ABSTRACT
Diversification into new business areas can be economically justified only if it leads to value creation. Therefore, the mere existence of economies of scope is a necessary but not a sufficient condition for diversification to be economically valuable. Diversification also can increase a firm's debt capacity, especially when the cash flows of the diversified firm's businesses are perfectly and negatively correlated. A third category of corporate value creating economies of scope derives from the reduction of competition. Diversified firms use three mechanisms to reduce this level: market power, vertical integration, and multipoint competition. Market power exists when a firm can sell its products at above the existing competitive level or reduce the costs of its primary and support activities below a competitive level, or both. Diversification provides additional market power, which creates corporate value through cross-subsidization and pooled bargaining power.
