A theoretical model was developed to analyze the differences in investment/competition behavior of pyramidal business groups and multi-division firms. First, the investment/competition behavior of a multi-division company, which consists of multiple d ...
A theoretical model was developed to analyze the differences in investment/competition behavior of pyramidal business groups and multi-division firms. First, the investment/competition behavior of a multi-division company, which consists of multiple divisions instead of independent firms, was analyzed. The analysis included both "entry deterrence" (predatory behavior by the conglomerate) and "predation" (victimization of the conglomerate in which its rival engages in predatory behavior). A multi-division firm with flexible internal capital markets may compete aggressively because it can add or withdraw investment ex post, while a stand-alone firm is locked into an initial decision. Neither the multi-division firm nor the stand-alone rival company enters the market if the market size is very small. Above the minimum market size, if the market volume is relatively small, the multi-division firm aggressively invests and deters the stand-alone rival’s entry. If the ex post additional investment sufficiently contributes to the success probability, it can expand the region of the parameters of entry deterrence. If the market volume is a little bigger than the case of entry-deterrence and if the rival, with its limited capital, has a probability of success greater than one half, it may engage in predatory action toward the multi-division firm. Neither firm can strategically deter the other’s entry if the market volume is large enough.
Next, business group’s investment/competition behavior, which can mobilize outside capital without diluting control rights but free from the agency problem of outside equity, was modeled. Identically to the multi-division firm model, neither the business group nor the stand-alone firm enters very small markets. As the market size increases above a minimum size, each firm invests more, depending on a given competitor’s strategy. However, owing to its larger outside financing capacity, the business group uses weakly less internal capital and invests the same amount or more than the multi-division firm to operate the business to the same scale. This explains why the specific business organization form prevails, especially, in the regions where capital is a scarce resource. On the other hand, a business group does not engage in qualitatively different strategic behavior than does the multi-division firm.
Finally, this paper considered the possibility that the business group may suffer from the agency problem of outside equity. To operate the business to the same scale, because of larger outside financing capacity, a business group generally needs weakly less internal capital and invests the same amount or more than does a multi-division firm. This explains the prevalence of business groups. However, if the market size is medium and the agency problem of outside equity is large, the business group does not necessarily use less internal capital or invest more than the multi-division firm. With respect to strategic competition, because of the controlling shareholder’s entrenchment, the business group deters the stand-alone rival’s entry only for larger markets, and is preyed upon in a smaller region of the parameters than does the multi-division firm. This is that the business group behaves less strategically than does the multi-division firm. Overall, this paper states that the business group saves internal capital, but, if it is subject to the agency problem of outside equity, does not generally have an advantage in economic efficiency or strategic competition over the multi-division firm. It suggests that the choice of business organization form depends on market size, the scarcity of capital and the extent of the agency problem.