Diversification of Business

Topics: Economics, Transaction cost, Costs Pages: 5 (1785 words) Published: February 25, 2013
Economics of Industry

1. Introduction
Most of the large corporations today operate in several markets providing more than one product or service, into more than one market, location or more than one group of customers. This phenomenon is known as diversification. In detail diversification means expanding a firm’s investments into other related or unrelated businesses in attempt to achieve higher efficiency or meeting managerial preferences. MARKMONITOR INC.. (2012) Entrepreneur Media, Inc.. (2012)

Diversification in attempt to increase efficiency can be achieved e.g. by Economies of scale and Scope. Diversification however is not always beneficial for the company. For example It can result in substantial influence cost or it may not always work as expected. Sometimes the actions for diversification are only made in the interest of managers, ignoring the interest of shareholders, and this may be harmful to the company.

Besanko, D (2010)

2. Diversification for efficiency reasons

3.2. Economies of Scale and Scope
Firms may choose to diversify in order to achieve economies of scale by mergers. By producing higher volume of similar products they can spread and reduce their fixed cost and thus achieve economies of scale. Diversification in attempt to achieve economies of scale has other benefit into it as well such as gaining higher market share and this way achieving competitive advantage of a bigger company. Nokia-Siemens networks, is a merger that has achieved economies of scale from its fusion. Kallasvuo, O (2006)

Diversifying might also be put into use to achieve economies of scope. Economies of scope is a strategy in attempt to decrease average total cost by producing variety of different goods that are related. Firms or goods are related if they share similar technological characteristics, production characteristics and/or similar distribution channels. For instance, if firm has some resources that are not fully utilized in its current product market, these underutilized resources can be effectively applied in other related product markets to spread and reduce costs in production and thus achieve economies of scope. Besanko, D (2010)

Samsung has diversified this way, economies of scope for efficiency. It produces cameras, laptops, smartphones, mp3 players etc. that are related businesses using for example, same technology. Lee, W. (2007)

3.3. Reduced Transaction Cost
Transaction cost are the costs of exchanging goods and services. These include the costs of locating, negotiating and enforcing a contract. Akbari, H. (2005)
Firm may want to diversify in order to minimize their transaction costs by market coordination of mergers in the presence of specialized assets, such as human capital. Reducing the transaction cost can also be achieved for example by Vertical integration. Besanko, D (2010) Vertical integration refers to action where firms expand their business to areas that are involved in same production, e.g. manufacturer buying its supplier. MARKMONITOR INC.. (2012)

3.4. Internal Capital Markets
A firm can combine two unrelated businesses to create internal capital market. For example you can combine a business with cash surplus with cash-constrained businesses with potential profitable opportunities in order to channel the cash from one business to another. This is a sensible strategy only if the investment will allow the financially constrained business to make profits that would not be possible without the extra funds. The reason why firms may want to diversify for attempt to achieve Internal Capital Markets might be that the external funds would be otherwise too expensive to acquire or limited. Besanko, D (2010) 3.5. Diversifying Shareholders’ portfolio

In order to reduce risk managers might diversify shareholders portfolio, which means investing in broad amount of small holdings. The rationale behind this is that if one company fails, it is not going...
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