Towards an Economic Theory
of the Multiproduct Firm
Author: David J. Teece
Journal of Economic Behavior and Organization (1982) page 39-63.
Presented by Nan Zhang
• Education
• BA, MComm, University of Canterbury
• MA, University of Pennsylvania
• PhD, Economics, University of Pennsylvania
• Current Research and Interests
• Role of product and process development, and
intellectual property in the competitive performance of
the business enterprise.
• Competitive performance of firms in the global
marketplace.
• Innovation and the organization of industry.
• Technology and intellectual property policy,
telecommunications policy, antitrust policy, and energy
policy at the national and international levels.
• Strategic management and corporate governance.
• Human capital and business organization.
Overview
Introduction
Traditional Perspectives
• Neoclassical firm
• Managerial explanation
Nature of the Firm
• Individual and organizational knowledge
• Fungible knowledge
Dynamic Capabilities
• General
• Learning, teaching and “Penrose-effects”
• Demand conditions
• Market failure consideration
Related Issues
• Slack and managerial discretion
• De novo entry vs. acquisition or merger
• Lateral vs. conglomerate diversification
• Historical observations
Implications and Conclusions
Introduction
• Motivation
– Penrose (1959) stated that diversification of firm activities are
inadequately treated in economic analysis.
– The theory of firm has yet to accommodate multiproduct character.
• Purpose
– Outline a theory of the multiproduct firm by considering the properties of
(1) organizational knowledge and (2) transactions cost properties
neglected by the neoclassical theory of the firm.
– Central issue: Explain why firms diversify into related and unrelated
product lines rather than reinvesting in traditional lines of business or
transferring assets directly to stockholders.
• Important building blocks
– Excess capability and its creation;
– Market imperfection;
– Characteristics of organizational knowledge (fungible and tacit).
Traditional Perspectives
• Neoclassical Firm and Multiproduct Organization
– Assumption: Profit maximizing entities operating in competitive products
and capital markets exhibiting zero transactions costs and competitive
equilibrium.
– Teece (1980): Under zero transaction cost assumptions one cannot derive a
theory of the multiproduct firm (e.g., “economies of scope” may explain joint
production but not the “scope of the firm”).
– Financial synergy arguments are not compelling within the classical
framework (e.g., reducing the variance in cash flows need not reduce
stockholder risk since stockholders can hold a diversified portfolio of
stocks).
– Multiproduct firms do not increase firm value by reducing default risks (e.g.,
reducing the risk to bondholders represents a redistribution of value from
shareholders, leaving the total value of the firm unchanged).
• Managerial explanation
– Marris (1996): Diversification into new products is the main engine of
corporate growth.
• Bu costs of diversification reduce the firms’ rate of return on capital.
– Muellers (1969): Managers are motivated to increase the firm size.
• But managerial compensation is more related to profit.
Traditional Perspectives contd.
• Main Argument
– Diversification can be efficiency driven (e.g., gains obtained from internal
learning).
– The author seeks to derive an efficiency-based theory of the multiproduct
firm.
Nature of the Firm
• Microeconomic Theory
– Representing the business enterprise by the productive transformation.
– Characterizing the productive transformation by a production
function/equilibrium.
• Individual and Organizational Knowledge
– Polanyi (1958): Individual knowledge can be tacit that knowhow and skills
cannot be articulated, and therefore not easily codified.
– Nelson and Winter (1982): Routines function as the basis of
organizational memory. Members need to know their routines and when to
perform certain routines.
• Fungible Knowledge
– Human capital inputs are not always entirely specialized to the particular
products and services which the firm is producing.
Nature of the Firm contd.
• Main point
– “A firm’s capability lies upstream from the end product – it lies in a
generalizable capability which might well find a variety of final product
applications” (Teece, 1982).
– Organizational view: The firm has both technological choices and end
product choices to make based on the capabilities and organizational
knowledge developed within the firm.
Dynamic Capabilities
• General
– The competitive process is viewed as dynamic, involving uncertainty,
struggle and disequilibrium.
– Two fundamental characteristics: (1) firms accumulate knowledge through
R&D and learning some of it incidental to the production process; and (2)
the market conditions facing the firm are constantly changing, creating
profit opportunities in different markets at different times.
• Learning, Teaching and “Penrose-effects”
– Growth exists because of unused productive services. Unused services
exist because of indivisibilities (which require less managerial oversight)
and learning and routines.
– However, the increment to total managerial services provided by each
additional manager is assumed to decrease the faster the rate at which
they are reoriented (Penrose Effect).
• Demand Conditions
– Firms confront the issue to either (1) sell the services of unused assets;
(2) diversify via acquisition or de novo; or (3) return unused cash to
stockholders through dividends or repurchase.
– Firms will diversify when transactions cost problems are likely to confound
efficient transfer.
Dynamic Capabilities contd.
• Market Failure Considerations
– Class 1: Indivisible but non-specialized physical capital as a common
input into two or more products.
• Recommendation: The market.
– Class 2: Indivisible specialized physical capital as a common input to two
or more products: bilateral monopoly (hold-up) problems.
• Recommendation: Multiproduct diversification.
– Class 3: Human capital as a common input to two or more products due
to tacit knowledge and Arrow’s fundamental paradox of information: “its
value to the purchaser is not known until he has the information, but then
he has in effect acquired it without cost” (1971: 152).
• Recommendation: Multiproduct diversification.
– Class 4: External economies
• Recommendation: Multiproduct diversification if there are high
transaction costs.
• Market Failure Considerations and Financial Capital
– Information asymmetry makes an economic function be performed the
internal allocation of capital within the firm.
– CAPM context.
Related Issues
• Slack and Managerial Discretion:
– Excess resources refers to excess factor services over and above what is
needed to meet managers requirements for organizational slack. Thus,
excess resources and organizational slack are different concepts.
• De Novo Entry vs. Acquisition or Merger:
– The current paper does not distinguish between entry mode. The author
notes the potential importance of complementary assets and slack as
influencing the entry mode decision, among others.
• Lateral vs. Conglomerate Diversification:
– The efficiency based theory provided in this paper aligns more with lateral
diversification but offers suggestions on how the internal capital market
efficiencies of firms may shed light into conglomerate diversification based
on Williamson (1975).
• Historical Observations:
– Depression trigged diversification by generating excess capacity.
– WWII created significant demand for military products. Firms used
capabilities for new civilian products after the war.
Implications and Contributions
• Implications
– Integrative approach from different theories or perspectives
allows for a better understanding of the phenomenon under
review.
• Contributions
– This paper advances ideas from Penrose (1959) coupled with
transaction cost economics to predict when firms may choose to
diversify or sell the services of its unused assets in the market.
– The building blocks of generating a theory of the multiproduct firm
used in this paper include “excess capacity and its creation,
market imperfections, and the peculiarities of organizational
knowledge, particularly its fungibility and tacit character”.