The literature on multi-product firms has focused on the `economies of scope' that occur when it is more efficient for one firm to produce a certain combination of products than for each of several firms to specialize in only one. These typically reflect complementarities in production or the presence of `quasi-public inputs', such as R&D or `large' and indivisible capital goods. Less attention has been paid to the limits to such diversification, but there must be eventual diseconomies of scope since there are well-known benefits from specialization, learning-by-doing and product- specific human and physical capital.

In Discussion Paper No. 732, Research Fellow Huw David Dixon considers firms' decisions to diversify in oligopolistic markets. In perfectly competitive or contestable markets, firms will take such decisions solely on efficiency grounds; by continuing to diversify after diseconomies of scope set in they would incur a cost disadvantage. In oligopolistic markets, however, imperfect competition implies the presence of supernormal profits; these provide firms in technologically-related markets with incentives to enter, even when this is `inefficient' in terms of production costs. This can lead to `over-diversification' if firms diversify by more than is justified on grounds of cost-efficiency.
Dixon argues that oligopolistic firms' diversification into each others' markets therefore tends to raise welfare by both improving cost efficiency and promoting competition, which reduces prices and raises consumer welfare. If there are (eventual) diseconomies, however, the production inefficiency may more than outweigh this welfare gain, so that overall welfare is reduced. Dixon concludes that the presence of supernormal profits (or `rents') in imperfectly competitive markets is likely to induce `over-diversification' to the extent that overall social welfare may be reduced.

Inefficient Diversification in Multimarket Oligopoly with Diseconomies of Scope
Huw David Dixon

Discussion Paper No. 732, November 1992 (AM)