Diversification, Ricardian rents and Tobin’s q

1. Diversification, Ricardian rents and Tobin’s q The RAND Journal of Economics (1988): 623-632 Presentedby Carla Fernández-Corrales, Fall 2013 Cynthia A. Montgomery BirgerWernerfelt NorthwesternUniversity (now at MITSloan) NorthwesternUniversity (now at HBS)

2. Motivation • Although multimarket firms play an important role, the theory of diversification lacked empirical tests atthe time of this article. • Theory of diversification: if a firm presents excess of capacity of productive factors, diversification is an efficient choice(Penrose, 1959) • The article considers the heterogeneity of factors and profit/maximizing decisions.

3. Ricardian rents • Economics rents from unique factors (e.g., good manager, good location, patent). • Rents also originatefrom imitable factors, when imitating them is an uncertain project for competitors (e.g. brand or reputation). • Rents likewise can derive from shared factors (e.g., team of managers that cannot market themselves as a package, manager or supplier that makes an unanticipated investment).

4. Diversification If a firm owns or share a factor with exceeded capacity, and this factor is subject to market imperfections, those are conditions for diversification. Assumptions: • The firm can dispose of excess capacity without affecting the rest of its operations. • If any firm in one industry will participate uniformly in other, those pair of industries are considered a single industry.

5. Diversification Assumptions • Only firms thatown or control rent-yielding factors • Static model of the case of a single diversification move in which a firm with excess capacity of a factor considers a marginal expansion of its scope.

6. Diversification

7. Hypotheses

8. Tobin’s q • Accounting measures are not good proxies for rent because they don’t consider differences in systematic risk, temporary disequilibrium effects, tax laws, and arbitrary accounting conventions. • Tobin’s q Value of intangible assets Ricardian rents Market value Replacement value of physical assets Value of collusive relationships with competitors Disequilibrium effects

9. Tobin’s q Specificity Diversification Opportunities s and o are unobservables, therefore, Industry dummies

10. Data • Sample of 167 firms (around 1976) • q from Lindenbergand Ross (1981) • Domestic market share data and dollar sales from Trinet/EIS • Replacement cost from 10 K's • Foreign sales estimates from EIS Directory • Industry estimates of marketing expenditures and company sponsored R&D from Line-of-Business Report • Four-firm concentration ratios growth rates per SIC code from the Census of Manufactures

11. Measures Ai = firm i’s marketing expenditures (sales weighted) Ri = firm i’s R&D (sales weighted) Ci= concentration in firm /'s markets (sales weighted) Gi= growth of shipments in firm i’s markets (sales weighted) Si = firm i’smarket share (sales weighted) Fi = firm i’s foreign sales (in percent) Vpi = replacement costs of firm i’s physical assets

12. Measures 0 if j and l have the same three-digit code 1 if they have identical two-digit code 2 if they have different two-digit code • Diversification • Concentricindex Percentage of firm I’s sales in industry

13. Tests After taking logs to reduce measurement error…

14. Results

15. Discussion The farther firms must go to use their factors, the lower the marginal rents they extract (p 630). Explanations • Firms underestimate the effort to gain rents • Free cash flow • Firms diversify to overcome moral hazard problems