LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

Understanding Food suppliers

: Diversification

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

1. Definition

■ Diversifications

producing more than one product (across products)

running more than one business (across businesses)

ex) across the products: different products or similar (related) products

Firm

Product A

Product B

Firm

Product AProduct B

Degree of diversification

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

1. Definition

■ Types of diversification (Besanko et al., 2010)

Type of

business

Proportion of Revenue

from Primary business

Examples

Single > 95 % New York Times, DeBeers

Dominant 70 ~ 95% Harley-Davidson

Related > 70 % Abbott Laboratories, RR

Donnelly & Sons

Conglomerate < 70 % 3M, GE

More diversified

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

2. Reasons

■ Market power regarding diversification

Increasing market share increased power to control price or

quantity

■ Economies of scale regarding diversification

■ Reasons of diversification

(i) Exercising market power

(ii) Exploiting economies of scale

(iii) Exploiting economies of scope

(iv) Reducing the firm’s risk

Average

cost

Quantity

LESE204

Depart

ment of

Food a

nd R

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e E

conom

ics

2. Reasons

P, cost

Quantity

DA

MCAACA

■ Economies of scale regarding diversification

<example> under same cost structure

Before diversification

(producing only product A)

- Monopolistic competition in market for A

P, cost

Quantity

MCAC

After diversification

(producing product A and B)

- Perfect competition in market for B

DA

PB

PA

QA QA

PA

QB

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

2. Reasons

■ Economies of scale regarding diversification

<example> under same cost structure

0)()( QCQPQQP BBAAA

0)(

])(

)([

A

A

A

AAAA

A Q

QCQ

Q

QPQP

Q

0)(

B

B

B Q

QCP

Q

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

2. Reasons

P, cost

Quantity

DA

MCAACA

■ Economies of scale regarding diversification

<example> with increased average cost

Before diversification

(producing only product A)

- Monopolistic competition in market A

P, cost

Quantity

MCAC

After diversification

(producing product A and B)

- Perfect competition in market B

DA

PB

PA

QA QA

PA

QB

AC’MC’

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

2. Reasons

P, cost

Quantity

DA

MCAACA

■ Economies of scale regarding diversification

<example> under same cost structure

P, cost

Quantity

MCAC

DA DB

Before diversification

(producing only product A)

- Monopolistic competition in market A

After diversification

(producing product A and B)

- Facing downward slopping curve in market B

PA

QA

PA

QA

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

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2. Reasons

■ Economies of scope regarding diversification

economies of scope:

joint output of in a single firm > output by two different firms that

produce a single product.

< Product transformation curve under economies of scope>

ConcaveProduct A

Product B

100

80

50 100

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

2. Reasons

■ Economies of scope regarding diversification

< Product transformation curve under economies of scope>

Optimal production combination under constraint

example of constraint: capacity constraint like size of factory

Product A

Q’B

Relative price line : PA/PB

Optimal combination of production

without constraint

Optimal combination of production

with constraint

Product B

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

2. Reasons

■ Economies of scope regarding diversification

< Product transformation curve under economies of scope>

Optimal production combination under constraint

example of constraint: capacity constraint like size of factory

Product A

Q’B

Relative price line : PA/PB

Optimal combination of production

without constraint

Optimal combination of production

with new relative price

Product B

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

2. Reasons

■ Economies of scope regarding diversification

< Product transformation curve under economies of scope>

Optimal production combination under constraint

example of constraint: capacity constraint like size of factory

Product A

Q’B

Relative price line : PA/PB

Optimal combination of production

without constraint

Product B

Increase in the capacity

: needs additional cost

needs the comparison between the additional costs and profits

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

2. Reasons

■ Reducing the firm’s risk via diversification

Market condition

Market

condition 1

(cold weather)

Market

condition 2

(warm weather)

Product

Type

Product A

(air conditioner)

1000 profits 500 profits

Product B

(heater)

500 profits 1000 profits

If firm produces only product A or B, profits are unstable(1000 or 500 )

according to the market condition

If firm produces both product A and B, profits are stable regardless of

market condition.

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

3. Measuring the degree of diversification

■ Entropy index

■ Herfindahl index

HHI = S wi2, wi = Si

Si is the share of sales in business i

E = S Si log(1/Si )

Si is the share of sales in business I

Entropy index of the firm producing single product is zero

During the 80s, the average entropy of Fortune 500 firms dropped form 1.0 to 0.67

Fraction of U.S. businesses in single business segments increased from 36.2% in 1978 to

63.9% in 1989 (Besanko et al., 2010)

LESE204

Depart

ment of

Food a

nd R

esourc

e E

conom

ics

3. Measuring the degree of diversification

■ Entropy index v.s. Herfindal index (example)

0.2 0.23

0.4

1.61

1.38

1.23

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

Case A Case B Case C

HHI

Entropy

Case A Case B Case C

s1 0.2 0.4 0.6

s2 0.2 0.2 0.1

s3 0.2 0.1 0.1

s4 0.2 0.1 0.1

s5 0.2 0.1 0.1