Concept and Motives of DIVERSIFICATION, INTEGRATION AND.pptx

This presentation talks about diversification and its types and why its needed and what are its motives

1. Md. Firdos Ahmad Department of Economics AMU CONCEPT AND MOTIVES OF DIVERSIFICATION, INTEGRATION AND MERGER

2. Diversification A firm produces some varieties of a product which are close substitutes for each other in the market. If the firm adds more variety of the product, then it is not diversification. We may simply call it product variation or differentiation. However, if the firm produces a totally different product which is not a substitute forth existing products in the market then it is called diversification. When a leather tanning firm starts manufacturing boots and other leather goods, we will then call it diversification because here the products are different as a result of which the market ‘area’ for the firm expands from one class of consumers to another one. Diversification is thus “the spreading of its operations by a business over dissimilar economic activities”. In the process of diversification, a firm makes significant changes in its ‘areas’ of operations related to technological base, market areas and productive activities.

3. Four different possibilities have been mentioned by Penrose for this When there are additional products within the firm’s existing technological bases and market areas, 2) When there are products involving the existing technological bases but destined to new market areas, When there are products which involve altogether new technological bases for existing markets, and 4) When there are new products with new technological bases for new market areas. Diversification thus cannot be conceived of changes in the products only; it implies the other two aspects of the change also, i.e., changes in the technological base and market areas. Anoff has taken diversification in a slightly different way. According to him, it is one of the four strategies which he named as ‘market penetration’, ‘market development’, ‘product development’ and ‘diversification' . 1) Market Penetration- It involves increasing company sales without departing from the original product-market strategy. The firm sells more to the existing customers and/or gets new customers for its products. 2) Market Development-It is a situation in which the firm adopts its existing product line by modifying it; characteristics to satisfy the needs of the customers in different markets.

4. Cont.. We may conceive this situation ‘when the product line of the firm is more or less constant but new uses for them are being searched. An aircraft company, for example, may modify its passenger plane to carry goods and, thus, enter in the goods ‘market for haulage. 3) Product Development- It is defined as expansion of product line by the firm to suit the different requirements of customers. Market ‘area’ is constant here but new products are being added to meet the needs of existing customers. The goods may be altogether different. For example Bread and butter for the urban consumers. 4) Diversification- It is the situation when product line as well as markets are expanding. Introduction of new products means enlarging the technological bases and marketing areas and strategies as well as the administrative expertise since all these aspects are interlinked.

5. Motives for Diversification Motives for diversification depend on its types. The types of diversification as observed in practice and motives for them are as following 1. Lateral Diversification When a firm produces different goods which diverge from the same process or source, or which are used as same materials for the same process or market. For example, a leather tanning firm will have lateral diversification when it starts making boots and shoes, leather garments and suitcases itself, because all such business“ diverge from leather tanning business. Similarly, a meat seller will have lateral diversification if it starts selling hides, horns, bones and even raw wool.

6. A firm may resort to lateral diversification because of the following reasons When production of one commodity of necessarily involves production of another, say, in by-products form, there would be a natural scope for lateral diversification in order to avoid wastages and gain advantages from the business. Production of mutton and wool, lubricants, paraffin, raw chemicals, etc. together with petroleum refining, coal, coke, and their by-products such as benzene, etc., is few examples of this situation. When market demand for existing products is declining or stagnant, a firm has to diversify its business laterally in order to maintain its earnings or to increase it. Better utilization of existing facilities such as managerial talents, R&D activities and certain categories of machines, etc., may be looked as a motive for lateral diversification. This leads to the economies of scope as a major source of lateral diversification. The market complementarity or interlocking pattern in seasonal demand also leads to lateral diversification say, for example, one may produce colours and water sprayers together for Holy festival. This type of diversification when done through merger brings more market power by reducing competition and through extension of operations in different industries. To maintain the rate of growth, without being accused of monopolizing this type of diversification is very much suitable and actually being followed all over the world. Lateral diversification is an effective barrier to entry to reduce potential competition.

7. Conglomerate Diversification This type of diversification, the products need not to have diverged from the same product or source, or converge at the same process or market as is the situation in the case of lateral diversification. The products will be quite unrelated. Why a firm adopts such pattern will be discussed in details under ‘motives for merger’. This stage we can simply express that all motives of lateral diversification will also be the motives of conglomerate diversification. In brief, it helps in extension of market power of the firm; brings stability in earnings through cross-subsidization, i.e., loss of one product is covered by the gain from other; causes an increase in the barriers to entry; provides more options for risk-taking for the sake of profits, through economies Scope maintains the process of growth; gives pecuniary gains to the firm; provides better utilization of me facilities, and so on.

8. Vertical Diversification This is vertical integration in fact. It involves diversification into process of manufacturing or distribution which precedes or succeeds those in which the firm is already engaged. It can be either ‘backward integration or forward integration’. The first one is seen where a firm starts manufacturing products previously purchased from others in order to use them in making its original product line. A chocolate firm, for example, may have its own cocoa plantation farm. A milk product company may have its own dairy farm and similarly, a bakery may have its own flour mill and so on. The second type, i.e., ‘forward integration’ occurs when the firm moves nearer to the final market for its product and carries out a function which was previously undertaken by its customers. A shoemaking firm may start its own distribution or selling shops like Bata Shoe Company, a flour mill may start making its own bakeries; a spinning mill may also start weaving activities and like that are few examples of forward integration. Vertical diversification, whether initiated by a firm itself or occurring by merging of two or more firms has several motives some of which are as follows.

9. Cont … 1. It provides security to the firm. Say, a firm integrates backward in order to have assured sources of supplies. The intensity of such integration will be more when demand conditions for the final product of the firm are very bright. Similarly, the firm integrates or diversifies in forward direction in order to assure market for its product. When demand conditions are slacking, such integration is likely to be more intensive. Vertical diversification or integration provides economies of linked processes and, thus, the efficiency of the firm goes up due to improvements in capacity utilization. There will be economies in marketing such as saving of transportation, advertisement, procurement and selling costs. All these imply a saving in the transaction costs. There may be saving by eliminating ‘the middle man’ and his ‘unnecessary’ profit-margin in the process of production. On the whole the firm gets more market power through its size or absolute cost advantages or pecuniary gains through vertical integration. It gives strength to the barriers to entry and therefore, reduces competition in the market.

10. Diagonal Diversification or Integration It consists of the provision within the same organization of auxiliary goods and services required for several main processes or lines of production of the organization. For example, a firm may have its own power plant to generate electricity or machine-tool making units since such things are required for running almost every processing activity. The motives of diagonal diversification or integration will be more or less the same as for lateral and vertical diversification. Among them the major one will be (i) mopping up of excess capacity, (ii) economies of scope and (iii) reduction of the risks.

11. The motives of all types of diversification can now be summarized in condensed form as ( i ) profitability or earning motive which implies fuller utilization of resources/capacities at the disposal of the firm; (ii) stability motive which implies reduction of risks and uncertainties through assured supplies of resources and markets for main line of production; (iii) growth motive which means expansion of productive capacities without being charged for being monopolizing, and in the face of market limitations; and (iv) market power motive which is assured through increase in barriers to entry as a result of diversification One may further condense these four motives of diversification in the two categories that is ‘creation of value‘ and ‘spreading of the empire’. In general, a new industry will have higher degree of diagonal and vertical integration but a mature industry will resort to more lateral diversification. This is because, in the case of a new industry, auxiliary services may not be available at all, so the firms have to make for their provision within its organization for a mature industry like textiles the demand for such services will be large enough, so independent units may come into existence for their supplies in an efficient way.

12. Merger This term refers to amalgamation or integration of two or more firms. The firms under different ownership and management controls come under a unified one through merger. The terms ‘acquisition’ and ‘takeover’ are also used for ‘merger’, which implies that a firm acquires assets or stocks in pan or full, of other firm or firms to get operational control over them. In legal sense, there is difference between these terms but from point of view of the economic analysis they are alike. The important feature of merger, that is relevant to us, is the transfer of control of business activity from one firm or firms to other. There are three different situations of merger: (l) a horizontal integration or merger of firms whose products are viewed by buyers as identical, that is their products have high cross elasticities of demand and supply, (2) a vertical integration or merger of firms where there is a successive functional link between their products, that is, the output of a firm is input for the output of another firm at higher stage of production. There may be such integration between a producing and a marketing firm for the same commodity or commodities and, (3) a conglomerate integration or merger of firms which are producing altogether different products, i.e., which are not substitutes for each other (zero cross elasticity of demand and supply) such a; merging of a cloth making firm and a drug manufacturing one. The amalgamated firm in this situation will be a market-diversified firm. Diversification is also implied in the situation of vertical merger. The terms ‘diversification’, ‘vertical integration’ and ‘merger’ have been defined above in brief. We have to examine now the motives behind them.

13. Motives for Merger Merger implies diversification except horizontal integration between the firms. The motive of diversification will therefore be equally applicable to merger also. However, there are some other important motives of merger which are not linked with diversification. Thus the general motives for all types of merger are: 1. Increase in profitability This may be possible either through increased degree of diversification of the combined firm or through other consequences of merger such as increased efficiency and market power. 2. Stability in earnings Profit rates of individual firms whether they are in the same industry or the other, may fluctuate widely as they are exposed to a greater degree of risks. \ When they merge together there may be little variation in their combined profit rate. This means they get stability in earnings by merger. The variability of profit rates are generally measured through their variance or standard deviation. The variance of profit rates of the combined or merged firms will be lower than the variance of the profit rates for the individual firms.

14. Cont… A simple situation for this is seen when one firm is having negative profit rate, the other one positive. When both merge together, there will be likely a table positive profit rate for them. This is what we may take as cross subsidization motive for the sake of stability and reduction of risks. It may be emphasized here that a reduction in variability of profit rate is a possible but not a necessary outcome of merger. There may be situation when there is an increase in it as a consequence of unforeseen business uncertainties after merger.  3. Stock market gains Financial experts attribute the motive of merger largely for stock market gains. Firms would like to merge together if there is a difference in the earning price ratio or market price for their shares in the stock market. There will be mutual gain for them through merger in this situation. We can show this by taking a simple example. Let us consider merger possibility of two companies, company A and company B. Company A has 2500 shares outstanding in the market and earns Rs. 15000 as profit after tax and interest. Its earning per share would thus be Re. 0.60. Company B has 50,000 share outstanding and Rs 50,000 as profit after tax and interest which gives it Re. 1.00 as earning per share. Now let us assume that market price of the shares of the company A is 10 times its earning per share, that is 10x0.6=Rs. 6.

15. Cont … Similarly, we assume that market price for the shares of company B is 20 times of its earning per share, i.e. 20 x l.0 = Rs. 20. Clearly there is a marked difference between the market prices of the shares of the companies A and B in this case. Suppose company A merges with company B. One modality for this is that company B offers higher market price for the shares of company A, say Rs. 10 per share. Company A will accept it gladly since it is getting Rs. 4 extra over the market price of its share. Company A will, in fact, be having 25,000 X 10/20 = 12,500 shares in Company B's equity after merger. Total number of shares of the combined (or merged) company would be 62,500. let us now assume that their combined profit is simple arithmetic sum of the previous situation, i.e. Rs. 15,000 + Rs. 50,000 = Rs. 65,000. The earning per share would be Rs. 65,000/62,500= Rs . 1.04. If market price of share for company B, which acquires company A, continues to be 20 times earnings per share, it will be then 20 X 1.04 = Rs. 20.80. Thus, we find a marginal increase of Re. 0.80 in the market price per share for company B, is a net gain to it after merger. Both the companies are better off in the stock-market as a result of their merger

16. Cont.. The inducement for merger in this situation is apparent from the fact that company A has a lower earning per share as well as a lower price-earning ratio than that of company B. It is, therefore, in its interest to merge with B. Suppose the situation is reversed. That is, company B which is a large one has lower earning per share and price-earning ratio than that of A's would then is an inducement for merger between them? Normally not, since it implies a loss in stock market for company A. However, if company B wants to acquire company A in this situation, it will be through an acquisition rather than through a merger. Acquisition means buying of the company.

17. 4 . Efficiency Motive This motive may be stronger in the case of ‘horizontal’ and ‘vertical’ mergers. As a result of such integration one can expect economies of scale in a variety of ways, such as reduction in inventory requirements, transportation and distribution costs, duplicate R&D activities, cheaper raw materials due to increased size of purchases, better management, etc. In the case of conglomerate merger such economics of scale are doubtful but there may be better management and more pecuniary gains. Coase and Weiss have found some evidence about the saving of costs by merger but Gort's findings have shown the opposite picture. The empirical material is almost negligible; so the test of efficiency hypothesis a motive for merger is still an open issue.

18. 5 . Market Power Motive Fred Weston, however mentioned the factors: (1) extended monopoly power, (2) encouraged cross-subsidization, (3) increased ‘deep pocket’ advantages, (4) increased entry barriers, (5) increased non-economic reciprocity arrangements, (6) increased macro-concentration, and (7) increased size of power groups, as sources for market power for conglomerate firms.

19. 6 . Growth Motive This is a possible outcome of merger. A firm grows or builds its empire by expanding itself in the market or by acquiring some existing firm or through merger. It is true that the combined firm after merger will command more assets, more sales, and more market power but should we call it growth or just a mere consolidation of the firms in the market? Take for example, two firms integrating horizontally. If synergy is observed after their merger in assets, sales or output, we may then support the growth motive; otherwise it is a consolidation of the firms. Same situation may arise in the case of vertical integration and conglomerate mergers. There may not be growth of the market but consolidation among the firms which in due course may encourage growth but not immediately. Further, for any type of merger we may take the accompanying process of diversification as a source of growth rather than the merger itself. It is not clear so far how much growth is to be attributed to the diversification and how much to the merger. Gort has no doubt found positive evidences on growth motive hypothesis of merger, but by and large, it is still an unexplored area.