EXTERNALITIES AND CORPORATE OBJECTIVES IN A WORLD WITH DIVERSIFIED SHAREHOLDER CONSUMERS

If shareholders own diversified portfolios, and if companies impose ex ternalities on one another, shareholders do not want value maximizatio n to be corporate policy. Instead, shareholders want companies to maxi mize portfolio values. This occurs when firms internalize between-firm externalities. Any kind of externality, pecuniary or nonpecuniary, ve rtical or horizontal, suffices. What matters is simply that one compan y's actions affect another's value, Thus, besides the traditional bene fit of risk reduction, portfolio diversification offers additional ben efits to shareholders through helping internalize externalities. This paper documents the extent of diversification and cross-ownership of s tocks among companies where these externalities are likely to be large and provides a capital market test of how merger offers vary with the extent of cross-ownership.