88 • Chapter 2 • The Horizontal Boundaries of the Firm

Finally, note that successful bidders tend to suffer from the “winner’s curse.” In other words, the firm with the most optimistic assessment of the target’s value will win the bidding. Given that all other bidders’ estimates of the target’s value are below the final purchase price, it is likely that the winner has overpaid. As Max Bazerman and William Samuelson point out in their article “I Won the Auction but Don’t Want the Prize,” unless the diversifying firm knows much more about the target than other bidders do, it will probably pay too much to “win” the bidding.19

Reasons Not to Diversify

When scope economies are not available, there are several reasons to avoid diversification. Within a diversified portfolio of holdings, a conglomerate will have some divisions that outperform others; the profitable ones effectively cross-subsidize the money losers. Not only does this reduce the share value of the conglomerate, it reduces the incentives of the managers of the money-losing divisions, who would be far more concerned for their jobs if theirs were stand-alone businesses.

Other reasons to avoid diversification may be loosely classified as stemming from bureaucracy effects. We take up most of these reasons in Chapter 3 in the context of vertical integration. Here is a brief synopsis. It is difficult to maintain the hard-edged incentives of the market within a diversified firm. The allocation of internal capital may suffer due to influence activities, whereby each division and work unit manager seeks corporate resources to advance their own careers. Finally, diversification imposes a uniform organizational design on business units that may benefit from different organizational structures.

MANAGERIAL REASONS FOR DIVERSIFICATION

A key feature of large corporations in modern economies is the separation of ownership and control. Hence, it is important to know whether managers may undertake diversifying acquisitions that do not generate net benefits for the firm’s shareholders.

Benefits to Managers from Acquisitions

One reason managers may diversify is that they enjoy running larger firms. As Michael Jensen puts it:

Corporate growth enhances the social prominence, public prestige, and political power of senior executives. Rare is the CEO who wants to be remembered as presiding over an enterprise that makes fewer products in fewer plants in fewer countries than when he or she took office.20

One might wonder whether this is a bad thing; after all, don’t shareholders want their firms to grow and prosper? Of course they do, but it is important to realize that growth can be either profitable or unprofitable. Shareholders want their firms to grow only if such growth leads to increases in profits. Jensen’s claim is that managers value growth whether or not it is profitable, especially if the manager’s compensation is only loosely tied to overall profitability and the manager personally values firm size, perhaps due to social prominence or prestige.

Although it is difficult to devise precise measures of such abstract notions as social prominence and public prestige, researchers have identified some ways in which