Diversification and Performance: Linking Relatedness, Market Structure, and the Decision to Diversify

Abstract

An extensive empirical literature in strategy and finance studies the performance implications of corporate diversification. Two core debates in the literature concern the existence of a diversification discount and the relative importance of industry relatedness and market structure for the performance of diversifiers. We address these debates by building a formal model in which the extent of diversification is endogenous and depends on the degree of industry relatedness. Firms’ diversification choices affect both their own competitiveness and market structure. We find a nonmonotonic effect of relatedness on performance: whereas greater relatedness increases the competitiveness of diversified firms, it can also spur additional diversification, thereby eroding market structure and performance. In this way, our theory also elucidates how heterogeneity in firm scope strategies can emerge even when firms are initially identical. We use the model to generate data and show how the negative effect of relatedness on market structure can give rise to spurious inference of a diversification discount in cross-sectional regressions. We extend our model to show how increases in relatedness can lead to both entry and exit dynamics. A second extension investigates the conditions under which resource endowments make firms more or less likely to diversify.