When the government takes action that results in increased spending, and an increased or decreased demand for products or services, it is called a “spending shock” or a “demand shock.” Ideally, firms should be prepared to benefit from shocks in government spending. But are some more prepared than others?
In “Cross-Subsidization in Conglomerate Firms: Evidence from Government Spending Shocks,” published in 2022 in the Journal of Financial and Quantitative Analysis, Culverhouse’s Dr. Lei Kong and collaborator Darren J. Kisgen (Boston College) investigated how the organizational structure of a firm affects its investment behavior when responding to demand shocks from government spending. The researchers drew upon data from various industries and segments to compare investment behavior.
The authors found that segments in industries that rely more on government spending invest more when government spending increases. However, this is less true in conglomerates, especially for those that are more dependent on government spending. This is because segments that depend on the government more tend to subsidize segments that depend on the government less, an effect they call cross-subsidization. This practice also reduces conglomerate value.
“Small firms can together form a large conglomerate, which may help to reduce their financial constraints,” Kong explained. “However, our findings show that these large conglomerates tend to engage in ‘corporate socialism,’ a phenomenon that strong segments within a conglomerate wind up subsidizing weak ones, which tends to be penalized by investors in the market. Firms that stay within their core competence are better rewarded by the market.”