Economic of Industry
Despite the different degree of competitions and the level of development in the market across the various types of industries, most firms are continuously and consistently looking for ways and opportunities to enhance their ability to grow or even to just maintain sustainability and survival in the industry. Firms carry out diversification such as developing new lines and products, joint ventures and acquiring firms in unrelated lines of business, to improve on their corporate efficiency and benefits of the shareholder.
For example, if a firm’s business focuses on seasonal products such as selling heating equipment, sales will do well during the autumn and winter months. However, to ensure the firm’s survival and maintain its business during the summer, it will need to carry out diversification such as establishing new product lines (i. e. Air conditioners). Therefore, firms diversify to achieve economies of scales and scope, to economize on transaction costs, improving shareholder’s diversification by reducing risks, as well as identifying undervalued firms.
This paper will look at the different advantages and drawbacks of diversification as well as their economic validity. Diversification for Economies of Scales and Scopes It has been said that when a firm is able to achieve economies of scale, the production levels becomes more efficient as the number of goods being produced increases. With the increase in production levels, firms will then able to lower their average cost per unit as the fixed cost are able to spread out over a large number of goods. For large firms, this will be a great advantage to them as it allows these firms to be able to gain access to a larger market.
Furthermore with a lower average cost in production, they will be able to position their products at a more cheaply and affordable pricing in the market, giving firms a competitive advantage as well as it sits greatly for the consumer. A good example of such company would be Wal-Mart WMT. Being a dominant player in the retailing industry as well as the sheer size of the company, Wal-Mart has great efficiencies at keeping costs low as the company has tremendous bargaining power with its suppliers. This allows Wal-Mart to be able to retail their products at a heaper price as well as having inexpensive distributions. However, it has been said that diversifying for economies of scales has an adverse effect on the smaller to medium size firms as it raises cost instead. It is generally true if the concept is viewed narrowly but small firms nowadays has managed to find ways to create opportunities to achieve economies of scales such as buying services, sharing risks and scaling through technology. Most small firms rather engaged services from a larger company as opposed to doing the job in-house to cut cost.
Therefore any organizations servicing these smaller businesses (i. e. payroll services) are view as an “economies of scale” from the perspective of the small firms. Economies of Scopes on the other hand has a similar concept as economies of scales but refers more to firms that are able to lower their average cost by developing and producing or providing two or more products in their businesses. This means that a given level of production cost of each product line by a firm is much lower as compared to the given output level of a single product each produced by a combination of separate firms.
An example of a company that uses economies of scope at its advantage would be Daiso. Daiso produced and retail hundreds of products from foods to house cleaning materials which allow them to offer standardization in their product’s pricings. With higher demands and production level as well as a lower average cost achieved through economies of scales, it definitely does help for firms to diversify so as to maximise their profit margins. Economizing on transaction costs
Transaction costs in economics are unavoidable by firms and are usually incurred when making economic transactions such as buying or making products. Transaction cost complicates coordination as well as affecting the firms’ profit and loss. It reduces profit margin and a high transaction cost over time may result in firms having to face huge losses. For example, for a firm to produce a product it will need to carry out R&D and obtain information from different kind of sources which cost money.
Therefore to reduce or economize the transaction costs, firms diversify by carrying out merger and acquisition. For example, in order to expand its revenue stream, Dell Inc, an American multinational computer technology corporation has decided to extend its target market to the gaming industry by creating a new line of product of gaming PCs. However, it requires Dell to carry out R&D to obtain and search for relevant information on the product and the target market and all this accumulates as transaction costs. Therefore to avoid incurring high transaction cost, Dell Inc. ad decided to acquire Alienware, a manufacturer of high-end gaming PCs in 2006. In conclusion, firm diversifying to economize transaction cost is viable and valid in the economic market as it helps to reduce cost thus improving the profit margin for the firms. Internal Capital Markets Internal Capital Markets of diversified firms allows firms to properly allocate its resources according to how its best use. It creates efficiencies and increases firm’s control of funds which allows easier monitoring and lowers the monitoring costs as well as reducing chances of fraud.
In addition, internal capital market allows firm to have informational advantage to make the necessary changes and allocation to its resources when it is being used improperly. For example; if the cost of issuing shares at a bargain price to the old shareholders outweigh project’s net profit value, the firm may decide to forgo NPV project which in return result in an underinvestment problem. However through internal capital market, diversified firms are able to allocate resources more efficiently and diminish the underinvestment problems.
Internal capital market however may cause firms more harm than good. As established by Stulz (1990), diversification may engender influence costs and result in cross-subsidisation where some diversified firms tend to underinvest in high-performing projects and overinvest in the lower ones. This may have adverse impact on firm’s return and profitability as a firm allocating too many resources on a segment that relatively had less investment opportunities is unconditionally leaving some of the better projects in other segments underinvested which may bring in more profits to the firm.
Shareholder’s diversification Diversifying helps to reduce firm’s risk and smooth out its earnings stream. However, most shareholders do not benefit from this as they are able to diversify their portfolio at near zero cost through investing in many different options. However, there is a fraction of shareholders whom are unable to carry out diversification on their own. They are usually the owners of firms whom investments are largely based on their own business and are the leasing shareholder of the firm.
Due to this, the shareholders are unable to carry out proper portfolio diversification and therefore rely and benefit greatly from the risk reductions carried out by firms. For example, a firm developing new lines of businesses internally reduce its risk of failing as it streams of revenue are being segregated and relied on different channels. If one was to fail, there will be other means of business for the firm to recoup its losses and streaming in revenue.
With this, the firm shareholders’ risks are being indirectly reduced as well. Identifying undervalued Firm Undervalued firm’s assets and potential earning power are usually inadequately reflected in its stock price. This means these firms are actually worth more than what is being expected of them in the market. Therefore, other firms whom are able to recognize this mispricing diversify and acquire these undervalued firms and benefits from the acquisition by gaining the differences between the value and purchased price as surplus.
For example, General Electronics has over the years been carrying out acquisition and diversifies its business which allows stability in its earnings. However, identifying undervalued firm is not easy and some firm acquisition can bring more harm the benefits to a company. Furthermore, public firms traded in reasonably efficient markets may have their valuation surplus quickly eliminated by the premiums paid on market prices.
Therefore, it is more viable in the economics to carry out acquisitions in less efficient markets or acquire private businesses. Conclusion In conclusion, though diversification come with a cost for firms and may be difficult to be carried out in some cases, I do believe that it is valid in economics as it greatly benefit firms in reducing risk and widen its revenue stream which in returns increases profit margins. Therefore, firms should see diversification as a viable option in expanding its business.