Corporate Diversification and Innovation: Managerial Myopia or Inefficient Internal Capital Market

Which is more innovative: the decentralized, diversified corporation or the smaller, more narrowly focused entrepreneurial firm? The finance literature argues that larger, diversified firms have a natural innovation advantage, 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 enables us to tease out the mechanisms influencing the relationship between diversification and innovation. Consistent with the conceptual and empirical work in strategy, we find a robust negative correlation with diversification strategy and research and development intensity, and we also find support for the hypothesis that diversification reduces innovation by discouraging investment. However, our analysis suggests that internal capital market inefficiencies, rather than managerial myopia, is responsible for this negative relationship.