Economies of Scope, Resource Relatedness, and the Dynamics of Corporate Diversification
| DOI | http://doi.org/10.1002/smj.2654 |
| Date | 01 November 2017 |
| Published date | 01 November 2017 |
Strategic Management Journal
Strat. Mgmt. J.,38: 2168–2188 (2017)
Published online EarlyView 21 April 2017 in WileyOnline Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2654
Received 29 March 2014;Final revisionreceived 27 February 2017
Economies of Scope, Resource Relatedness,
and the Dynamics of Corporate Diversification
Arkadiy V. Sakhartov*
Department of Management, The Wharton School, University of Pennsylvania,
Philadelphia, Pennsylvania
Research summary: The dominant view has been that businesses that are more related to
each other are more often combined within diversied rms. This study uses a dynamic model
to demonstrate that, with inter-temporal economies of scope, diversied rms are more likely
to combine moderately related businesses than the most-related businesses. That effect occurs
because strong relatedness reducesredeployment costs and makes rms redeploy all resources to
better performing businesses. The strength of that effectdepends on inducements for redeployment
measured as the current return advantage of one business over another business, volatilities
of business returns, and correlation of those returns. This study develops hypotheses for those
relationships and suggests empirical operationalizations, encouraging empiricists to retest the
implications of relatedness for the dynamics of corporate diversication.
Managerial summary: It is believed that diversied rms are morelikely to combine more-related
businesses because relatedness enables sharing of resources between businesses. Indeed, a rm
can apply knowledge created in one business to another business, avoiding costly duplication in
knowledge development. Resource sharing also adds value when a rm offers several products,
adding the convenience of one-stop shopping and charging higher prices. However, resource
sharing is not the only motivation for corporate diversication. In environmentswhere protability
of businesses changes frequently, rms diversify by redeploying part of resources from an
underperforming business to a better performing business. This study uses a dynamic model
to demonstrate that, with that second motivation for corporate diversication, rms end up
combining moderately related businesses rather than the most-related businesses. Copyright ©
2017 John Wiley & Sons, Ltd.
Introduction
A key rationale for corporate diversication is that
rms aim for economies of scope (Panzar & Willig,
1981; Teece, 1980).1From the resource-based
Keywords: corporate diversication; resource-based
view; resource relatedness; economies of scope; dynamic
choice model
*Correspondence to: Arkadiy V.Sakhartov, Department of Man-
agement, The Wharton School, University of Pennsylvania, 2017
Steinberg Hall-Dietrich Hall, 3620 Locust Walk,Philadelphia, PA
19104-6370. E-mail: arkadiys@wharton.upenn.edu
1While focusing on economies of scope as a motive for
diversication, this study only briey discusses risk-reduction by
rms (Amit & Livnat, 1988; Amit & Wernerfelt, 1990) and does
not explicitly consider agency issues (Amihud & Lev,1981).
Copyright © 2017 John Wiley & Sons, Ltd.
view (Penrose, 1959), such economies represent
a reduction in costs for a diversied rm, which
deploys resources in many businesses, relative to
the costs those businesses would incur if managed
as focused rms. Scope economies were linked
to resource relatedness, the similarity of resource
requirements between businesses (Rumelt, 1974).
Relatedness supports economies by raising the
applicability of resources across the combined
businesses and enabling frugal use of the resources
(e.g., employees, plants, and technological and
marketing knowledge) in those businesses (Hill,
Hitt, & Hoskisson, 1992). In line with that logic,
many empirical have studies conrmed that rms
are more likely to become diversied by entering
Economies of Scope, Relatedness, and Dynamics of Diversication 2169
businesses that are more related to their existing
businesses (Anand, 2004; Chang, 1996; Neffke &
Henning, 2013; Silverman, 1999; Wu, 2013; Zhou,
2011).
Despite the compelling evidence that rms ini-
tiate diversication by entering related businesses,
the impact of relatedness on the dynamics of diver-
sication was unclear.2On one hand, the pattern
that rms are also less likely to exit businesses more
related to their other businesses (Chang, 1996; Lien
& Klein, 2013; O’Brien & Folta, 2009) reinforced
the view that relatedness keeps rms diversied. On
the other hand, relatedness of combined businesses
destabilizes the corporate scope. As Helfat and
Eisenhardt (2004) argued, relatedness enables a
rm to exit a business and enter a new business
making the rm focused rather than diversied.
Lieberman, Lee, and Folta (2017) veried empir-
ically that relatedness of an entered business to a
rm’s other businesses raises the likelihood that the
rm will subsequently exit that business. Together,
those ndings introduced ambiguity regarding the
ultimate effect of relatedness on the diversication
propensity, the probability that a rm will be diver-
sied across two businesses as opposed to being
focused on one of them. In addition to the ambigu-
ity of the effect of relatedness on the diversication
propensity, two other issues were unresolved:
whether relatedness alone sufces to predict the
diversication propensity, and how that propensity
evolves overtime. The lack of clear answers to these
three questions, listed in the rst column of Table 1,
resulted from the respective limitations in previous
research outlined in the second column of the table.3
The rst aw was that, except for Lieberman
et al. (2017), previous studies of the effect of
relatedness on corporate scope choices did not
distinguish between the types of economies of
2The term dynamics of diversication accounts for the full
evolution of a rm’sscope (Helfat & Eisenhardt, 2004) involving
both the expansion of the scope from focused to diversied and
the contraction of the scope from diversied to focused.
3Besides the limitations listed in Table 1, the argument that
relatedness unambiguously enhances the diversication propen-
sity confronts the effect of relatedness on coordination costs.
Thus, Rawley (2010) speculated that relatedness raises coordina-
tion costs offsetting the realized economies of scope. Hence, rms
may be less inclined to diversify relatedly to avoid coordination
costs. That effect was also implied by Zhou (2011) showing that
relatedness between existing and new businesses exacerbates the
negative effect of the complexity of the existing business on the
propensity of the rm to diversify into the new businesses. This
article offers a theory for the non-monotonic effect of relatedness
on diversication that is independent of coordination costs.
scope. According to Helfat and Eisenhardt (2004),
“intra-temporal” economies occur when a rm
shares its resources between related businesses,
whereas “inter-temporal” economies are realized
when a rm exits a business and enters another
related business by redeploying its resources
between them. The focus on the sharing of
resources between related businesses led to the
prevalent belief that relatedness between two
businesses should enhance the propensity of a rm
to be diversied across them (Breschi, Lissoni, &
Malerba, 2003; Fan & Lang, 2000; Lemelin, 1982).
The second shortcoming was that the extant
accounts implicitly assumed that the effect of
relatedness on the diversication propensity is
independent of other determinants of economies
of scope. However, as Penrose (1959) argued,
economies from corporate diversication depend
on “inducements,” return advantages of one busi-
ness over another. Sakhartov and Folta (2015)
formally demonstrated that inducements moderate
the effect of relatedness on economies of scope.
Inasmuch as scope economies determine corporate
diversication decisions, inducements are also very
likely to moderate the effect of relatedness on the
diversication propensity.
The third limitation was that the theory on
the effects of relatedness on the dynamics of
diversication was informal. Nevertheless, verbal
arguments can be “very misleading” when there are
inter-temporal links between choices (Ghemawat
& Cassiman, 2007). With corporate diversication,
such links exist because resource redeployment
is costly to reverse. Hence, in deciding whether
to enter (or exit) a business, a rm considers not
only current redeployment costs, but also costs of
a future exit from (or re-entry into) the business,
making scope decisions path-dependent (Sakhartov
& Folta, 2014). The informal reasoning in that con-
text led to the tenuous idea that relatedness linked to
resource redeployment, unlike relatedness involved
in resource sharing, has only short-run effect on
corporate scope choices (Bryce & Winter, 2009).
Considering the three limitations, this study
reviews the determinants of scope economies and
builds a dynamic model of corporate diversica-
tion. Rooted in the general principle of dynamic
optimality (Bellman, 1957), the model identies
the sequence of a rm’s scope choices. The sim-
ilarity between such choices and the allocation of
wealth across securities by investors (Merton, 1969)
enables the use of the simulation-based portfolio
Copyright © 2017 John Wiley & Sons, Ltd. Strat. Mgmt. J.,38: 2168–2188 (2017)
DOI: 10.1002/smj
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