Vertical Is the New Horizontal

27 June 2008 at 6:15 am 6 comments

| Lasse Lien |

Unrelated horizontal diversification is widely seen as smoking-gun evidence of agency problems, and heavily sanctioned by capital markets, boards, media, etc. Consequently, we don’t see much blatant conglomeration anymore. But if you are a manger with a strong desire to build an empire, or more generally grow at “all costs,” what do you do?

My conjecture is that unjustified vertical integration is increasingly taking the place of unjustified horizontal diversification as an expression of such tendencies. Why? Simply because the penalties (i.e. the costs) of growing via the latter have increased, which presumably creates a tendency to substitute towards the former.

Admittedly, I don’t have much data to support this, but I do seem to recall that Fan & Lang (2000) found a strong positive link between verticality and the diversification discount. Less scientifically, I have tourist sampled the link between vertical integration and government ownership in my home country (Norway). There seems to be a strong positive correlation between public ownership and vertical integration, but no obvious correlation with horizontal diversification.

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6 Comments Add your own

  • 1. Peter Klein  |  27 June 2008 at 10:37 am

    An interesting (and IMHO underappreciated) paper in this regard is John Matsusaka’s “Did Tough Antitrust Enforcement Cause the Diversification of American Corporations?” JFQA, June 1996. He challenges the (usual) view that US firms became conglomerates in the 1960s because antitrust law prevented them from making horizontal mergers, leaving diversification as the only option for growth-oriented firms. He finds, in contrast, that mergers between small firms (less likely to be challenged by antitrust authorities) were just as likely to be diversifying as mergers between large firms. This doesn’t exactly get at Lasse’s point but deals with the general issue of firms expanding across a particular dimension because they’re unable to expand across another, preferred dimension.

  • 2. Michael F. Martin  |  27 June 2008 at 4:03 pm

    I recommend also this paper by Richard A. Booth:

    He points out that the shift from conglomerates to mutual funds occurred after the NYSE abolition of fixed commissions for institutional investors — in effect, M&A became more expensive than diversification through mutual funds overnight.

    As Peter’s comment suggests, there are multiple moving parts here. In addition to antitrust law, I believe that modern portfolio theory’s influence on managers and investors, relative transactions costs, and the availability of credit through the bond market (or the Fed!) have had an influence on these issues.

  • 3. Peter Klein  |  27 June 2008 at 4:18 pm

    Michael, thanks for the pointer to Booth. Looks valuable. I’ve made a similar point elsewhere, though less elegantly than you. Quoting myself:

    To explain the particular pattern of mergers and acquisitions observed in the 1960s, 1970s, and 1980s, market-process explanations must introduce changes in the legal, political, competitive, or regulatory environments across these years. In other words, why was it more difficult for entrepreneurs to forecast — based on their own Verstehen as well as generally available information — the success of acquisitions in the 1960s and 1970s? Why did entrepreneurs feel a greater need to experiment with various combinations of businesses during the 1960s and 1970s?

    A likely candidate is the SEC’s deregulation of brokerage houses in 1975 and the subsequent end of fixed-price commissions. The investment community in the 1960s has been described as a small, close-knit group where competition was minimal and peer influence strong (Bernstein, 1992). As Bhide (1990, p. 76) puts it, “internal capital markets . . . may well have possessed a significant edge because the external markets were not highly developed. In those days, one’s success on Wall Street reportedly depended far more on personal connections than analytical prowess.” During that period the financial markets were relatively poor sources of capital. The effect of deregulation, not surprisingly, was to increase competition among providers of investment services. “This competitive process has resulted in a significant increase in the ability of our external capital markets to monitor corporate performance and allocate resources” (Bhide, 1990, p. 77). As the cost of external finance has fallen, firms have tended to rely less on internal finance, and thus the value added from internal capital market allocation has fallen.

  • 4. Michael F. Martin  |  27 June 2008 at 7:42 pm


    We clearly share a common view of what’s going on. I was glad to have found your blog and you through the Creative Capitalism blog.

    I’ve added this blog to my feed reader. I’ll look forward to keeping up with your work.

  • 5. Rajiv Krishnan KOZHIKODE  |  30 June 2008 at 4:30 pm

    I am not an emerging economy researcher, but my observation suggest that the story about unrelated diversification being an evidence of agency concern doesn’t seem to hold in emerging economies. Two things need to be addressed here. First, is it bad for corporations to engage in conglomerate diversifications? Second, what is the motive for such a diversification? The answers to both these questions are subject to the context. While in developed economies like the US and UK, the market for entrepreneurship and that for corporate control are more efficient than they are in the emerging economies such as India and China. The efficiency of these markets determines whether there would be enough entrepreneurs to participate in the market for new ventures and whether the control of corporation would be in the hands of a powerful few or whether it would be dispersed. In the case of emerging economies, owing to the lack of efficient markets for entrepreneurship, not many new players are willing and capable of venturing into virgin areas, even if these areas might have tremendous potential. Therefore, an opportunistic firm with sufficient slack resources would grab the opportunity even if this would mean unrelated diversification. The lack of competition arising from the inefficient market for entrepreneurship would eventually help the opportunistic firm to profit from its conglomerate diversification without much difficulty. Moreover, the lack of efficient markets for corporate control would mean that the managers of these firms have ultimate control over their decisions. However, this does not mean that they would display hubris or narcissism. In most cases, the managers who make such decision on conglomerate diversification are also the owner of the corporation and in such cases there is only minimal separation of ownership and control, a necessary condition for agency concerns to exist. Hence, these owner managers are not acting as agents, but they are more of efficient stewards (read captains) who steer their corporation toward a brighter future. For example, the Ambanis did it for Reliance, Ratan Tata did it for Tata and Asim Premji did it for Wipro. These business leaders are continuing to steer their conglomerates into virgin avenues. I think the “managers as agents (with a capital A)” assumption should be dropped and instead let the empirics decide the same. We ought to be a little more tolerant towards the managers and give them a fair treatment.

    Rajiv Krishnan Kozhikode
    ( )

  • 6. Lasse  |  1 July 2008 at 6:33 am

    Thanks for posting. Good point. I certainly agree with you that there are better arguments for conglomerate diversification in emerging markets. As I am sure you are (but others may not be) aware of , Khanna and Rivkin have made similar points (2001, 2006). Note also that I’m not trying to characterize all managers, but simply say that in situations were the agency theory of diversification applies, the wide public acceptance of this theory changes the relative costs of growing vertically vs. horisontally. Vertical will always be somewhat related, and therefore more difficult to challenge and less likely to lead to sanctions.
    And finally, yes, unless you’re a mathematician, empirics should decide, always and evrywhere .

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