Diversification And Economies Of Scope Research Paper

Three related research fields have much to say on corporate diversification. The ‘resource-based’ view of the firm draws attention to the quasi-fungible nature of the firm’s assets, and postulates that diversification is a way to use excess capacity. Transaction cost economics helps explain whether and when excess capacity is better used internally (diversification) or contracted out to parties seeking to outsource services and products. Evolutionary economics helps explain how excess capacity comes about. These three intellectual wellsprings help explain the nature, timing, and pattern of observed diversification in advanced industrial nations.

It must be pointed out, however, that there is a largely discredited literature that offers an alternative view. Theories of market strength and monopoly position stress these attributes as drivers of diversification (Montgomery 1994). Studies in this genre have been actively explored empirically, but offer little to inform the diversification process. Measures such as Tobin’s Q provide a framework to compare how firm (stock) market evaluation changes with added products and markets. Such measures are useful but do little to explain why firms diversify and the relationship between direction of diversification and organizational factors, such as legal structure. This line of research has provided excellent measurement and context with which to compare diversification outcomes. However, it does not illustrate satisfactorily the decision to diversify or the real constraints on diversification that managers and firms face.

We now turn to two fundamental questions: why do firms diversify, and how do they organize for diversification. The goal in the next section is to communicate the logic and strategy of diversification, motivating the subsequent discussion on organizing for diversification. We do not mean to describe these two activities as serial, but rather interactive. The decision to diversify for profit seeking firms requires them to analyze how they can secure extra profits from the process. We can conclude that successful diversification is the combination of managers making strategic choices as to lines of business and developing appropriate organizational structures to support the resulting diversification. This conclusion has implications for empirical testing, and several scholars have recently begun to undertake an effort to integrate theories of diversification (Silverman 1999).

2. Why Firms Diversify: Corporate Diversification And The Resource-Based View Of The Firm

Although the resource-based view has, since the 1980s, been applied to several areas in firm strategy, the theory has its roots in the study of firm diversification (Teece 1982). We begin by summarizing the major points, and describe the decision to add product lines as a response to the availability of underutilized assets created by prior activity. We then discuss the strategy of diversification as the choice of those areas in which to diversify that maximize the value of the unused assets. This typically results in what has been referred to as corporate coherence (Teece et al. 1994).

Note that corporate diversification issues, as discussed herein, is a superset of multiproduct firm issues. Much of our current attention focuses on multiproduct firms, with less attention on other diversification modes (new customer or geographic markets, for example). However, firm diversification in a broader context includes many of the same analyses that are applied below. That is, diversifying international markets follows much of the same logic and reasoning as adding product lines.

2.1 The Firm As A Set Of Resources

The resource-based view seeks to understand why firms grow and diversify. The theory grew largely out of Penrose’s (1959) study, in which she cites unused managerial resources as the primary driver of growth. Penrose recognized that internal managerial resources are both drivers and limits to the expansion any one firm can undertake. This stream of literature was expanded in the 1970s and early 1980s on the heels of significant diversification and firm expansion (Rubin 1973, Teece 1980, 1982).

The resource-based view advances the importance of firm-specific resources, that is, those resources that maintain value in the context of the given firm’s markets and other resources that are difficult to replicate by other firms (Wernerfelt 1984). Such resources include managerial ability, customer relationships, brand reputation, and tacit knowledge regarding specific manufacturing process. Resources are not the same as competencies or capabilities. Rather, a firm’s access to resources and ability to mobilize and combine these resources in specific ways determine the firm’s competence in a given product area. As a firm gathers resources for one business, these resources will, to differing extents, be sufficiently fungible for use in other product lines or markets (Teece 1982). Some of these resources will maintain excess capacities over time, especially since the units required for operations in one area are not necessarily consistent across multiple fields.

In some cases it is knowledge which is the ‘excess resource’ (Teece 1982, 1986). It is this excess capacity, coupled with profit-seeking behavior, that drives decisions to diversify. Some scholars have noted that such resources are transferable in a limited sense between firms, but such endeavors require organizational interaction beyond market contracting to include acquisitions or hybrid forms of governance (Chi 1994). This point will be considered in Sect. 4.

2.2 The Logic And Coherence Of Diversification

The literature on diversification includes analysis of whether specific diversification patterns are associated with improved firm performance (Chatterjee and Wernerfelt 1991). Specifically, scholars have sought to discern whether there exist performance differences between related and unrelated diversification. Many efforts have focused considerably on outcome measures that do little to inform the rationale behind diversifying. The resource-based foundation provides scholars with a motivation for examining the linkages (or ‘coherence’) between classes of resources within a given firm (Teece et al. 1994). Fungible resources allow for firms to apply managerial practices and reputations to other industries, as discussed in the previous section. However, these assets have varying degrees of value across industries. The resources of firms even within the same industry may not be identical. Moreover, the degree of coherence that one expects to observe among the parts of an organization at a particular point in time depends on the relationship between learning, path dependencies, the technological opportunities available to the firm, and the firm’s existing complimentary assets. This suggests that seemingly homogeneous (in terms of primary product outputs) firms may exhibit radically different diversification strategies.

While empirical evidence will be examined in more detail below, existing research suggests that there exists a logic to diversification. As firms grow more diverse, they maintain a constant level of coherence between neighboring activities. For example, the sales, distribution, and market understanding maintained in pharmaceutical industries is relevant to a specific set of other industries, such as medical equipment and over-the-counter medicines. The latter is in turn related to candy and confectionery and other drug store items. Note that this result contrasts with the purely market power studies discussed earlier in that the focus of analysis is on firm specific assets as an input to the diversification process, rather than solely on the industries in which a firm ends up.

We now turn to the consideration of how firms organize to diversify, and consider the implications for a combined analysis of diversification strategy and underlying organizational structures.

3. How Firms Organize To Diversify: Corporate Diversification And Transaction Cost Economics

Transaction cost economics argues that economic agents organize activities so as to economize on the costs of transacting. Specifically, the probability of observing a given form of organization is a function of various features of the transaction under consideration and the influence of these features on the relative costs of alternative modes of organizing. While transaction cost theory is most noted for its use in analyzing vertical integration decisions (i.e., make-vs.-buy decisions), its logic has also been applied to issues related to diversification (Teece 1980, 1982).

Early work in this area focused on the so-called ‘conglomerate’ form of organization. Williamson (1975) argues that large, diversified conglomerates are best understood as a logical outgrowth of the multidivisional form (M-Form) mode for organizing complex economic transactions. Building on work by Chandler (1962), Williamson suggests that the M-form offers a number of advantages in managing separable, related lines of business, such as a group of automobile divisions. Specifically, the M-form allows for improved transaction governance in directing and monitoring the use of assets, where a unified or function-based organization would falter under in- formation asymmetries, bounded rationality, and managerial opportunism. Recognizing these merits, he goes on to argue that the M-form may be similarly advantaged when it comes to managing less closely- related activities (Williamson 1988). While he is careful to note that the management of diverse products is not without problems, Williamson (1988) nevertheless proposes that the advantages of the M-Form of organization carry over to the case of diverse product lines. Thus, early research in organizational economics suggested that it is more efficient to administer diversification in a multidivisional corporation than in other, more centralized forms of internal organization.

More recently, the question of how to most efficiently organize for diversification has been extended to include a direct comparison of specific alternative modes of diversification. Bethel and Liebeskind (1998), for instance, employ transaction cost reasoning to account for the decision of firms to diversify by means of a ‘simple corporation,’ in which a single legal entity is responsible for all contracting relationships, vs. a ‘corporate group’ approach, in which a parent corporation owns or partially owns a series of subsidiary corporations. Firms select a particular mode of diversification to minimize a specific type of transaction cost; namely ‘protection costs.’ Because diversification has a differential effect on the various stakeholders within a firm, disadvantaged stakeholders may take action to protect themselves either by seeking to prevent diversification or by seeking compensation after diversification has taken place. A ‘corporate group’ form of organization can reduce the costs associated with these protection measures by reducing the losses from diversification that some stakeholders would otherwise bear. However, the use of ‘corporate groups’ to manage diversification is not costless. Although ‘corporate groups’ may reduce or eliminate the negative effects of diversification, they carry with them costs: economies of scope may be lower within a ‘corporate group’ than within a ‘simple corporation.’ Managers must explicitly trade off the advantages of economies of scope with the disadvantages associated with protection efforts by corporate stakeholders.

The research in transaction cost theory related to diversification thus attempts to account of how diversification is organized by exploring the nature of the diversification taking place, as well as its impact on the relative costs of different modes of diversification. The theory predicts that the mode of organization (such as vertical integration or joint venture) chosen in a given instance will be that which minimizes the total costs of transacting. By exploring how it is that firms diversify, transaction cost theory complements the work coming out of the resource-based view. Whereas the resource-based view analyzes the direction of corporate diversification, transaction theory allows one to predict which organizational structures are necessary to support diversification efforts.

4. Integrating Two Views Of Diversification

The above discussion highlights the theoretical similarities and complementarities between the resource-based view and transaction cost theory. Indeed, asset specificity, a key analytical frame in traditional transaction cost economics theory, is analogous to the firm-specific resources that are the engines of diversification in the resource-based view. Recently, researchers have begun to explicitly combine these two approaches.

Among these efforts is Silverman’s (1999) examination of how contractual hazards affect the likelihood of corporate diversification. As was noted in Sect. 2, the resource-based view draws heavily on Penrose’s view that firm growth is driven by the internal exploitation of excess resources. A result of Penrose’s approach is that firms always enter new markets, but never divest. In contrast, transaction cost theory suggests that there are multiple ways in which excess assets may be utilized, including contracting these assets to outside parties and spinning them off into stand-alone enterprises (Teece 1980). The added incentive intensity associated with exploiting excess resources through markets rather than internally provides a rationale for utilizing various contracting approaches. The relevant empirical question with respect to diversification is: under what circumstances are excess resources more suitably exploited through internal diversification than through outside contracting?

Drawing on work by Teece (1986), Silverman suggests that the contractual exploitation of technological knowledge resources (e.g., licensing) is a feasible alternative to diversification except for cases where the knowledge is highly tacit or easily transferred but weakly protected. In the former case, licensing contracts are difficult to write and enforce due to the tacit nature of the resource being contracted for. In the latter case, attempts to negotiate a licensing contract are plagued by problems of appropriating the returns to technology. Silverman therefore hypothesizes that a firm is more likely to diversify into a business when contracting out its technological resources in that business is subject to high contractual hazards. His analysis of diversification decisions for firms entering new SICs between 1982 and 1985 indicates that in fact a firm is less likely to diversify into an industry when viable contractual alternatives exist to exploit its technological resources.

5. Conclusion: The Future Of Diversification Research

The efforts by Silverman and the others cited in this research paper to exploit and, where possible, combine the resource-based and transaction cost approaches to diversification are useful to help elucidate the critical aspects of each theoretical approach with respect to corporate diversification. While important first steps, the research examined here by no means provides definitive resolution to the topic of firm diversification. In particular, a number of theoretical and empirical issues remain. On the theoretical side, efforts to recognize the dynamic nature of corporate diversification decisions are needed. The treatment of diversification in this research paper and in much of the existing literature treats the why and how of diversification as two distinct (and serial) activities. In practice, successful diversification is a combination of both choosing where to diversify and how to support a diversification strategy.

While resource-based scholars have begun developing a theoretical understanding of corporate coherence, there exist few empirical tests of these predictions. Resource-based explanations for diversification have struggled with how to operationalize the resources that are relevant in diversification decisions. That is, the lack of adequate measures for critical firm resources has limited empirical testing of the theory’s predictions with respect to diversification. Finally, greater effort to explicate and test the transaction level factors that are relevant in driving how diversification efforts are organized is needed.

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