By Vojislav Maksimovic and Gordon M. Phillips

We develop a profit-maximizing neoclassical model of optimal firm size and growth across different industries, basing our model on differences in industry fundamentals and firm productivity. The model predicts how conglomerate firms will allocate resources across divisions over the business cycle and how their responses to industry shocks will differ from those of single-segment firms.

The model we develop shows that firms with a comparative advantage in producing within an industry have higher growth and attain a larger size in that industry. Firms that do not have a comparative advantage limit their growth within the industry and expand in other industries. The key prediction of our model is that demand shocks faced by a segment of a conglomerate firm affect the growth rates of other segments, and do so even in the absence of agency costs and financial market imperfections. If a division is less (more) productive than single-segment firms in its industry, a positive demand shock in one division increases (decreases) the growth rates of other segments. Because models that postulate an important role for internal capital markets imply a different relation, this prediction can be used to distinguish empirically between these models and our neoclassical model.

We then test both our model and existing theories that posit advantages and costs of being a conglomerate firm using firm-segment data aggregated from individual plants for over 50,000 firms from 1975 to 1992. Our neo-classical model fits the data well.

We find that growth is related to fundamental industry factors and individual firm-segment relative productivity suggested by our simple neoclassical theory. Conglomerate firms concentrate their growth in their relatively most productive industry segments. Conglomerates grow less in a particular segment if their other segment(s) is more productive and experiences a larger positive demand shock and if their other segment is in a high-returns-to-scale industry. We find that the growth rates of peripheral segments are especially very sensitive to relative productivity and that conglomerates sharply cut the growth of unproductive peripheral segments.

Our evidence is not consistent with conglomerates expanding unproductive industry segments or protecting them from recessions by using cash flows from other divisions. We do find some evidence consistent with agency problems for conglomerate firms that are broken up. However, the majority of conglomerate firms exhibit growth across business segments that is consistent with optimal behavior.

Download the paper: http://www.mbs.umd.edu/Finance/gphillips/papers/conglom.pdf