Multidimensional Signalling and Diversification

This article offers a new explanation of why firms diversify. I present a model in which a firm has private information about both its own cost and the demand function of the market on which it competes with another firm. I show that diversification can be used by the informed firm to signal private information in order to obtain competitive advantages. This provides an important motive for a firm to diversify. The signalling explanation of diversification is consistent with some empirical observations. A phenomenon called natural signalling is also studied in the model where both signals and private information are multidimensional.