1. 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

2. 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.

3. Overview IntroductionTraditional 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

4. 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).

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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”.