What a firm produces matters: Diversification, coherence and performance of Indian manufacturing firms

Economic growth and development of a country involves accumulation of knowledge and dynamic capabilities (Cimoli et al., 2009). Past research has begun to investigate the capability accumulation and macro-economic development of countries and sectors (Dosi et al., 1990), also by means of introduction of new products (Hausmann and Rodrik, 2003). In this work, recognizing that firms are the actual domain in which production takes place, we focus on the firm-level process of capability accumulation and diversification in a developing country. We investigate the relationship between diversification (and coherent diversification) and firm performance by employing an extensive database of Indian manufacturing firms with detailed information on product mix of firms. We claim that such an understanding of firms' incentives to diversify is relevant not only for the corporate management, but also for the diversification of countries and thereby its development. First, we explore the reasons behind firms' strategy to diversify, i.e, which firms choose a broad product scope and whether the change in the scope of the firm results in improved performance in terms of firm profitability and sales growth. Second, we look at the idiosyncratic characteristics of different products, by emphasizing the synergies of a product line with respect to the overall product basket of the firm. In this line, we develop a measure that captures the synergies and economies of scope between different products, and observe that the firms' future performance crucially depend on the interactions between the products that comprise its basket. Overall, our results are consistent with an intangible-capabilities model of firm diversification: diversification results in improved firm performance if the firm has underused capabilities and the new production line is able to exploit them.