Ekonomika Bisnis, 20 April 2021

Introduction
 Diversification refers to a strategy where a firm is
involved in the production of a number of different
goods and services

 Three different types can be identified :

 Product extension
 Market extension
 ‘Pure’ diversificatio
 Product extension

 Firms can diversify by moving into familiar or related

activities

 A sweet manufacturer who sells a milk chocolate may

decide to produce and sell a dark chocolate bar, ice cream
or snack foods as a product extension

 Product extension usually occurs when there are

potentials for economies of scope (when two related
goods can be produced jointly at a cost lower than if they
were produced independently)
 Market extension

 As a firm gains a specialization in a given technology and

product base, it may wish to exploit different markets,
such as different industries, different social groups or
different geographical areas

 Example, a chemical company may decide to sell its

chemicals not only to industrial users but also to the
agricultural sector of the economy.
 ‘Pure’ diversification

 This type of diversification exists when firms move into

unrelated fields of activity

 Firms which are involved in different industries are often

referred to as conglomerates

 An example of such pure diversification is the British firm

Virgin plc, which began as a record store, but is currently
involved in aero planes, trains, financial products, soft
drinks, mobile phones, holidays, cars, wines, publishing
and bridal wear
Reasons for Diversification
 The basic reasons for diversification can be
summed up under three headings

 Three different types can be identified :

 the market power view
 the agency view
 the resources view
 The market power view

This approach suggests that diversified firms might be able

to exploit anticompetitive behavior. Three examples of such
behavior are as follows:

 Cross-subsidization or ‘deep pocket’ strategies

This occurs when a firm relies on profits from its various operations to
finance predatory practices in other markets

 Reciprocal buying
involves an agreement by which, for example, firm A purchases its
inputs from firm B on the condition that firm B then purchases its inputs
from firm A. Clearly, conglomerate firms are in a stronger reciprocal
position than specialized firms

 Mutual forbearance
where large conglomerates recognize each other’s power and decide to
co-exist and accommodate one another in various shared markets
 The agency view
Managers may be tempted to do this for three reasons :

 First, their power, status and remuneration may be related to the growth of the
organization

 Second, diversification in other activities may complement the talents and skills
of the managers, thus making them in dispensable to the organization

 Lastly, unlike shareholders, who are able to reduce business risks by diversifying
their portfolios, managers are exposed to employment risks should the firm fail

 The resource view

Firms possess a range of resources and assets which can be exploited in other
markets
Market Power
Large near-monopolies and oligopolies seeking more
market power may be reluctant to expand in one
market as this would alert the anti-monopoly
authorities
1. Cross-subsidization and predation
2. Reciprocity
3. Tie in sales
4. Entry barriers
Cross-subsidization and predation

 The diversified firm can outbid, outspend and outdo the specialized
firm since it can rely on profits and cash flows from many sources

 A typical strategy for a diversified firm might be to undercut the

prices of a specialized firm and force it out of the market

 In order for this strategy to succeed the predator must have a

‘deeper pocket’ than its prey

 Once the firm has left the market, prices are reset at the original or
higher level

 Such behavior is referred to as predatory pricing

Reciprocity

 Reciprocity occurs when firms encounter each other in the dual

capacities as buyers and sellers

 Thus reciprocal buying is an arrangement whereby firm A buys

inputs from firm B on the condition that B buys from A

 Thus sellers realize that a buyer may shift purchases elsewhere if

reciprocal transactions are not made
Tie in Sales

 tie-in sales (or tying) as the sale of two distinct products where the
sale of one good is conditional on the purchase of another

 Thus a conglomerate supplies a buyer with good X on the condition

that the buyer also purchases good Y from the conglomerate

 In this way the diversified firm is able to increase revenues

Entry Barriers

 conglomerate mergers may increase the height of entry barriers

Cost Reductions
 Economies of scale and scope

 economies of scale can be realized if a firm can spread its

indivisible inputs over a greater output

 Such economies can also be achieved if a firm is able to

spread its indivisible inputs over a greater variety of
output, This is often referred to as economies of scope

 Example : A fruit grower has to leave enough space in

between the trees to allow access for labour and farm
equipment. The land between the trees can be exploited
by grazing sheep or rent it to a sheep farmer
 Reduction of risk and uncertainty

 All firms are vulnerable to adverse and unpredictable

changes in demand and increased competition for their
individual products

 The more products a firm develops the lower is this

vulnerability

 Stable cash flows can be achieved when firm develop

products or services with different seasonal peaks

 Ex : Winter & Summer Appliances

 Specific assets

 Gorecki (1975) noted that some, if not all, firms possess

specific assets that can be of value if exploited in other
industries
 These assets would include such things as a new
technology, trade secrets, brand loyalty, managerial
experience and expertise
 It can either sell the assets in the market or diversify into
the relevant industry to exploit the asset itself

 Tax reductions

 Diversification can, under various tax regimes, reduce a

firm’s tax liability
Differentiation vs Diversification
 Product Differentiation is the process of distinguishing a product from
others already in the market, especially the competition

 Product Differentiation is about highlighting the ways in which a product

is different from another, in order to create that sense of value

 Product Diversification is the modification of a product or service to

reach a more expansive target market. Unlike Product Differentiation,
this isn't about highlighting anything; rather it is about finding a new
section of the market to attract

 In terms of differentiation versus diversification, it is often less risky to

differentiate
 Related
Diversification
Unrelated