We propose a micro-founded theory of diversified firms. The theory suggests that diversified firms exist because they allow better deployment of factors that, because of sub-additive contracting costs, are hard to trade in fractions. Firms diversify into industries in which these factors are more productive than any alternatives available in the factor market. Like markets, diversified firms allow specialization by enabling factors to be used on a larger scale. The individual businesses making up a diversified firm exhibit specific similarities in behavior.
