Only by making the additional assumption that the services of the machine (more generally the factor) cannot be sold without added transaction costs has it recently become possible for economists to understand diversification (Teece 1983). Economies of scope thus occur where a factor is subject to market failure and cannot economically be exhausted in a single market. Know-how residing in a complex organizational network may be such a factor. Selling such know-how would be very difficult and yet it may be sufficiently fungible that it applies (at very low marginal cost) to several markets.
Based on the above logic, we can associate a diversified firm with the set of fungible
factors on which it has diversified. Following Rumelt ( 1982), we denote these as core factors. Combining the idea of core factors with the logic from §2. It is evident that the relative efficiency and thus the profitability of a diversified firm depends critically on the nature of its core factors. In particular, the value of a core factor is, ceteris paribus, decreasing in the number of firms which have it. From this we would expect that factors of very general applicability (e.g., administrative skills or financial economies) would be less valuable than relatively more specific factors (e.g., consumer advertising skills).
Given this, we would expect that the efficiencies of firms carrying idiosyncratic factors from market to market will be greater than those of firms employing nonspecific factors in many markets. Studies which have found a positive association between relatedness of d,iversification and firm profitability (Christensen and Montgomery 1981; Rumelt 1974, 1982) are consistent with this view.
Adding the linkage developed in §2 between specific skills and efficiency, and associating "efficient" diversifiers with relatively efficient firms and "inefficient" diver
sifiers with relatively inefficient firms, we can state our hypotheses:
(H.1) Efficient diversifiers are better off the more profitable their industries.
(H.11) Inefficient diversifiers are worse off the more profitable their industries.
And, because high industry growth indicates circumstances which shield inefficient firms:
(H.III) High industry growth benefits inefficient diversifiers more than efficient diversifiers.
Let us now proceed to an empirical test of these hypotheses.