The Rise of Specialized Firms

By Lorenz K.F. Ekerdt & Kai-Jie Wu. They are both with The University of Rochester.

Abstract 

"This paper studies firm diversification over 6-digit NAICS industries in U.S. man- ufacturing. We find that firms specializing in fewer industries now account for a substantially greater share of production than 40 years ago. This reallocation is a key driver of rising industry concentration. Specialized firms have displaced diversi- fied firms among industry leaders—absent this reallocation concentration would have decreased. We then provide evidence that specialized firms produce higher-quality goods: specialized firms tend to charge higher unit prices and are more insulated against Chinese import competition. Based on our empirical findings, we propose a theory in which growth shifts demand toward specialized, high-quality firms, which eventually increases concentration. Our theory indicates that one should expect rising concentration in a growing economy."

Conclusions

"This article advances an alternative view of the much-discussed shift in activity toward large firms observed in the average U.S. industry over the past 50 years. Rather than reflecting structural changes in the nature of competition, we argue that this development reflects shifts in demand toward higher-quality products that inevitably occur as national income grows. Because industry concentration naturally changes on the growth path, any changes of this measure should be viewed relative to this secular trend. 

Our interpretation is based on the observation that there has been a marked shift in activity toward more specialized firms that coincides with the rise in the average industry revenue share of large firms; this shift can be reconciled with growing relative demand for higher-quality products as long as more specialized firms tend to produce higher-quality products. 

To support this view, we first study firms’ unit prices within narrowly-defined product cat- egories. We find that, conditional on firm size, more specialized firms tend to charge higher unit 51 prices, while they do not seem to face higher distortions in the input or product markets. Secondly, we study firms’ responses to the rapid rise in Chinese import competition beginning in the early 1990s. The results of this analysis are stark: more diversified firms shrink dramatically relative to specialized firms when faced with the same exposure to Chinese import competition. Noting that developing countries export low quality products to developed countries, we inter- pret this finding as favoring our posited link between specialization and product quality. 

We construct a model to show that the average industry revenue share of large firms is naturally increasing over a growth path. Because quality is a luxury, relative demand increasingly favors more specialized firms as income grows. We can thus generate an increasing path of average industry concentration which is not driven by structural changes in the nature of competition, but instead simply reflects income growth."