Corporate Diversification and Innovation : Managerial Myopia or Inefficient Internal Capital Markets?

Which is more innovative: the decentralized, diversified corporation or the smaller, more narrowly focused entrepreneurial firm? The economics and finance literatures argue that larger, diversified firms have natural innovation advantages, as their operating units have access to an internal capital market. In contrast, the strategy and entrepreneurship literatures argue that managers of large, decentralized firms suffer from “managerial myopia,” which prevents them from investing in projects with long-term, uncertain payoffs. This paper takes a fresh look at the relationship between innovation and diversification using a comprehensive sample of diversified and non-diversified firms along with a novel analytical approach that teases out the mechanisms influencing the relationship between diversification and innovation. Consistent with both conceptual and empirical work in strategy, we find a robust negative correlation with diversification strategy and research and development intensity. We also find support for the hypothesis that diversification reduces innovation by discouraging investment. However, our analysis suggests that internal capital market inefficiencies, not managerial myopia, is primarily responsible for this observed negative relationship