United States. Phoenix is the home
airport of America West. Within just a few weeks, America West withdrew its low
introductory fares in the Houston market, and Continental withdrew its reduced
prices in the Phoenix market. The threat of retaliation across markets apparently
led America West and Continental to tacitly collude on prices.30
Some recent research investigates the conditions under which mutual forbear-
ance strategies are pursued, as well as conditions under which multipoint compe-
tition does not lead to mutual forbearance.31 In general, the value of the threat of
retaliation must be substantial for multipoint competition to lead to mutual forbear-
ance. However, not only must the payoffs to mutual forbearance be substantial,
but the firms pursuing this strategy must have strong strategic linkages among
their diversified businesses. This suggests that firms pursuing mutual forbearance
strategies based on multipoint competition are usually pursuing a form of related
diversification.32
Diversification and Market Power  Internal allocations of capital among a diversi-
fied firm’s businesses may enable it to exploit in some of its businesses the mar-
ket power advantages it enjoys in other of its businesses. For example, suppose
that a firm is earning monopoly profits in a business. This firm can use some of
these monopoly profits to subsidize the operations of another of its businesses.
This cross-subsidization can take several forms, including ­p redatory pric-
ing—that is, setting prices so that they are less than the subsidized business’s

Figure 9.3 Multipoint
Competition Between
Firm A
­Hypothetical Firms A and B

I II III IV

I II III IV

Firm B
246    Part 3: Corporate Strategies

costs. The effect of this cross-subsidy may be to drive competitors out of the
­subsidized business and then to obtain monopoly profits in that subsidized
business. In a sense, diversification enables a firm to apply its monopoly power
in several different businesses. Economists call this a deep-pockets model of
diversification.33
Diversified firms with operations in regulated monopolies have been criti-
cized for this kind of cross-subsidization. For example, most of the regional tele-
phone companies in the United States are engaging in diversification strategies.
The consent decree that forced the breakup of the original AT&T expressly for-
bade cross-subsidies between these regional companies’ telephone monopolies
and other business activities, under the assumption that such subsidies would
give these firms an unfair competitive advantage in their diversified business
activities.34
Although these market power economies of scope, in principle, may exist,
relatively little empirical work documents their existence. Indeed, research on
regulated utilities diversifying into nonregulated businesses in the 1980s sug-
gests not that these firms use monopoly profits in their regulated businesses to
unfairly subsidize non-regulated businesses, but that non-competition-oriented
management skills developed in the regulated businesses tend to make diver-
sification less profitable rather than more profitable.35 Nevertheless, the poten-
tial that large diversified firms have to exercise market power and to behave in
socially irresponsible ways has led some observers to call for actions to curtail
both the economic and political power of these firms. These issues are discussed
in the Ethics and Strategy feature.

Firm Size and Employee Incentives to Diversify

Employees may have incentives to diversify that are independent of any benefits
from other sources of economies of scope. This is especially the case for employees
in senior management positions and employees with long tenure in a firm. These
employee incentives reflect the interest of employees to diversify because of the
relationship between firm size and management compensation.
Research over the years demonstrates conclusively that the primary deter-
minant of the compensation of top managers in a firm is not the economic per-
formance of the firm but the size of the firm, usually measured in sales.36 Thus,
managers seeking to maximize their income should attempt to grow their firm.
One of the easiest ways to grow a firm is through diversification, especially unre-
lated diversification through mergers and acquisitions. By making large acquisi-
tions, a diversified firm can grow substantially in a short period, leading senior
managers to earn higher incomes. All of this is independent of any economic
profit that diversification may or may not generate. Senior managers need only
worry about economic profit if the level of that profit is so low that unfriendly
takeovers are a threat or so low that the board of directors may be forced to
replace management.
Recently, the traditional relationship between firm size and management com-
pensation has begun to break down. More and more, the compensation of senior
managers is being tied to the firm’s economic performance. The use of stock and
other forms of deferred compensation makes it in management’s best interest to be
concerned with a firm’s economic performance. These changes in compensation do
not necessarily imply that firms will abandon all forms of diversification. However,
they do suggest that firms will abandon those forms of diversification that do not
generate real economies of scope.
 Chapter 9:  Corporate Diversification     247

Can Equity Holders Realize These Economies

of Scope on Their Own?
Earlier in this chapter, it was suggested that for a firm’s diversification strategies
to create value, two conditions must hold. First, these strategies must exploit valu-
able economies of scope. Potentially valuable economies of scope were presented
in Table 9.1 and discussed in the previous section. Second, it must be less costly
for managers in a firm to realize these economies of scope than for outside equity
holders on their own. If outside equity holders could realize an economy of scope
on their own, without a firm’s managers, at low cost, why would they want to
hire managers to do this for them by investing in a firm and providing capital to
managers to exploit an economy of scope?
Table 9.3 summarizes the discussion on the potential value of the different
economies of scope listed in Table 9.1. It also suggests which of these economies
of scope will be difficult for outside equity investors to exploit on their own and
thus which bases of diversification are most likely to create positive returns for a
firm’s equity holders.
Most of the economies of scope listed in Table 9.3 cannot be realized by equity
holders on their own. This is because most of them require activities that equity
holders cannot engage in or information that equity holders do not possess. For
example, shared activities, core competencies, multipoint competition, and exploit-
ing market power all require the detailed coordination of business activities across
multiple businesses in a firm. Although equity holders may own a portfolio of
equities, they are not able to coordinate business activities across this portfolio. In
a similar way, internal capital allocation requires information about a business’s
prospects that is simply not available to a firm’s outside equity holders. All this sug-
gests reasons why firms may engage in diversification. Some of the potential ethical
implications of this diversification are discussed in the Ethics and Strategy feature.
Indeed, the only two economies of scope listed in Table 9.3 that do not have the
potential for generating positive returns for a firm’s equity holders are diversifica-
tion to maximize the size of a firm—because firm size, per se, is not valuable—and

TABLE 9.3  The Competitive Implications of Different Economies of Scope

Can They Be Realized by Performance

Types of Economy of Scope Can They Be Valuable Equity Holders on their Own Implications

Shared activities Yes No Positive

Core Competencies
Business Level Yes No Positive
Corporate Yes No Positive

Financial
Capital Allocation Yes No Positive
Risk Reduction Yes Yes Negative
Tax Savings Yes No Positive

Anti-Competitive
Multipoint Competition Yes No Positive
Exploiting Market Power Yes No Positive

Management Compensation No No Negative

248    Part 3: Corporate Strategies

diversification to reduce risk—because equity holders can do this on their own at very
low cost by simply investing in a diversified portfolio of stocks. Indeed, although risk
reduction is often a published rationale for many diversification moves, this rationale,
by itself, is not directly consistent with the interests of a firm’s equity holders. How-
ever, some scholars have suggested that this strategy may directly benefit other of a
firm’s stakeholders and thus indirectly benefit its equity holders. This possibility is
discussed in detail in the Strategy in Depth feature.

Ethics and Strategy

I n 1999, a loose coalition of union

members, environmentalists,
youth, indigenous peoples, human
affluent societies such as the United
States, people find it increasingly diffi-
cult to meet their financial obligations.
rights activists, small farmers, and Falling real wages, economic insecurity,
displaced workers took to the streets and corporate downsizing have led
of Seattle, Washington, to protest a many people to work longer hours, to
meeting of the World Trade Orga- hold two or more jobs, and to remain
nization (WTO) and to fight against underemployed as they have watched
the growing global power of corpora- their factory jobs being shipped to cost
tions. Government officials and cor- centers overseas.
porate officers alike were confused The causes of this apparent
by these protests. After all, hadn’t contradiction—global economic
world trade increased 19 times from growth linked with growing global
1950 to 1995 ($0.4 trillion to $7.6 tril- economic frustration—are numerous
Globalization and the Threat of
lion in constant 2003 dollars), and and complex. However, one explana-
the Multinational Firm
hadn’t the total economic output of tion focuses on the growing economic
the entire world gone from $6.4 tril- business was that these aggregate power of the diversified multinational
lion in 1950 to $60.7 trillion in 2005 growth numbers masked more truth corporation. The size of these institu-
(again, in constant 2003 dollars)? Why than they told. Yes, there has been eco- tions can be immense—many interna-
protest a global economic system—a nomic growth. But that growth has tional diversified firms are larger than
system that was enhancing the level benefited only a small percentage of the entire economies of many nations.
of free trade and facilitating global the world’s population. Most of the And these huge institutions, with a
economic efficiency—that was so population still struggles to survive. single-minded focus on maximizing
clearly improving the economic well- The combined net worth of 358 U.S. their performance, can make profit-
being of the world’s population? This billionaires in the early 1990s ($760 bil- making decisions that adversely affect
1999 protest turned out to be the first lion) was equal to the combined net their suppliers, their customers, their
of many such demonstrations, cul- worth of the 2.5 billion poorest people employees, and the environment, all
minating in the Occupy Movement on the earth! 83 percent of the world’s with relative impunity. Armed with
after the financial crisis of 2007 and, total income goes to the richest fifth of the unspoken mantra that “Greed is
in some ways, the election of Don- the population while the poorest fifth good,” these corporations can justify
ald Trump as President of the United of the world’s population receives only almost any action if it increases the
States in 2016. And, still, many busi- 1.4 percent of the world’s total income. wealth of their shareholders.
ness and government leaders remain Currently, 65.3 million people world- Of course, even if one accepts
confused. Empirically, globalization wide have had to leave their home this hypothesis—and it is far from
has improved the world economy, so countries to find work—and safety—in being universally accepted—solu-
why the controversy? foreign lands, and approximately 1.4 tions to the growing power of inter-
The message that these events billion people around the world live nationally diversified firms are not
were sending to government and big on less than $1 a day. Even in relatively obvious. The problem is that one way
 Chapter 9:  Corporate Diversification     249

that firms become large and power- simply because they are large could Whatever the causes and solu-
ful is by being able to meet customer easily have the effect of making citi- tions to these problems, protests that
demands effectively. Thus, firm size, zens worse off. However, once firms began in Seattle in 1999 have at least
per se, is not necessarily an indication are large and powerful, they may one clear message: global growth for
that a firm is behaving in ways incon- very well be tempted to exercise that growth’s sake is no longer universally
sistent with the public good. Govern- power in ways that benefit themselves accepted as the correct objective of
ment efforts to restrict the size of firms at great cost to society. international economic policy.37

Corporate Diversification and Sustained Objective 9.3  Specify

the circumstances under
­Competitive Advantage which a firm’s diversifi-
cation strategy will be a
Table 9.3 describes those economies of scope that are likely to create real economic source of sustained com-
value for diversifying firms. However, as we have seen with all the other strategies petitive advantage.
discussed in this book, the fact that a strategy is valuable does not necessarily imply
that it will be a source of sustained competitive advantage. For diversification to
be a source of sustained competitive advantage, it must be not only valuable but
also rare and costly to imitate, and a firm must be organized to implement this
strategy. The rarity and imitability of diversification are discussed in this section;
organizational questions are deferred until the next chapter.

The Rarity of Diversification

At first glance, it seems clear that diversification per se is usually not a rare firm
strategy. Most large firms have adopted some form of diversification, if only the

Strategy in Depth

A lthough diversifying to reduce

risk generally does not directly
benefit outside equity investors in a
a firm is much greater than the value
of those same investments would be in
other firms. Consider, for example, a
firm, it can indirectly benefit outside firm’s employees. An employee with
equity investors through its impact on a long tenure in a firm has generally
the willingness of other stakeholders made substantial firm-specific human
in a firm to make firm-specific invest- capital investments. These invest-
ments. A firm’s stakeholders include ments include understanding a firm’s
all those groups and individuals who culture, policies, and procedures;
have an interest in how a firm per- knowing the “right” people to contact
forms. In this sense, a firm’s equity to complete a task; and so forth. Such
investors are one of a firm’s stakehold- investments have significant value in
ers. Other firm stakeholders include the firm where they are made. Indeed,
employees, suppliers, and customers. such firm-specific knowledge is gener-
Firm stakeholders make ally necessary if an employee is to be
­firm-specific investments when the Risk-Reducing Diversification able to help a firm conceive and imple-
value of the investments they make in and a Firm’s Other Stakeholders ment valuable strategies. However, the
(Continued)
250    Part 3: Corporate Strategies

specific investments that an employee Thus, valuable, rare, and costly- Because it is often very costly for
makes in a firm have almost no value to-imitate firm-specific investments a firm’s employees, suppliers, and cus-
in other firms. If a firm were to cease made by a firm’s employees, suppli- tomers to diversify the risks associated
operations, employees would instantly ers, and customers can be the source of with making firm-specific investments
lose almost all the value of any of the economic profits. And because a firm’s on their own, these stakeholders will
firm-specific investments they had outside equity holders are residual often prefer that a firm’s managers
made in that firm. claimants on the cash flows generated help manage this risk for them. Man-
Suppliers and customers can also by a firm, these economic profits ben- agers in a firm can do this by diversify-
make these firm-specific investments. efit equity holders. Thus, a firm’s out- ing the portfolio of businesses in which
Suppliers make these investments side equity holders generally will want a firm operates. If a firm is unwilling
when they customize their products or a firm’s employees, suppliers, and cus- to diversify its portfolio of businesses,
services to the specific requirements of a tomers to make specific investments in then that firm’s employees, suppli-
customer. They also make firm-specific a firm because those investments are ers, and customers will generally be
investments when they forgo oppor- likely to be sources of economic wealth unwilling to make specific investments
tunities to sell to other firms in order for outside equity holders. in that firm. Moreover, because these
to sell to a particular firm. Customers However, given the riskiness of firm-specific investments can gener-
make firm-specific investments when firm-specific investments, employees, ate economic profits and because eco-
they customize their operations to suppliers, and customers will gen- nomic profits can directly benefit a
fully utilize the products or services of erally only be willing to make these firm’s outside equity holders, equity
a firm. Also, by developing close investments if some of the riskiness holders have an indirect incentive to
­relationships with a firm, customers associated with making them can be encourage a firm to pursue a diver-
may forgo the opportunity to develop reduced. Outside equity holders have sification strategy, even though that
relationships with other firms. These, little difficulty managing the risks strategy does not directly benefit them.
too, are firm-specific investments made associated with investing in a firm Put differently, a firm’s diver-
by customers. If a firm were to cease because they can always create a port- sification strategy can be thought of
operations, suppliers and customers folio of stocks that fully diversifies this as compensation for the firm-specific
would instantly lose almost the entire risk at very low cost. Therefore, diver- investments that a firm’s employees,
value of the specific investments they sification that reduces the riskiness of suppliers, and customers make in a
have made in this firm. a firm’s cash flows does not generally firm. Outside equity holders have an
Although the firm-specific directly benefit a firm’s outside equity incentive to encourage this compen-
investments made by employees, sup- holders. However, a firm’s e­ mployees, sation in return for access to some of
pliers, and customers are risky—in the suppliers, and customers usually the economic profits that these firm-
sense that almost their entire value is do not have these low-cost diversi- specific investments can generate. In
lost if the firm in which they are made fication opportunities. Employees, general, the greater the impact of the
ceases operations—they are extremely for example, are rarely able to make firm-specific investment made by a
important if a firm is going to be able firm-specific human capital invest- firm’s employees, suppliers, and cus-
to generate economic profits. As was ments in a large enough number of tomers on the ability of a firm to gen-
suggested in Chapter 3, valuable, different firms to fully diversify the erate economic profits, the more likely
rare, and costly-to-imitate resources risks associated with making them. that pursuing a corporate diversifica-
and capabilities are more likely to And although suppliers and custom- tion strategy is indirectly consistent
be a source of sustained competitive ers can diversify their firm-specific with the interests of a firm’s outside
advantage than resources and capa- investments to a greater degree than equity holders. In addition, the more
bilities without these attributes. Firm- employees—through selling to mul- limited the ability of a firm’s employ-
specific investments are more likely tiple customers and through buying ees, suppliers, and customers to diver-
to have these attributes than non- from multiple suppliers—the cost of sify the risks associated with making
firm-specific investments. Non-firm- this diversification for suppliers and firm-specific investments at low cost,
specific investments are investments customers is usually greater than the the more that corporate diversification
that can generate value in numerous costs that are borne by outside equity is consistent with the interests of out-
different firms. holders in diversifying their risk. side equity investors.38
 Chapter 9:  Corporate Diversification     251

limited diversification of a dominant-business firm. Even many small and medium-

sized firms have adopted different levels of diversification strategy.
However, the rarity of diversification depends not on diversification per se
but on how rare the economies of scope associated with that diversification are.
If only a few competing firms have exploited an economy of scope, that economy
of scope can be rare. If numerous firms have done so, it will be common and not a
source of competitive advantage.

The Imitability of Diversification

Both forms of imitation—direct duplication and substitution—are relevant in eval-
uating the ability of diversification strategies to generate sustained competitive
advantages, even if the economies of scope that they create are rare.

Direct Duplication of Diversification

The extent to which a valuable and rare corporate diversification strategy is immune
from direct duplication depends on how costly it is for competing firms to realize
this same economy of scope. As suggested in Table 9.4, some economies of scope
are, in general, costlier to duplicate than others.
Shared activities, risk reduction, tax advantages, and employee compensation
as bases for corporate diversification are usually relatively easy to duplicate. Because
shared activities are based on tangible assets that a firm exploits across multiple busi-
nesses, such as common research and development labs, common sales forces, and
common manufacturing, they are usually relatively easy to duplicate. The only dupli-
cation issues for shared activities concern developing the cooperative cross-business
relationships that often facilitate the use of shared activities—issues discussed in the
next chapter. Moreover, because risk reduction, tax advantages, and employee com-
pensation motives for diversifying can be accomplished through any type of diversi-
fication, these motives for diversifying tend to be relatively easy to duplicate.
Other economies of scope are much more difficult to duplicate. These diffi-
cult-to-duplicate economies of scope include core competencies, internal capital
allocation efficiencies, multipoint competition, and exploitation of market power.
Because core competencies are more intangible, their direct duplication is often
challenging. The realization of capital allocation economies of scope requires
very substantial information-processing capabilities. These capabilities are often
very difficult to develop. Multipoint competition requires very close coordination
between the different businesses in which a firm operates. This kind of coordina-
tion is socially complex and thus often immune from direct duplication.39 Finally,
exploitation of market power may be costly to duplicate because it requires that a
firm must possess significant market power in one of its lines of business. A firm
that does not have this market power advantage would have to obtain it. The cost
of doing so, in most situations, would be prohibitive.

TABLE 9.4  Costly Duplica-

Less Costly-to-Duplicate Costly-to-Duplicate
tion of Economies of Scope
Economies of Scope Economies of Scope

Shared activities Core competencies

Risk reduction Internal capital allocation
Tax advantages Multipoint competition
Employee compensation Exploiting market power
252    Part 3: Corporate Strategies

Substitutes for Diversification

Two obvious substitutes for diversification exist. First, instead of obtaining cost
or revenue advantages from exploiting economies of scope across businesses in a
diversified firm, a firm may decide to simply grow and develop each of its busi-
nesses separately. In this sense, a firm that successfully implements a cost leader-
ship strategy or a product differentiation strategy in a single business can obtain
the same cost or revenue advantages it could have obtained by exploiting econo-
mies of scope but without having to develop cross-business relations. Growing
independent businesses within a diversified firm can be a substitute for exploiting
economies of scope in a diversification strategy.
A second substitute for exploiting economies of scope in diversification can be
found in strategic alliances. By using a strategic alliance, a firm may be able to gain
the economies of scope it could have obtained if it had carefully exploited econo-
mies of scope across its businesses. Thus, for example, instead of a firm exploiting
research and development economies of scope between two businesses it owns, it
could form a strategic alliance with a different firm and form a joint research and
development lab. Instead of a firm exploiting sales economies of scope by linking
its businesses through a common sales force, it might develop a sales agreement
with another firm and obtain cost or revenue advantages in this way.

Summary
Firms implement corporate diversification strategies that range from limited ­diversification
(single-business, dominant-business) to related diversification (related-constrained, related-
linked) to unrelated diversification. To be valuable, corporate diversification strategies must
reduce costs or increase revenues by exploiting economies of scope that outside equity
­holders cannot realize on their own at low cost.
Several motivations for implementing diversification strategies exist, including
exploiting shared activities, core competencies (shared business level competencies, corpo-
rate competencies), financial economies of scope (internal capital allocation, risk reduction,
obtaining tax advantages), anti-competitive economies of scope (multipoint competition,
market power advantages), and employee incentives to maximize compensation. All these
reasons for diversifying, except diversifying to maximize management compensation and
(maybe) risk reduction, have the potential to create economic value for a firm. Moreover,
a firm’s outside equity holders will find it costly to realize all these bases for diversifica-
tion, except risk reduction. Thus, diversifying to maximize management compensation
or diversifying to reduce risk is not consistent with the wealth-maximizing interests of a
firm’s equity holders.
The ability of a diversification strategy to create sustained competitive advantages
depends not only on the value of that strategy, but also on its rarity and imitability. The
rarity of a diversification strategy depends on the number of competing firms that are
exploiting the same economies of scope through diversification. Imitation can occur
either through direct duplication or through substitutes. Costly-to-duplicate economies of
scope include core competencies, internal capital allocation, multipoint competition, and
exploitation of market power. Other economies of scope are usually less costly to dupli-
cate. Important substitutes for diversification are when relevant economies are obtained
through the independent actions of businesses within a firm and when relevant economies
are obtained through strategic alliances. This discussion set aside important organizational
issues in implementing diversification strategies. These issues are examined in detail in
the next chapter.
 Chapter 9:  Corporate Diversification     253

MyLab Management
Go to www.pearson.com/mylab/management to complete the problems marked with this icon .

Challenge Questions
9.1.  One simple way to think about firm to realize any valuable economies this information in your own invest-
relatedness is to look at the products of scope that could not be duplicated ment activities?
or services a firm manufactures. The by outside investors on their own?
more similar these products or ser- Why or why not? 9.4.  A firm is owned by members of
vices are, the more related is the firm’s a single family. Most of the wealth of
diversification strategy. Would firms 9.3.  One of the reasons why internal this family is derived from the opera-
that exploit core competencies in their capital markets may be more effi- tions of this firm, and the family does
diversification strategies always pro- cient than external capital markets not want to “go public” with the firm
duce products or services that are like is that firms may not want to reveal by selling its equity position to out-
each other? Why or why not? full information about their sources side investors. Will this firm choose to
of competitive advantage to external pursue a highly related diversification
9.2.  A firm implementing a diver- capital markets in order to reduce the strategy or a somewhat less related
sification strategy has just acquired threat of competitive imitation. This diversification strategy?
what it claims is a strategically related suggests that external capital markets
target firm but announces that it is not may systematically undervalue firms 9.5.  Under what conditions will a
going to change this recently acquired with competitive advantages that are related diversification strategy not be
firm in any way. Would this type of subject to imitation. If you agree with a source of competitive advantage for
diversifying acquisition enable the this analysis, how could you trade on a firm?

Problem Set
9.6.  Visit the corporate Web sites for the following firms. How would you character-
ize the corporate strategies of these companies? Are they following a strategy of limited
diversification, related diversification, or unrelated diversification?
(a) ExxonMobil
(b) Google
(c) General Motors
(d) JetBlue
(e) Citigroup
(f) Entertainment Arts
(g) IBM
(h) Dell
(i) Alphabet

9.7.  Consider the following list of strategies. In your view, which are examples of poten-
tial economies of scope underlying a corporate diversification strategy? For those strate-
gies that are an economy of scope, which economy of scope are they? For those strategies
that are not an economy of scope, why aren’t they?
(a) The Coca-Cola Corporation replaces its old diet cola drink (Tab) with a new diet cola
drink called Diet Coke.
(b) Apple introduces an iPhone with a larger memory.
(c) PepsiCo distributes Lay’s Potato Chips to the same stores where it sells Pepsi.
(d) Wal-Mart uses the same distribution system to supply its Wal-Mart stores, its Wal-Mart
Supercenters (Wal-Mart stores with grocery stores in them), and its Sam’s Clubs.
254    Part 3: Corporate Strategies

(e) Head Ski Company introduces a line of tennis rackets.

(f) General Electric borrows money from Bank of America at three percent interest and then
makes capital available to its jet engine subsidiary at eight percent interest.
(g) McDonald’s acquires Boston Market and Chipotle (two restaurants where many custom-
ers sit in the restaurant to eat their meals).
(h) A venture capital firm invests in a firm in the biotechnology industry and a firm in the
entertainment industry.
(i) Another venture capital firm invests in two firms in the biotechnology industry.

9.8.  Consider the following facts. The standard deviation of the cash flows associated
with Business I is 0.8. The larger this standard deviation, the riskier a business’s future
cash flows are likely to be. The standard deviation of the cash flows associated with Busi-
ness II is 1.3. That is, Business II is riskier than Business I. Finally, the correlation between
the cash flows of these two businesses over time is 0.8. This means that when Business I is
up, Business II tends to be down, and vice versa. Suppose one firm owns both businesses.
(a) Assuming that Business I constitutes 40 percent of this firm’s revenues and Business
II constitutes 60 percent of its revenues, calculate the riskiness of this firm’s total rev-
enues using the following equation:

sdI,II = 2w2sd2I + (1 - w)2sd2II + 2w(1 - w)(rI,IIsdIsdII)

Where w = 0.40; sdI = 0.8, sdII = 1.3, and rI, II = -8.

(b) Given this result, does it make sense for this firm to own both Business I and Business
II? Why or why not?

MyLab Management
Go to www.pearson.com/mylab/management for Auto-graded writing questions as well as the following Assisted-graded writing
questions:

9.9. Not all firms will choose corporate diversification. Describe the benefits and challenges of the alternatives.

9.10. Internal capital markets have several limitations. When a firm is confronted by these limitations, what is it likely to do?

End Notes
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September 15, 2013; AP Wide World Photos. 9 See, for example, Davis, P., R. Robinson, J. Pearce, and S. Park. (1992).
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1-388-147. 10 Loomis, C. J. (1993). “Dinosaurs?” Fortune, May 3, pp. 36–42.
4 H. P. Lang and R. M. Stulz (1994). “Tobin’s q, corporate diversification, 11 Rapoport, C. (1992). “A tough Swede invades the U.S.” Fortune, June
and firm performance.” Journal of Political Economy, 102, pp. 1248–1280; 29, pp. 776–779.
R. Comment and G. Jarrell (1995). “Corporate focus and stock returns.” 12 Prahalad, C. K., and G. Hamel. (1990). “The core competence of the
Journal of Financial Economics, 37, pp. 67–87; D. Miller (2006). “Tech- organization.” Harvard Business Review, 90, p. 82.
nological diversity, related diversification, and firm performance.” 13 See also Grant, R. M. (1988). “On ‘dominant logic’ relatedness and the
Strategic Management Journal, 27(7), pp. 601–620; B. Villalonga (2004). link between diversity and performance.” Strategic Management Journal,
“Does diversification cause the ‘diversification discount’?” Financial 9, pp. 639–642; Chatterjee, S., and B. Wernerfelt. (1991). “The link between
Management, 33(2), pp. 5–28; T. Mackey, J. Barney, and J. Dotson (2017) resources and type of diversification: Theory and evidence.” Strategic
“Corporate diversification and the value of individual firms: A Bayesian Management Journal, 12, pp. 33–48; Constantinos C. Markides, and P.
approach. Strategic Management Journal, 32(2): pp. 322–341. J. ­Williamson. (1994). “Related diversification, core competencies, and
5 See Rogers, A. (1992). “It’s the execution that counts.” Fortune, Novem- corporate performance.” Strategic Management Journal, 15, pp. 149–165;
ber 30, pp. 80–83; and Porter, M. E. (1981). “Disposable diaper industry ­Montgomery, C. A., and B. Wernerfelt. (1991). “Sources of superior perfor-
in 1974.” Harvard Business School Case No. 9-380-175. A more general mance: Market share versus industry effects in the U.S. brewing industry.”
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7 See about.att.com/story/att-completes-acquisition-of-DirectTV. 14 See Bartlett, C.A. and S. Ghoshal (1989) Managing Across Borders: The
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 Chapter 9:  Corporate Diversification     255

15 Presentation by V. P. of Research and Development, General ­Electric Academy of Management Review, 23(4), pp. 724–740; Chen, M.-J. (1996).
Medical Imaging Chinese Division, SMS Special Conference in “Competitor analysis and interfirm rivalry: Toward a theoretical inte-
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