Much of this corporate diversiﬁcation literature takes the existence of core competencies as given and asks, ‘What is the most eﬃcient way to exploit the value of these core competencies?’ Diversiﬁcation is one of the answers that is provided to this question.
However, a logically prior question is also possible. That question is: ‘Where do core competencies that might be exploited across multiple businesses come from in the ﬁrst place?’ In answering this question, it is possible to show that over and above any eﬀect that core competencies might have on diversiﬁcation, diversiﬁcation might have an impact on the development of core competencies.
Indeed, there is a paradox at the heart of current resource-based theories of superior ﬁrm performance. On the one hand, these theo- ries recognize that employee ﬁrm-speciﬁc investments are among the most important sources of economic rents for ﬁrms (Barney 1991a). Employee ﬁrm-speciﬁc investments—including employee knowledge of how a ﬁrm operates, knowledge about a ﬁrm’s key suppliers and customers, and knowledge about how to work eﬀectively with other employees— often meet the criteria established in resource-based logic for generating sustained competitive advantages (Dierickx and Cool 1989; Barney 1991a).
The rents generated by these ﬁrm-speciﬁc investments are often shared between a ﬁrm’s employees and its owners (Becker 1964; Hashimoto 1981; Rumelt 1987) and thus can be a source of wealth for both the employees and the owners.1
On the other hand, a great deal of research in organizational economics suggests that employees who make ﬁrm-speciﬁc investments risk oppor- tunistic actions by the ﬁrms in which they invest (Williamson 1985). Once employees make ﬁrm-speciﬁc investments, ﬁrms can systematically extract wealth from these employees and employees have few ways they can pro- tect themselves. Indeed, the hazards associated with making ﬁrm-speciﬁc investments are so signiﬁcant that, absent some protection, current the- ories suggest that employees will avoid making ﬁrm-speciﬁc investments altogether (Alchian and Demsetz 1972).
A great deal of research has documented ways that employees can pro- tect themselves against the threat of opportunistic behaviors if they make ﬁrm-speciﬁc investments (Williamson 1975, 1985). Additional work has identiﬁed ways that ﬁrms can credibly reassure employees that they will not behave opportunistically in such settings (Jensen and Meckling 1976; Grossman and Hart 1986; Castanias and Helfat 1991; Rajan and Zingales 1998). With these protections and reassurances in place, current theory seems to suggest that employees will be willing to make ﬁrm-speciﬁc investments.
However, beyond the threat of opportunism that plagues speciﬁc invest- ments made by employees, there is another risk accepted by employees making these investments that has received less attention in the literature.2 This is the risk that the value of the underlying assets controlled by a ﬁrm— the assets that an employee makes investments speciﬁc to—will fall. If these assets drop in value, then the value of the investments made by employees that are speciﬁc to these assets will also fall. This will be the case even if none of the parties in this exchange engage in opportunistic behaviors. Employees may be very reluctant to make ﬁrm-speciﬁc investments when the future value of a ﬁrm’s underlying assets is very risky, even if protec- tions and reassurances are in place that eﬀectively eliminate any threat of opportunism in this exchange.
Here, the implications for both employees and ﬁrms of these risky assets are examined. For employees, it is shown that risky core ﬁrm assets can reduce employee incentives to make ﬁrm-speciﬁc investments, even when there is no threat of opportunism in these exchanges. Some actions ﬁrms can take to address concerns employees might have about making spe- ciﬁc investments in risky ﬁrm assets are discussed. These actions include directly compensating employees for risk bearing and engaging in a par- ticular type of corporate diversiﬁcation—resource-based product market diversiﬁcation. This latter mechanism is then explored in detail, and the implications of this analysis for the theory of diversiﬁcation are then dis- cussed. We begin by developing a simple model of employee decisions about whether to invest in ﬁrm-speciﬁc human capital that depends both on the threat of opportunism in this exchange and the riskiness of the value of a ﬁrm’s underlying assets.
1. A MODEL OF EMPLOYEE DECISIONS TO MAKE FIRM-SPECIFIC INVESTMENTS
Two kinds of resources are important in a model of the employee deci- sion to make ﬁrm-speciﬁc investments: (a) the rare and costly to imitate resources controlled by a ﬁrm that an employee is contemplating making speciﬁc investments in, and (b) the resources controlled by an employee that will be modiﬁed if speciﬁc investments are made. Here, the ﬁrst kind of resource is called a ‘core ﬁrm resource’ and the second kind is called a ‘human capital resource’.
Of course, not all the resources controlled by a ﬁrm are rare and costly to imitate—that is, not all the resources controlled by a ﬁrm are core ﬁrm resources as deﬁned here. Indeed, many noncore ﬁrm resources, that is, many ﬁrm resources that are not rare or costly to imitate, may be necessary if a ﬁrm is to gain competitive advantages and earn economic rents. How- ever, these common and imitable resources do not separate ﬁrms that have the potential to gain competitive advantages from those that do not have this potential. These ﬁrms are separated by the rare and costly to imitate resources they do and do not control.
It is also the case that just possessing rare and costly to imitate resources, by itself, is usually insuﬃcient for a ﬁrm to generate economic rents. In addition, employees need to know how to exploit these resources through the strategies a ﬁrm pursues. As Porter (1991: 108) argued, ‘resources are not valuable in and of themselves, but they are valuable because they allow ﬁrms to perform activities.’
Noncore ﬁrm resources are neither rare nor costly to imitate, and thus can be exploited by nonspeciﬁc human capital investments made by a ﬁrm’s employees. However, core ﬁrm resources will generally require highly ﬁrm-speciﬁc investments in human capital if they are to be exploited in a ﬁrm’s strategies. That is, employees must understand the nature of these core resources, develop a working knowledge of how they can be used in conceiving of and implementing strategies, and how they can be protected and nurtured over time if they are to be fully exploited in creating competitive advantages and economic rents. These human capital investments have little value in alternative settings, but can create a great deal of value in a particular ﬁrm.
Now, consider an employee, i , of a ﬁrm choosing an optimal level of human capital investment speciﬁc to a ﬁrm’s core resource. The amount (units) of speciﬁc investments made by this employee is denoted as xi . It is further assumed that the payoﬀ that the employee is expected to appropriate from the total rent generated per unit of his/her speciﬁc investment (in combination of the core resource of the ﬁrm) is a fraction, a(0 < a < 1), of the total expected amount of rent generated per unit of his/her speciﬁc human capital investment, ri . ri is in turn an increasing function of the value of the ﬁrm’s core resource, V . The more valuable the core resource, the more potential rents can be generated from this core resource (∂ri /∂V > 0). Thus, the amount of rents appropriated by the employee is ari .
Also, assume that the employee incurs an opportunity cost while making speciﬁc human capital investments. The opportunity cost comes from the fact that instead of making speciﬁc human capital investments, the employee can alternatively make general human capital investments, for example, developing skills that improve his/her marketability. Since gen- eral human capital does not suﬀer the problem of value loss in case of transferring across business settings, the payoﬀ from the employee’s per unit general human capital investment is denoted as w¯ i , which is assumed to be a constant.3
The total units of human capital investments, including both speciﬁc and general, is denoted as n (n can also be thought of as the total hours the employee devotes to making these investments). Since xi is the total amount of speciﬁc investments, the amount of general investments is then (n − xi ). Thus, the employee’s total payoﬀ, denoted as wi , includes the payoﬀs from both his/her speciﬁc human capital investments (xi ari ) and his/her general human capital investments [(n − xi )w¯i ]:
The employee then chooses the optimal amount of ﬁrm-speciﬁc invest- ments, xi , that maximizes his/her utility. The employee’s concern over the risk associated with the payoﬀ from his/her investments can be cap- tured using a risk-averse utility function. The particular form of standard mean variance utility function is thus chosen to capture the idea that employee utilities increase with the expected amount of payoﬀ from his/her investments, E (wi ), but decrease with the risk associated with this payoﬀ, var(wi ) (Sargent 1987). It follows that the employee solves the following utility function, subject to his/her payoﬀ constraint4:
A is the absolute risk-averse parameter that captures the employee’s degree of risk aversion. Without loss of generality, the parameter, A, is normal- ized to 1 (A ≡ 1). The wealth constraint shows that when the employee increases his/her level of speciﬁc human capital investment (higher xi ), his/her total wealth will covary more with the expected rents generated per unit of speciﬁc human capital investment.
From the ﬁrst-order condition with the normalized risk-aversion para- meter (A ≡ 1), the optimal amount of speciﬁc human capital investment chosen by the employee can be obtained as follows (please see appendix of this chapter for a more detailed derivation):
This equation has several important implications. First, the numerator of this equation suggests that the optimal amount of speciﬁc human capital investments an employee chooses to make (or, an employee’s incentive to specialize), xi*, depends on the amount of rents the employee is expected to appropriate, aE(ri ), relative to the rents from risk-free general human capital investments. This is perfectly consistent with previous research in organizational economics which suggests that employee investments in ﬁrm-speciﬁc human capital can generate economic rents, but the will- ingness of employees to make these investments depends on how much of the rent they expect to be able to appropriate (Grossman and Hart 1986; Hart and Moore 1990; Castanias and Helfat 1991, 2001; Rajan and Zingales 1998, 2001). Moreover, a small amount of rent appropriation suggests that an employee expects signiﬁcant opportunistic actions on the part of a ﬁrm, while a large amount suggests that an employee does not expect such actions. Eﬀorts by employees to contractually protect them- selves from opportunism, and eﬀorts by ﬁrms to reassure employees that they will not behave opportunistically, can both be interpreted as eﬀorts to guarantee that the employees will realize their expected amount of rent appropriation and thereby increase the likelihood that these employ- ees will make speciﬁc human capital investments that generate economic rents.
Second, xi* is inversely related to var(ari ), the risk associated with the amount of rent that the employee expects to appropriate per unit of his/her
speciﬁc human capital investment. This establishes a basis for the analysis in this chapter: the incentives for an employee to make speciﬁc human capital investment are negatively aﬀected by the risk to the per unit payoﬀ from his/her speciﬁc human capital investment. As ri , the rents generated from an employee’s speciﬁc human capital investment, increases with V , the value of the core resource owned by the ﬁrm, so does the payoﬀ to the employee from his/her per unit speciﬁc investment, ari . It then follows that the riskiness of this payoﬀ, var(ari ), should also increase with the riskiness of the value of a ﬁrm’s core resources. That is, when the value of a ﬁrm’s core resource falls, so does the value of employee ﬁrm-speciﬁc investments and the potential payoﬀ the employee obtains from these investments. Therefore, the riskier is the value of a ﬁrm’s core resources, the lower the employee’s incentives to make speciﬁc human capital investments.
A lower level of ﬁrm-speciﬁc human capital investments, in turn, reduces the total amount of rents that can be generated from the underly-ing core resources and the amount of rents that is eventually appropriated by the ﬁrm. In this setting, the ﬁrm has a motive to adopt mechanisms to mitigate employee concerns over the risk to the value of the core resource to induce employees to make these rent generating investments.
1. MANAGING THE RISK OF FIRM CORE RESOURCES AND EMPLOYEE INCENTIVES TO MAKE FIRM-SPECIFIC INVESTMENTS
Thus, in order for a ﬁrm to induce its employees to make ﬁrm-speciﬁc investments, not only must potential opportunism problems in this exchange be managed, but ﬁrms must also discover ways of managing the risks associated with making human capital investments that are speciﬁc to a ﬁrm’s risky core resources. Two possible solutions to this problem are considered here: (a) compensating employees directly for accepting these risks, and (b) using resource-based related diversiﬁcation to mitigate these risks.
Compensating employees for risk bearing
The most straightforward solution to the employee incentive problem stemming from the riskiness of a ﬁrm’s core resources seems to be for the ﬁrm to directly compensate employees it needs to make ﬁrm-speciﬁc investments for bearing this risk. That is, to get these ‘key employees’ to make ﬁrm-speciﬁc investments, pay them to do so. Theories and empirical ﬁndings in the strategic management literature indeed suggest that diverse stakeholders, including a ﬁrm’s employees, suppliers, and customers, often demand compensation for risk bearing (Aaker and Jacobson 1990; Amit and Wernerfelt 1990; Miller 1998; Deephouse and Wiseman 2000; Miller and Chen 2003). The expected amount of payment to the employees should be based on an estimation of the risk to the value of ﬁrm core resources to which these employees are making speciﬁc human capital investments.
These observations lead to the following proposition:
Proposition 1: The higher is the risk associated with a ﬁrm’s core resources, the more likely that the ﬁrm’s key employees will have a larger amount of total expected compensation.
On the other hand, compensating employees for risk bearing has some limitations in functioning as an eﬀective employee incentive mechanism.
First, it can be very diﬃcult to write and enforce a compensation contract described above (Titman 1984; Hart 1995). Bounded rationality linked with environmental uncertainty make it diﬃcult, if not impossible, to identify all the future states of nature that would aﬀect the value ofa ﬁrm’s core resources. Even if these states could be anticipated, their speciﬁc eﬀects on the value of core resources and employee speciﬁc investments remain challenging to quantify. Because ﬁrm core resources are rare, nontradable and employee speciﬁc human capital investments are nontangible, both are diﬃcult to value.
Moreover, the ﬁrm may default on the terms of compensation contract in the case of severe negative economic outcome. For example, a ﬁrm may approach bankruptcy when it no longer has valuable assets that allow it to continue to operate. In such case, terms of contract cannot be eﬀectively enforced.
Second, although compensating employees for risk bearing can to some extent create incentives for them to make ﬁrm-speciﬁc human capital investments, it directly increases ﬁrm expenditures and thus imposes costs on the ﬁrm (Miller and Chen 2003). When the risk associated with ﬁrm core resources is very high, it becomes increasingly expensive for the ﬁrm to compensate employees for risk bearing despite the motivational beneﬁts of such compensation. As the risk associated with a ﬁrm’s core resource increases, for a given amount eﬀort to make ﬁrm-speciﬁc investments, the employee will demand higher compensation resulting in higher marginal cost per unit eﬀort and no corresponding increase in the expected revenue for the ﬁrm. Therefore, it may not pay for the ﬁrm to motivate the employ- ees beyond a certain point through compensation, because the utility of an additional unit of eﬀort to make ﬁrm-speciﬁc investment is worth less to the ﬁrm than the cost of motivating the employees for an incremental unit of eﬀort. Thus, the optimal compensation schedule often does not fully compensate the employees for risk bearing (Shavell 1979). This of course will leave the employees to reduce eﬀorts and underinvest in ﬁrm-speciﬁc human capital.
Due to the limitations associated with compensating employees for risk bearing and the costs of such compensation imposed on the ﬁrm, sometimes the ﬁrm may be better oﬀ ﬁnding additional ways to reduce the risk associated with core resources. Resource-based product market diversiﬁcation is one such alternative.5
Resource-based corporate diversiﬁcation
Generally, the value of a ﬁrm’s core resource is determined in the prod- uct markets where that resource is deployed (Barney 1991a; Peteraf 1993; Bowman and Amrosini 2000). This implies that if the ﬁrm’s core resources can be deployed in multiple product markets, the value of the resource in one product market is likely to be diﬀerent from that in the other product markets. Moreover, a change in the value of a core resource in one product market may not necessarily aﬀect its value in a diﬀerent product market. This suggests that the risk associated with core resources can be reduced by exploring the applicability of these core resources in other product markets and to diversify accordingly.
Note that diversifying into multiple product markets through deploying a ﬁrm’s core resource does not directly reduce the risk to the resource value in each individual product market. However, as long as the factors that lead to changes in one product market are not perfectly correlated with those in another product market, uncertainty in one product market that has a signiﬁcant eﬀect on the value of the core resource in that particular market is not likely to have a similar eﬀect on that in another market. Therefore, through diversifying into product markets with less than perfectly corre- lated environmental factors, the overall risk associated with the value of the core resource can be reduced. This risk reduction, in turn, can potentially increase the employees’ incentives to make human capital investments that are speciﬁc to a ﬁrm’s core resources.6 Generally speaking, the positive eﬀect of resource-based product market diversiﬁcation on employee incen- tives is expected to increase with the level of the risk associated with the ﬁrm’s core resources in the ﬁrm’s original market(s).
These observations lead to:
Proposition 2: The higher is the risk associated with a ﬁrm’s core resources, the more likely that the ﬁrm will diversify into other product markets based on these core resources.
To the extent that resource-based product market diversiﬁcation can sub- stitute for compensating employees for risk bearing as the means of facilitating employee to make ﬁrm-speciﬁc human capital investments, the ability for a ﬁrm to engage in resource-based diversiﬁcation can reduce the need for the ﬁrm to pay employees for risk bearing. Therefore,
Proposition 3: Ceteris paribus, ﬁrms that have diversiﬁed based on their core resources will subsequently compensate their key employees at a lower level than if they have not diversiﬁed in this way.
Note that the arguments above are built on the implicit assumption that management is able to implement a resource-based diversiﬁcation strategy in such a way that the risks of existing businesses of the ﬁrm are not altered. However, to the extent that the existing businesses are disturbed, the eﬀect of resource-based diversiﬁcation on risk reduction and therefore on employee incentives should be discounted accordingly.
2. IMPLICATIONS FOR THEORIES OF DIVERSIFICATION
Note that the pattern of diversiﬁcation and the deﬁnition of resource relat- edness discussed above are in spirit very close to those based on the concept of the ‘strategic asset’ in the resource-based theory of diversiﬁcation (e.g. Teece 1982; Markides and Williamson 1994, 1996). To the extent that a core ﬁrm resource is rare and costly to trade, the diversiﬁcation pattern predicted here, that is, diversiﬁcation by deploying core ﬁrm resources, resembles the resource-based theory of corporate diversiﬁcation, which argues that multibusiness organizations exist to exploit core competencies (Teece 1982; Mahoney and Pandian 1992; Peteraf 1993).7 However, there are some important diﬀerences in the pattern of corporate diversiﬁcation derived from this theory of diversiﬁcation and traditional resource-based theories of diversiﬁcation. These diﬀerences are manifest in the path and the scope of diversiﬁcation.
Traditional resource-based logic suggests that diversiﬁcation is appropriate when a ﬁrm’s resources are applicable across the multiple businesses a ﬁrm engages in (Montgomery and Wernerfelt 1988; Markides and Williamson 1994; Silverman 1999). The logic developed here suggests that risk reduction, in addition to the ability to apply ﬁrm resources across multiple businesses, may motivate diversiﬁcation. This suggests that a diversifying ﬁrm will look to exploit its current resources and capabilities in its diversi- ﬁcation moves, but that it will also look for businesses where it can apply those resources that have cash ﬂows that are uncorrelated with its current business activities. This suggests the following:
Proposition 4: Firms that diversify into businesses that exploit their current core resources and that have a pattern of cash ﬂow that is not highly correlated with their current businesses will generate higher levels of employee ﬁrm- speciﬁc investment than ﬁrms that diversify into businesses that only exploit their current core resources but have a pattern of cash ﬂow that is highly correlated with their current businesses.
Traditional resource-based logic suggests that there are often decreasing returns associated with diversiﬁcation. This is because, generally, ﬁrms will diversify into the highest return related business ﬁrst, the second highest return related business second, and so forth. Barring an exogenous shock that changes the value of a ﬁrm’s core assets, the last diversiﬁcation moves made by a ﬁrm that exploit a particular core resource are likely to be less valuable than the ﬁrst few diversiﬁcation moves made by a ﬁrm that exploited the resource.
The theory of diversiﬁcation developed here also suggests that returns from risk reduction (i.e. the willingness of employees to make ﬁrm-speciﬁc investments that have rent-generating potential) will also have decreasing returns. This is because portfolio risk is generally a concave function of the number of assets in the portfolio (Elton and Gruber 1995), which implies that with the increase in the number of businesses a ﬁrm diversiﬁes into, the overall risk to the value of the core resources falls but at a decreasing rate. A decreasing incremental amount of risk reduction is then likely to lead to decreasing returns for the ﬁrm.
However, while both core competence-exploitation and risk reduction may be characterized by decreasing returns, these two beneﬁts of diver- siﬁcation may not move together over time. Figure 9.1 shows that as a ﬁrm diversiﬁes further away from its original businesses, both the marginal advantage obtained from exploiting core competencies and that obtained from providing incentives for employees to specialize are expected to decrease; and the marginal cost of diversiﬁcation is expected to increase. When considering each eﬀect separately, the optimal scope of the ﬁrm is determined by the point where the marginal revenue of diversiﬁcation equals marginal cost (OS1∗ and OS2∗ in Figure 9.1). However, when both eﬀects are considered, the optimal diversiﬁcation distance is at OS3∗, where the marginal revenue of diversiﬁcation from the combined eﬀects equals to the marginal cost of diversiﬁcation.
Figure 9.1. The determinants of the optimal scope of a ﬁrm
Notes: OS1∗ is the optimal scope when only the beneﬁt from employees’ increased investment incentives is considered; OS2∗ is the optimal scope when only the beneﬁt from economies of scope is considered; OS3∗ is the optimal scope when both the beneﬁts of economies of scope and employee incentives are considered
Of course, the analysis in Figure 9.1 assumes that the beneﬁt from exploiting core competencies, which is determined by the applicability of core ﬁrm resource (or strategic asset) in other product markets, and that from providing employee investment incentives, which is determined by the degree of reduction in risk to the core resource value, are not correlated. To the extent these beneﬁts are correlated, the optimal diversiﬁcation scope would be less than OS3∗ (Figure 9.1). Some strategy scholars have suggested that businesses that exploit the same underlying core resources can nev- ertheless have very diﬀerent patterns of cash ﬂow over time (e.g. Prahalad and Hamel 1990; Markides and Williamson 1994, 1996), implying a low correlation between these two beneﬁts from diversiﬁcation. However, the extent to which these beneﬁts are correlated is ultimately an empirical question. All this suggests the following:
Proposition 5: When the beneﬁts of realizing economies of scope and increased employee incentives to specialize are not perfectly correlated, a ﬁrm will diver- sify more widely than when only one of the beneﬁts is considered. And the opti- mal diversiﬁcation scope increases with a decrease in the correlation between the two beneﬁts.
Finally, it is worth noting that this emphasis on risk reduction from diver- siﬁcation is also related to the argument of agency theory, in which diversiﬁcation is used to reduce overall ﬁrm risk exposure. The agency argument, however, considers diversiﬁcation as an outcome of conﬂicts between shareholder and managers since it reduces managers’ employment risk, but at the expense of the shareholders of the ﬁrm (Amihud and Lev 1981). In contrast, this part of this chapter argues that shareholders as well as employees (including managers) potentially gain from the ﬁrm’s diversiﬁcation, because diversiﬁcation encourages employees to join the ﬁrm and to invest in ﬁrm-speciﬁc knowledge and skills. Another notable diﬀerence between these two perspectives is that central to our argument is ‘resource-based’ diversiﬁcation (related), which reduces risks associated with the core resources. In contrast, agency theory emphasizes conglom- erate diversiﬁcation (unrelated), which leads to ﬁnancial risk reduction, that is, it smoothes cash ﬂow at the corporate level, but does not eﬀectively reduce the risk of the underlying core resources.
Source: Barney Jay B., Clark Delwyn N. (2007), Resource-Based Theory: Creating and Sustaining Competitive Advantage, Oxford University Press; Illustrated edition.