It has been observed that there has been an ever growing trend toward more extensive corporate diversification. The thesis here is that a great deal of the observed diversification has been the result of an effort by firms to develop internal markets for resources which do not trade well through external markets. The nature of this resource, called firm specific capital, is examined theoretically and empirically.

The work begins with a presentation of a neoclassical model of the firm, where firm specific capital is produced as a joint output in the firm. It is shown how this capital, which for simplicity can be thought of as managerial expertise, would lead a firm to diversify. Then the model is subjected to an empirical test. This test supports the argument that firms use diversification to develop and exploit internal markets. In addition, the test suggests that the diversification process is procompetitive, not anticompetitive as some have argued.

After the general industry level test, the study examines the effect of diversification on the individual firm. This portion of the study was concerned with the impact of diversification on corporate risk. Using risk and performance measures derived from the Capital Asset Pricing Model, and diversification measures calculated for individual firms, the study analyzes the impact of diversification on 97 firms for the years 1960 and 1965. The results of this portion of the study also demonstrate the importance of firm specific capital in the firm's diversification decision.