Opportunity costs and non-scale free capabilities: profit maximization, corporate scope, and profit margins

• Published in: Strategic management journal Vol. 31; no. 7; pp. 780 - 801
• Main Authors: Levinthal, Daniel A., Wu, Brian
• Format: Journal Article
• Language: English
• Published: Chichester, UK John Wiley & Sons, Ltd 01.07.2010; John Wiley & Sons; Wiley; Wiley Periodicals Inc
• Subjects: Business structures; corporate diversification; Corporate finance; Corporate strategies; Debt management; Diversification; diversification discount; Diversifikation; Duopol; Economic resources; Empirical research; firm capabilities; Industrial market; industry dynamics; Modeling; opportunity cost; Opportunity costs; Opportunitätskosten; Penrose, Edith T; Planning methods; Portfolio diversification; Product diversification; Product markets; Profit margins; Profit maximization; resource-based view of the firm; Ressourcenorientierter Ansatz; Strategic management; Studies
• ISSN: 0143-2095; 1097-0266
• DOI: 10.1002/smj.845

The resource-based view on firm diversification, subsequent to Penrose (1959), has focused primarily on the fungibility of resources across domains. We make a clear analytical distinction between scale free capabilities and those that are subject to opportunity costs and must be allocated to one use or another, thereby shifting the discourse back to Penrose's (1959) original argument regarding the stock of organizational capabilities. The existence of resources and capabilities that must be allocated across alternative uses implies that profit-maximizing diversification decisions should be based upon the opportunity cost of their use in one domain or another. This opportunity cost logic provides a rational explanation for the divergence between total profits and profit margins. Firms make profit-maximizing decisions to increase total profit via diversification when the industries in which they are currently competing become relatively mature. Due to the spreading of these capabilities across more segments, we may observe that firms' profit-maximizing diversification actions lead to total profit growth but lower average returns. The model provides an alternative explanation for empirical observations regarding the diversification discount. The self-selection effect noted in recent work in corporate finance may not be indicative of inferior capabilities of diversifying firms but of the limited opportunity contexts in which these firms are operating.