Montgomery, C. & Wernerfelt, B. Diversification, Ricardian rents, and Tobin’s qRAND Journal of Economics, 1988

Eva Herbolzheimer University of Illinois at Urbana-

Champaign

Objective Testing prevailing theory: diversification is based

on excess capacity of productive factors (Penrose, Teece…)

Extending this theory by considering heterogeneity of factors and profit-maximization considerations of firms

Showing how Ricardian rents are reflected in Tobin’s q

Main Hypothesis: Rents decrease as large companies diversify more widely

Diversification, Ricardian rents, and Tobin’s q

Sources of Rents Collusive relationships with competitors

Disequilibrium effects (luck)

Unique factors = Ricardian Rent focus of paper

Diversification, Ricardian rents, and Tobin’s q

Diversification as a way to appropriate Ricardian rents

If factor is subject to market imperfections, firm can use capacity internally instead of selling or renting it, this circumstance leads to diversification (Williamson, 1985)

Four Assumptions:- Firm can dispose of excess capability without affecting its other operations- Cases with natural economies of scope are not considered- Firms own or control rent-yielding factors- Static model evaluating a single diversification move of a firm with excess capacity, marginal expansion of scope

Diversification, Ricardian rents, and Tobin’s q

Diversification, Ricardian rents, and Tobin’s q

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

yield less advantage.

Diversification, Ricardian rents, and Tobin’s q

Prediction: as optimal diversification increases, average rents decline

Tobin’s q as a measure of rents Tobin’s q: ratio of market value to the replacement cost of the

firm The extent to which q differs from 1 is a measure of the extent to which a firm’s capitalized rents differ from the fair market price of its physical assets

Diversification, Ricardian rents, and Tobin’s q

Data, measures, and tests (I) Sample of 167 firms (data from different researchers /

institutions) Montgomery and Wernerfelt constructed the following variables from the data

Diversification, Ricardian rents, and Tobin’s q

Data, measures, and tests (II)

Prediction of ßs:- ß(0) should be roughly 1 (value of q under perfect competition)- ß(1) should be 10/3 and ß(2) should be 10 (iSalinger, intangible

assets)- ß(3) is unlikely to be significantly different from 0 (Smirlock,

concentration)- ß(4) expected to be positive (sign of Ricardian rent) - ß(5) predicted negative (wide diversification low rent)- ß(6) difficult to predict (foreign sales)- ß(7) expected to be positive (disequilibrium effects, Salinger)

Diversification, Ricardian rents, and Tobin’s q

Results (I)

Diversification, Ricardian rents, and Tobin’s q

Results (II) R^2 similar to other studies (Salinger) As expected:- Intercept close to 1- A/V and R/V consistent with Salinger results and predictions- S (market share) is positive while C (concentration) has a negative

effect- D (diversification) negative & significant Large firms in otherwise fragmented industries reap high Ricardian

rents As firms diversify more widely, their rents decline- F (foreign sales) is positive foreign sales are more similar to

domestic sales than diversification

Diversification, Ricardian rents, and Tobin’s q

Conclusion Firms earn decreasing average rents as they diversify more widely Consistent with idea that diversification is prompted by excess

capacity of factors that are subject to market failure The farther a firm must go to use these factors, the lower the

marginal rent

Discussion:- “Free-Cash-Flow” Hypothesis: Firms may undertake diversification

against interest of shareholders argue that firm will begin with the most profitable opportunities and move towards the least profitable ones

Diversification, Ricardian rents, and Tobin’s q