Department of Food and Resource Economics

LESE204

Understanding Food
suppliers
: Diversification

Department of Food and Resource Economics

1. Definition
LESE204

Diversifications
producing more than one product (across products)
or running more than one business (across businesses)
ex) across the products: different products or similar (related)
products
Firm
Firm
Degree of diversification

Product A

Product A
Product B

Product B

Department of Food and Resource Economics

1. Definition
LESE204

Types of diversification (Besanko et al., 2010)

Type of
business
Single
Dominant

Proportion of Revenue
from Primary business
> 95 %
70 ~ 95%

Examples
New York Times, DeBeers
Harley-Davidson

Related

> 70 %

Abbott Laboratories, RR
Donnelly & Sons

Conglomerate

< 70 %

3M, GE

More diversified

Department of Food and Resource Economics

2. Reasons
LESE204

Reasons of diversification
(i) Exercising market power
(ii) Exploiting economies of scale
(iii) Exploiting economies of scope
(iv) Reducing the firms risk and smoothing the earnings
stream
Market power regarding diversification
Increasing market share more power to control price or quantity
Economies of scale regarding diversification
Average
cost

Quantity

Department of Food and Resource Economics

2. Reasons
LESE204

Economies of scale regarding diversification

<example> under same cost structure
P, cost

P, cost

MCA
PA

AC

MC

ACA
PA

PB

DA

QA

QB
Quantity

Before diversification
(producing only product A)
- Monopolistic competition in market for A

QA

DA
Quantity

After diversification
(producing product A and B)
- Perfect competition in market for B

Department of Food and Resource Economics

2. Reasons
LESE204

Economies of scale regarding diversification

<example> under same cost structure

PA(QA)QA PBQB C (Q) 0

PA(QA)
C (Q)
[ PA(QA)
QA]
0
QA
QA
QA

C (Q)
PB
0
QB
QB

Department of Food and Resource Economics

2. Reasons
LESE204

Economies of scale regarding diversification

<example> with increased average cost
P, cost

P, cost
MC
MC

ACA

MCA
PA

AC
AC

PA
PB

DA

QA

QB
Quantity

Before diversification
(producing only product A)
- Monopolistic competition in market A

QA

DA
Quantity

After diversification
(producing product A and B)
- Perfect competition in market B

Department of Food and Resource Economics

2. Reasons
LESE204

Economies of scale regarding diversification

<example> under same cost structure
P, cost

P, cost

MCA
PA

AC

MC

ACA
PA

DA

QA

DA
Quantity

Before diversification
(producing only product A)
- Monopolistic competition in market A

QA

DB

Quantity

After diversification
(producing product A and B)
- Facing downward slopping curve in market B

Department of Food and Resource Economics

2. Reasons
LESE204

Economies of scope regarding diversification

economies of scope: Situation in which joint output of a single firm
is greater than the output that could be achieved by two different firms
when each produces a single product.
< Product transformation curve under economies of scope>
Concave
Product A
100
80

50

100

Product B

Department of Food and Resource Economics

2. Reasons
LESE204

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

Optimal combination of production

with constraint
Optimal combination of production
without constraint

Relative price line : PA/PB

QB

Product B

Department of Food and Resource Economics

2. Reasons
LESE204

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
Optimal combination of production
with new relative price

Product A

Optimal combination of production

without constraint

Relative price line : PA/PB

QB

Product B

Department of Food and Resource Economics

2. Reasons
LESE204

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

Increase in the capacity

: needs additional cost
needs the comparison between the additional costs and profits

Optimal combination of production

without constraint

Relative price line : PA/PB

QB

Product B

Department of Food and Resource Economics

2. Reasons
LESE204

Reducing the firms risk via diversification

Market condition

Product
Type

Market
condition 1
(cold weather)

Market
condition 2
(warm weather)

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.

Department of Food and Resource Economics

3. Measuring the degree of diversification

LESE204

Entropy index
E = 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)

Herfindahl index
HHI = wi2, wi = Si
Si is the share of sales in business i

Department of Food and Resource Economics

3. Measuring the degree of diversification

LESE204

Entropy index v.s. Herfindal index

s1
s2
s3
s4
s5

Case A
0.2
0.2
0.2
0.2
0.2

Case B
0.4
0.2
0.1
0.1
0.1

Case C
0.6
0.1
0.1
0.1
0.1