Economics of the Divisionalized Firm

NE of the reasons why practical O men of affairs commonly believe X~f that economic theory has little relevance for real business problems is the assumption in elementary presentations that each firm produces a single product. Where, on the other hand, the theory discusses the multiproduct case in full generality, the analysis is frequently too complex or too empty to be of practical usefulness. The primary purpose of this article is to provide theoretical solutions to certain economic problems of an important special type of multiproduct firm. Consider a firm producing a number of products for sale and also producing a number of commodities or services to be used as inputs or components to the final products. We shall call production of these intermediate commodities supplier Now suppose, and this is the crucial assumption, that the marginal and average costs of production of each of the final products are independent of each other and also of the supplier operations-with one important exception. The exception is that a change in the output of any final product will of course dictate a change in the level of the internal supplier operations, and this change will modify the latter's marginal and average costs, since these are normally a function of output. In this way, changes in the output of any division do affect the other divisions' costs but only through the consequences of changes in the level of supplier operations. To make this point somewhat clearer, let us regard the costs of production for any single product as equal to the sum of the internal procurement costs and the operating costs. The internal procurement costs are those incurred in connection with inputs of intermediate commodities or services from the internal supplier operations to or on account of the product in question. The operating costs include all other costs. Our essential assumption is that the operating cost functions for each product are independent of one another, although the internal procurement costs will not generally be independent. Such a range of cost independence between products is almost a necessaryconditionof divisionalization, that is, the devolution of decision-making authority among autonomous profit centers each responsible for one product or a group of products. We shall, therefore, refer to our analysis as relating to the economics of divisionalized firms, although our analysis would apply (given the specified type of independence of product cost structures) even for firms not adopting a divisionalized organization. The full nature of the special assumption about the interdependence of the products on the cost side will become clearer later. One possible example of a firm satisfying these conditions is the General Motors organization, divisionalized (so far as its automobile business * Assistant professor of business economics, School of Business, University of Chicago. Research on this project was supported, in part, by Joel Dean Associates.