A Theory of Diversification

 5
the object (capital concentration), the linking verb (diversifying). As for the subject, I 
shall define the very large firms (VLFs).  
 I will also provide such firms with an historical reference (Chandler 1997).  
 With regard to the object I will show the significant merger waves of last century 
(Nelson 1959). As far as the linking verb is concerned, I will provide the diversification 
with three possible definitions (Gort 1962, Rumelt 1974, Salter 1979).  
  The second part is concerned with the theory.  
 It now comes in useful to show some methodological points. In line with a 
mathematical approach, in chapter 3 I will provide the theory with a list of landmarks 
(like for the postulates in Euclidean geometry) wherein the theory can be assessed.  
 Then in chapter 4 I will divide the theory into two blocks, each of which is 
based on an assumption (as in the hypothesis). Therefore I shall show the reasoning (as 
in the demonstration) that leads to the desired conclusion (as in the thesis)
2
. 
Having looked at the methodology, we can continue the outlining of contents. In 
chapter 3 I will list six propositions that serve the purpose of giving a quick picture of 
the theory of VLFs (Leijonhufvud 1986, La Grassa 1996, Pagano and Rowthorn 1997). 
In chapter 4 I will discuss the softening of the budget constraint (Kornai 1986) and the 
increasing returns (Leijonhufvud 1995, Arrow, Ng, and Yang 1999, Heal 1999). The 
former shows that many ex-post incentives to diversification can be grouped into the 
rationale of relaxing the budget constraint. The latter concerns the ex-ante rationale for 
VLFs to diversify.  
 Therefore I will show at once the robust connection that exists between 
geographical and conglomerate diversification and the evident link to the reality.  
 Finally I will discuss a few Strategic Management issues concerning the role of 
the top management. 
In the conclusion I will highlight the results and I will point out eventual 
developments of related topics. 
In addition to the final references, I will also write those relevant to each 
chapter, given that each chapter refers to quite different literature.  
                                                           
2
 Another methodological point is that I will not examine the internal life of VLFs in details 
because I am inclined to believe that managers, consultants, and Strategic Management theorists have 
much more to say about that than a candidate economist. 
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PART 1 
CORPORATE DIVERSIFICATION: AN 
OVERVIEW 
 
 
 
 
 
 
�Traditional economic analysis examines the advantages and disadvantages of 
being a particular size and explains movement from one size to another in terms of the 
net advantages of different sizes. Growth becomes merely an adjustment to the size 
appropriate to given conditions; there is no notion of an internal process of development 
leading to cumulative movements in any one direction. Still less is there any suggestion 
that there may be advantages in moving from one position to another quite apart from 
the advantages of being in a different position. It is often presumed that there is a �most 
profitable� size of firm and that no further explanation than the search for profit is 
needed of how and why firms reach that size. Such an approach to the explanation of 
the size of firms will be rejected in this study.� 
 Edith Penrose  
 7
 
INTRODUCTION  
Diversification is an issue quite neglected by economic science.  
 Yet diversification is an important phenomenon in the economic reality.  
 As a matter of fact, every business book about strategy has a section dealing 
with diversification.  
 Why do not most economists analyse such a phenomenon? In my opinion it is 
due to several reasons but one of them is certainly predominant. I am concerned with 
the inadequacy of mainstream microeconomics to resolve the phenomenon of 
diversification.  
 In fact, should we consider either firm as production function or firm within the 
theory of monopoly and oligopoly, we would not get any theoretic apparatus in order to 
study diversification. On the one hand, the production function represents a too bare 
abstraction even though we take into account different types of input through a 
sophisticated function.  
 On the other hand, the theory of monopoly is industry limited (e.g.: assumption 
of homogeneity), namely it cannot understand the role of a diversifying firm in its 
entirety. 
Things being as they are, it becomes difficult to examine diversifying activity.  
There is no common framework whereas there are many concepts and 
explanations of diversification.  
 Moreover, such concepts and explanations accrue from different branches of 
social sciences and, as we know, each branch applies various approaches, in other 
words: a host of diverse points of view within frameworks which do not have 
diversification as their main subject.  
 Owing to that, anyone who intends to introduce the issue in hand, runs the risk 
of writing a puzzling list of the numerous opinions. 
The next chapter is going to show the structure of such a puzzle. 
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CHAPTER 1. LOOKING AT THE MAIN THEORIES 
 
Introduction 
 
The purpose of this chapter is to give the best known answers to the question: 
�why do firms diversify�.  
 In doing that, as I already said, basic theory that is taught in courses of 
industrial economics and economics of institutions, will be assumed as prior knowledge.  
I am going to focus on the different mechanisms that make firms diversify rather 
than the different theories explaining them.  
 There are two reasons why I will do so.  
 First, since I do not follow any of the present frameworks, I consider a 
classification according to each mechanism more suitable (in other words, incentives for 
firms to diversify).  
 This will be useful in the central part of the writing. Secondly, I think I am not 
old and expert enough to divide every author into different theories and group them 
accordingly. 
That being stated I must acknowledge the particular help the reading �Corporate 
Diversification� by Cynthia Montgomery (1994) has given me in order to shed a little 
light on this field of economic literature.  
 Yet, given that this essay is the only one -as far as I know- it has been published 
in the nineties, I do not feel it is right to follow its approach (rightly on account of a lack 
of other sources). 
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Excess Capacity in Productive Factors 
A probable rationale of diversifying is the need for rent-seeking firms to exploit 
their excess capacity in productive factors.  
 Such a rationale implies that the firm does not lie in an equilibrium state.  
 Edith Penrose in �The Theory of the Growth of the Firm� (1959: 68) elucidates 
this point: �the attainment of a state of rest is precluded by three significant obstacles: 
those arising from the familiar difficulties posed by the indivisibility of resources; those 
arising from the fact that the same resources can be used differently under different 
circumstances, and in particular, in a �specialized� manner; and those arising because in 
the ordinary processes of operation and expansion new productive services are 
continually being created.� 
A recent theory known as Resource-Based follows this approach but, while 
Penrose (1959: 28) distinguish between resources and services, Resource-Based theory 
does not.  
 In their view, resources �include factors the firm has purchased in the market, 
services the firm has created from those factors, and special knowledge the firm has 
accumulated through time� and �so long as expansion provides a way of more 
profitably employing its underused resources, a firm has an incentive to expand� 
(Montgomery 1994: 167). 
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Market Failures  
Diversifying may be a result of market failures.  
 In other words, firms sometimes deem it less effective to sell their unused 
resources in the market than enlarge their businesses through an appropriate 
diversification. Such an issue, connected with that of the preceding paragraph, has been 
mostly analysed in the light of Transaction Costs economics especially by Coase (1937: 
395) and Williamson (1986: 182).  
 The reasoning is given as follows.  
  
1. Different businesses employ common or complementary resources such as 
technology, plants, brand names or distribution system 
2. Such resources exhibit scale or scope economies 
3. If they cannot be efficiently exploited through market transactions 
4. Then, there is an economic incentive to unite different businesses into an 
organisation (say a firm) to capitalise on scale or scope economies. 
Reasonably, market fails (namely item 3), when resources are systemic, such as the 
services and the knowledge the firm itself has created.  
 As far as this last point is concerned, evolutionary theorists (Nelson and Winter, Teece 
1982) have significantly contributed by discovering that inside a firm many skills and 
much knowledge are intangible assets deeply imbedded in the routines of the firm. 
Another example wherein it is possible to get an efficient alternative to the market occur 
when firms encourage internal capital markets in order to solve some of the 
informational problems associated with external financing
3
. 
Indirectly, this might be viewed in addition to another type of diversification which 
accrues from the firm�s will to reduce financial risk.  
  
                                                           
3
 Consider the Japanese keiretsu , which gives you the idea of such a phenomenon.