Can a multimarket firm successfully diversify its resources? What happens when they do? Cynthia A. Montgomery and Birger Wernerfelt present a study on this subject in the essay “Diversification.” In the paper, the authors test whether a company’s average rent decreases the further afield it transfers factors from their main business. The essay also touches on the effect of resource specificity on firm profit.
This essay indirectly applies to management literature and business organization. If the factors of a company within its core market experience slack or failure, the company might do better if they transfer these factors to a different market. But two problems surface, and the authors of the essay clearly illustrate and differentiate both problems. The first problem with diversifying for a firm is that average firm rents are predicted to decrease. This statement is backed by two points; firstly, the broad diversification means less specified assets which can be diversified, and, secondly, the resources transferred to a new market should experience a decrease in rent. The second problem the authors discuss involves the value of the resources. The authors state that the more afield the factors transfer from the main market, the lower the rent, and that they experience a greater loss in rent extraction the more specialized the resources are to the original market when transferred.
In my opinion, however, there are two issues with the aforementioned analysis in the paper. The first issue has to do with the reasons a firm diversifies in the first place. While the essay lists only two reasons, I believe there are other practical reasons that a firm might diversity its markets. One reason could be if a firm gains rent based on a name-brand. The second issue with the analysis in the paper is that a company that was hit with severe market cycle effects might create a second related business that it could transfer it factors to during economic slumps.
This article was written by Phineas Upham. Phineas Upham is an investor from SF and NYC. For more details visit his website at www.phineas-upham.com and his twitter page at Phineas Upham Twitter.