The impact of inefficiency on diversification

Diversification is often seen as a risk management tool, but specialization allows operators to exploit scale economies in single outputs and offers specialized operators more opportunities to fine-tune their skills which can promote a greater degree of technical proficiency. Measuring economies of scope facilitates the assessment of the benefits from output diversification versus specialization for operators and provides a metric for explaining and predicting trends towards specialization or diversification. However, the current literature on economies of scope provides little insight into the potential trade-off between the benefits of diversification and the presence of inefficiency in production and decision making. To remedy this shortcoming, this paper develops a measure of an effective (or behavioral) measure of scope economies which measures the benefits of diversification accounting for the contributions of allocative, congestion and technical efficiency in scaling the perfectly efficient version of scope economies. The application focuses on measuring and explaining economies of scope on Dutch crop farms.