Diversification, Industry Structure, and Firm Strategy: An Organizational Economics Perspective

Abstract

We review theory and evidence on corporate diversification, industry structure, and firm strategy from an organizational economics perspective. First, we examine the implications of transaction cost economics (TCE) for diversification decisions. TCE is essentially a theory about the costs of contracting, and TCE sheds light on the firm’s choice to diversify into a new industry rather than contract out any assets that are valuable in that industry. While TCE does not predict much about the specific industries into which a firm will diversify, it can be combined with other approaches, such as the resource-based and capabilities views, that describe which assets are useful where. We also discuss the transaction-cost rationale for unrelated diversification, which focuses on the potential efficiencies from exploiting internal capital markets. We review this argument as it emerged in the transaction cost literature in the 1970s and 1980s and, more recently, theoretical and empirical literature in industrial organization and corporate finance. We then discuss how diversification decisions, both related and unrelated, affect industry structure and industry evolution. Here, the stylized facts suggest that diversifying firms have a crucial impact on industry evolution because they are larger than average at entry, grow faster than average, and exit less often than the average firm. We conclude with thoughts on unresolved theoretical, methodological, and empirical issues and problems and provide suggestions for future research.

Keywords: diversification, transaction cost economics, the resource-based view, excess capacity, resource substitutability, resource complementarity, internal capital markets, industry evolution

JEL Classification: L25, G34, L11, D23, L14