Journal of Economic Perspectives—Volume 6, Number 3—Summer 1992—Pages 79–100

Organizational Capabilities
and the Economic History
of the Industrial Enterprise
Alfred D. Chandler

A
s a historian who has spent a career in examining the operations and
practices of business firms, I have not given much thought to precise
definitions of the firm. I have had little trouble locating information on
literally hundreds of individual enterprises. Nor do individuals have difficulty
in identifying the firms in which they work or the securities of those in which
they invest.
But for economists, the question of defining a firm and its role and
functions in modern economies is more significant and complex. Ronald Coase
(1937) first raised the theoretical issue years ago when he asked (p. 388): If
economics generally argues that the coordination of the flow of goods and
services is done through the price mechanisms, "why is such an organisation
necessary?" Therefore, he continued (p. 390), "our task is attempt to discover
why a firm emerges at all in a specialised exchange economy."
At least four attributes of the firm have since appeared in the theoretical
literature. The firm is a legal entity—one that signs contracts with its suppliers,
distributors, employees and often customers. It is also an administrative entity,
for teams of managers must coordinate and monitor its different activities.
Once established, a firm becomes a pool of physical facilities, learned skills and
liquid capital. Finally, although this is rarely mentioned in the literature, "for
profit" firms have been and still are the primary instruments in capitalist
economies for the production and distribution of current goods and services
and for the planning and allocation for future production and distribution. I
think most economists would agree at least on the first three of these attributes
of the firm.

• Alfred D. Chandler is Straus Professor of Business History, Emeritus, Harvard

University Graduate School of Business Administration, Boston, Massachusetts.
80 Journal of Economic Perspectives

In both The Visible Hand (1977) and Scale and Scope (1990), I've concen-
trated on practice rather than theory. In the first, I investigated the beginnings
and subsequent development of what I term the modern multi-unit enterprise
(a firm consisting of more than a single plant, shop, or office) in American
transportation, communication, production and distribution. In Scale and Scope,
I focused on the history of the modern industrial firm—the most complex and
the most transforming of modern business enterprises—from the 1880s, when
such firms first appeared, through World War II. I did so by comparing the
fortunes of more than 600 enterprises—the 200 largest industrial firms at three
points in time (World War I, 1929, and World War II) in each of the three
major industrial economies—those of the United States, Britain and Germany
—which until the Great Depression produced two-thirds of the world's output
of industrial goods.
What I plan to do in this paper is first to describe the similarities in the
historical beginnings and continuing evolution of these enterprises, and then to
outline my explanation for these similarities. Next, I relate my explanation of
these "empirical regularities" to four major economic theories relating to the
firm: the neoclassical, the principal-agent, the transaction cost, and the evolu-
tionary. In the final section, I try to indicate the value of the transactions cost
and evolutionary theories to historians and economists who are attempting to
explain the beginnings and growth of modern industrial enterprises.

Regularities Described

A new type of industrial enterprise appeared suddenly in the last two

decades of the 19th century. Throughout the 20th century, these firms were
created and continued to grow in much the same manner, and they continued
to cluster in industries with the same characteristics. These industrial firms
first appeared as modern transportation and communication networks were
completed—networks that themselves were built, operated, enlarged and coor-
dinated by large hierarchical firms. By the 1880s, the new railroad, telegraph,
steamship and cable systems made possible the steady and regularly scheduled
flow of goods and information, at unprecedented high volume, through the
national and international economies. Never before could manufacturers order
large amounts of supplies and expect their delivery within, say, a week; nor
could they promise their customers comparable large-scale deliveries on some
specific date. The potential for greatly increased speed and volume of produc-
tion of goods generated a wave of technological innovations that swept through
western Europe and the United States during the last decades of the 19th
century, creating what historians have properly called the Second Industrial
Revolution (to differentiate it from the "first" that occurred in Britain at the
end of the 18th century, through the application of coal produced steam-
powered machinery to mining and the production of textiles, metals and metal
products).
 Alfred D. Chandler 81

Old industries were transformed, including the making of steel, copper

and aluminum; the refining of oil and sugar; the processing of grain and other
agricultural products; and the canning and bottling of the products thus
processed. New industries were created. In chemicals, new processes produced
man-made dyes, medicines, fibers and fertilizers. New mass-produced office,
agricultural and sewing machines quickly came on the market, as did heavy
machinery for a wide variety of industrial uses. The most revolutionary of the
new technologies were those that generated and transmitted electricity for
lighting, urban traction and industrial power. These new industries drove
economic growth and played a critical role in the rapid reshaping of commer-
cial, agrarian, and rural economies into modern, urban industrial ones. The
newly formed enterprises that created and expanded these industries almost
immediately began to compete in international markets.
Firms in these transformed or new industries differed from older ones, like
textiles, apparel, furniture, lumber, leather, publishing and printing, shipbuild-
ing and mining. The new firms were far more capital-intensive, and able to
exploit the potential of economies of scale and scope made possible by the new
technologies of production far more effectively. Nevertheless, as I wrote in Scale
and Scope (1990, p. 24):

These potential cost advantages could not be fully realized unless a

constant flow of materials through the plant or factory was maintained to
assure effective capacity utilization. If the realized volume of flow fell
below capacity, then actual costs per unit rose rapidly. They did so
because fixed costs remained much higher and "sunk costs" (the original
capital investment) were also much higher than in the more labor-
intensive industries. Thus, the two decisive figures in determining costs
and profits were (and still are) rated capacity and throughput, or the
amount actually processed within a specified time period. (The economies
of scale theoretically incorporate the economies of speed, as I use that
term in The Visible Hand, because the economies of scale depend on both
size—rated capacity—and speed—the intensity of which the capacity is
utilized.) In the capital-intensive industries the throughput needed to
maintain minimum efficient scale required careful coordination not only
of the flow through the processes of production but also the flow of inputs
from suppliers and the flow of outputs through intermediaries to final
users.

Such coordination did not, indeed could not, happen automatically. It

demanded the constant attention of a managerial team or hierarchy. The
potential economies of scale and scope, as measured by rated capacity, are the
physical characteristics of the production facilities. The actual economies of
scale and scope, as measured by throughput, are organizational. Such economies
depend on knowledge, skill, experience, and teamwork—on the organized
human capabilities essential to exploit the potential of technological processes.
82 Journal of Economic Perspectives

Examples of the cost advantages of the economies of scale and scope in the
new capital-intensive industries of the Second Industrial Revolution are dra-
matic. During the 1880s, John D. Rockefeller's Standard Oil Trust concen-
trated its refining of kerosene in three major new 6,500 barrel-a-day works that
reduced unit costs from close to 2.5 cents in 1880, when the largest plants had a
capacity of 1,500 to 2,000 barrels a day, to .45 cents in 1885. This reduction
permitted Standard Oil's U.S.-made kerosene to outsell competitors in the
European market using Russian oil and those in the Asian markets using East
Indian oil. Its direct successor, Exxon, is still the world's largest oil company. As
to scope, three German firms—Bayer, BASF and Hoechst, still today more than
a century later the world's three largest chemical companies—reduced the cost
of a single dye, Alizarin, from close to 200 marks per kilo in the early 1870s to
23 marks in 1878 and to 9 marks by 1886. By the 1890s, these firms concen-
trated their production in one or two giant works on the Rhine in which raw
materials brought by water and rail were transformed into a variety of interme-
diate chemicals which in turn were processed into hundreds of different
finished dyes and pharmaceuticals. The addition of each new dye or pharma-
ceutical added little to the overall production costs and thus permitted the
reduction of the unit costs of each individual dye and pharmaceutical far below
those of their smaller competitors.
Such enterprises in these new capital-intensive industries began and con-
tinued to grow in similar ways. All exploited the cost advantages of scale and
scope. Nevertheless, the investment in production facilities large enough to
exploit these advantages were in themselves not enough. As is described later,
two other sets of investments were made. The entrepreneurs organizing these
enterprises created national and then international marketing and distributing
organizations. They then had to recruit teams of lower and middle managers to
coordinate the flow of products through the processes of production and
distribution, and teams of top managers to monitor current operations and to
plan and allocate resources for future ones. The first firms to make the
three-pronged investments in manufacturing, marketing, and management
essential to exploit fully the economies of scale and scope quickly dominated
their industries. Most continued to do so for decades.
The tripartite investment by the "first movers," as I term them, provided a
base upon which managers and workers learned the potential of the new
technologies and the ways of improving processes of production and distribu-
tion. Challengers had to construct plants of comparable size and do so after the
first movers had already begun to work out the bugs in the new production
processes. The challengers had to create distribution and selling organizations
to capture markets where first movers were already established. They had to
recruit management teams to compete with those already well down the
learning curve in their specialized activities of production, distribution, and (in
technologically advanced industries) research and development. Such chal-
lengers did appear, but only a few of them.
 Organizational Capabilities and the Economic History of the Industrial Enterprise 83

In the new and transformed capital-intensive, oligopolistic industries, the

first movers and challengers competed vigorously for market share in national
and international markets. Although product pricing remained a significant
competitive weapon, these firms competed even more forcefully through func-
tional and strategic efficiency: that is, by carrying out processes of production
and distribution more capably; by improving both product and process through
systematic research and development; by locating more suitable sources of
supply; by providing more effective marketing services; by product differentia-
tion (in branded packaged products primarily through advertising); and by
moving more quickly into expanding markets and out of declining ones. In
this climate of oligopolistic competition, market share and profits changed
constantly.
Consider the history of the automobile industry. Volume production began
in the United States in the 1910s. By the 1920s the Big Three dominated the
U.S. industry. (In 1935, they accounted for 90 percent of the output.) Except
for the Hitler-sponsored "people's car," Volkswagen, that went into production
in 1940, today's European leaders dominated their national markets by the
early 1930s. Except for Honda, established in 1948, the producers that today
account for 90 percent in Japan were all in production during the 1930s. In
this industry where the major players remained much the same for well over
half a century, market share has changed constantly. And those changes
resulted far more from functional and strategic competition than from price
competition (Bardou, 1982).
Such competition for market share kept oligopolies from becoming
monopolies. The cumulative learning sharpened by such oligopolistic competi-
tion created organizational capabilities that became powerful barriers to new
entrants. Such capabilities accounted for the long-term persistence of profits by
the same players over the decades. Such capabilities and the resulting retained
earnings became the basis for their continued growth.
Firms grew by moving backward to control materials and forward to
control outlets (vertical integration); but, as will be described shortly, they did
so largely in response to the specifics of the short-lived business needs or
opportunities. For most, the long-term continuing strategy of growth was
expansion into new geographical or product markets. The move into geo-
graphically distant areas was normally based on the competitive advantages
provided by organizational capabilities learned through exploiting economies
of scale. Moves into related product markets rested more on capabilities
developed from the exploiting of the economies of scope.

The Importance of Organizational Capabilities

Organizational capabilities, honed by oligopolistic competition, provided
the dynamic not only for the continuing growth of such firms, but also for the
84 Journal of Economic Perspectives

industries which they dominated, and for the national economies in which they
operated. They were created during the knowledge-acquiring processes that
are always involved in commercializing a new product for national and interna-
tional markets. These learned capabilities resulted from solving problems of
scaling up the processes of production, from acquiring knowledge of customers'
needs and altering product and process to services needs, coming to know the
availabilities of supplies and the reliability of suppliers, and in becoming
knowledgeable in the ways of recruiting and training workers and managers.
Such learned knowledge manifested itself in the firms' facilities for production
and distribution. It was even more evident in the firms' product- and process-
specific human skills. Of these skills the most critical were those of the senior
executives—the top managers who recruited and motivated the middle and
lower level managers, defined and allocated their responsibilities, monitored
and coordinated their performance, and who, in addition, planned and allo-
cated resources for these enterprises as a whole.
Such knowledge and skills were developed by learning through trial and
error, feedback and evaluation; thus, the skills of individuals depended on the
organizational setting in which they were developed and used. Such learned
skills and knowledge were company-specific and industry-specific. They were
not, of course, patentable. They were difficult to transfer from one industry to
another, or even from one company to another, precisely because they had
been learned within a very specific organizational context. If these company-
specific and industry-specific capabilities continued to be enhanced by constant
learning about products, processes, customers, suppliers, and other relation-
ships between workers and managers within the firm, enterprises in capital-
intensive industries were usually able to remain competitive and profitable. If
not, they normally lost market share in domestic and international markets to
those firms that did.
The creation, maintenance and expansion of such capabilities permitted
American and German firms in the two decades before World War I to drive
British competitors from international markets, and even Britain's home mar-
ket, in most of the capital-intensive industries of the Second Industrial Revolu-
tion. They made it possible for German enterprises to regain their position in
world markets swiftly after a decade of war, defeat and inflation between 1914
and 1924, and to come back again in the 1950s after a far more devastating
war. So too, organizational learning permitted Japanese firms, first, to carry
out a massive transfer of technology from the west to Japan; then, as Japan's
domestic market grew enough to permit building enterprises large enough to
exploit potential economies of scale and scope, to develop organizational
capabilities necessary for competitive advantage in international markets.
On the other hand, the economies that followed the Soviet model—relying
on central planning agencies to coordinate production and distribution and to
allocate resources for the future—prevented managers in units of production
and distribution from learning how to coordinate effectively. These managers
 Alfred D. Chandler 85

never developed hands-on organization knowledge about current facilities,

available supplies and market demand. The failure to develop such capabilities
has been central to the disintegration of these centrally planned economies.

Organizational Capabilities and the Economics of the Firm

How do established theories involving the firm—neoclassical, principal-

agent, transactions cost and evolutionary theories—relate to this historical view
of the development of the modern industrial firm? How do these theories
contribute to an explanation of industrial growth and transformation?
Neoclassical theory in its basic form views the firm as a legal entity with a
production set (a set of feasible production plans) the knowledge of which is
presumably common. From such a set a manager acts rationally with full
information, choosing the one most likely to maximize profits or the present
value of the firm (Hart, 1989, p. 1758). Principal-agent theory accepts the
neoclassical firm as a production set but gives it managers, and is more specific
about the assets of the principals and agents. The proponents of agency theory
concern themselves with owners' and managers' problems of coping with
asymmetric information, measurement of performance, and incentives. Both
theories see the firm as a legal entity that contracts with outsiders (suppliers,
dealers, financial institutions and the like) and insiders (workers and managers).
Transactions cost theory, like agency theory, focuses on information asym-
metry and the resulting information costs. Where agency theory proponents
concentrate on the information involved in designing contractual relations
between principals and agents, those of transaction cost focus more on the
problems of asymmetric information involved in transactions. They stress that
microeconomic activity is organized to economize the costs of production and
transactions. They also emphasize more strongly than do the users of agency
theory the significance of asset specificity—that is, the specialized physical
facilities and human skills that, because they can only be used in the production
and distribution of specific products and services, lose value if deployed in
other activities.
For Oliver Williamson, the leading figure of this approach, asset specificity
and bounded rationality and opportunism (the primary causes of information
asymmetry) determine whether transactions costs will be lower if they are
internalized within the firm than if they are left to be carried out in external
markets. In Williamson's words, "Any attempt to deal seriously with the study
of economic organization must come to terms with the combined ramifications
of bounded rationality and opportunism in conjunction with asset-specificity"
(1985, p. 42, also p. 30, 53). Because of his concern with firm-specific assets and
skills, I, as an economic historian, have learned much from Williamson.
The basic difference between myself and Williamson is that for him (1985,
p. 41): "The transaction is the basic unit of analysis." For me, it is the firm and
86 Journal of Economic Perspectives

its specific physical and human assets. If the firm is the unit of analysis, instead
of the transaction, then the specific nature of the firm's facilities and skills
becomes the most significant factor in determining what will be done in the
firm and what by the market. For example, the new capital-intensive industries
had a much greater need to monitor high-level throughput than the older
labor-intensive ones. Therefore, firms in the capital-intensive industries inter-
nalized distribution, while those in the labor-intensive ones continued to rely
on independent distributors (Chandler, 1990, pp. 142–143, 153). Moreover,
the pressure to internalize in capital-intensive industries varied from industry
to industry because the source of supplies, nature of technology of production,
and the size and requirements of markets all varied.
Proponents of the recently formulated evolutionary theory of the firm also
see the firm, not the transaction, as the main unit of analysis. That theory, built
on the concept of the firm's activities and growth developed by Alfred Marshall,
Joseph Schumpeter and Edith Penrose, was first spelled out by Richard Nelson
and Sidney Winter in An Evolutionary Theory of Economic Change (1982). As
Winter notes (1988, p. 173), neoclassical "orthodoxy and transactions costs
economics place deal-structuring at center stage, and cast the economics of
production and cost in a supporting role." Their emphasis, on the other hand,
is placed on production rather than exchange.
In a recent paper, building on his and Winter's past work and the more
recent writings of David Teece, Giovanni Dosi, William Lazonick, and myself,
Nelson (1991, pp. 67–68) presents "an emerging theory of dynamic firm
capabilities." He focuses on "three different if strongly related features of a firm
that must be recognized if one is to describe it adequately: its strategy, its
structure, and its core capabilities." Such core organizational capabilities are
based on "a hierarchy of practiced organizational routines, which define lower
order organizational skills [skills required at the lower levels of the hierarchy],
and how these are coordinated, and higher order decision procedures for
choosing what is to be done at lower levels. The notion of a hierarchy of
organizational routines is the key building block under our concept of core
organizational capabilities. At any time the practiced routines that are built into
an organization define a set of things the organization is capable of doing
confidently."
For the history of industrial enterprise, learned routines are those involved
in functional activities—those of production, distribution and marketing, ob-
taining supplies, improving existing products and processes, and the devel-
oping of new ones. Even more important are those routines acquired to
coordinate these several functional activities. Essential, too, are those learned in
the strategic activities of responding to moves by competitors, of carrying on
the long, costly, and risky process of moving into new markets and of adjusting
to the constantly changing economic, social and political environment. The
resulting organizational capabilities permit the enterprise to be more than the
sum of its parts. They give it a life of its own above and beyond those of the
 Organizational Capabilities and the Economic History of the Industrial Enterprise 87

individuals involved. The individuals come and go, the organization remains.
On the basis of these capabilities many of the enterprises that a century ago
helped to fashion the Second Industrial Revolution have prospered and grown
during a century of global wars, deep economic depressions, dramatic political
changes and continuing profound technological transformations. Let me now
turn to indicate the value of using the firm and its learned capabilities as a unit
of analysis in explaining the regularities in the beginnings and growth of
modern industrial enterprise.

Creating the Base for Organizational Learning

The distinctive feature of firms in the new capital-intensive industries of

the late 19th century was that they were able to use new technologies of
production to exploit advantages of scale and scope in a way that firms in older
labor-intensive industries could not. To reap these advantages, however, they
needed to maintain throughput at close to minimum efficient scale. Therefore,
their founders were under greater pressure than processors in other industries
to be certain of a continuous flow of inputs and a relatively assured market for
their large market. This, I must stress, was much less true in the labor-intensive
industries such as textiles in past times and the service industries, software and
the like today. In labor-intensive industries, the creation of a learning base and
the resulting pattern of continuing growth differed substantially.
Transactions cost considerations played a significant part in the determina-
tion of the extent of both forward and backward integration. Even when
suppliers and distributors were competent and reliable, they were often unable
to deliver on schedule and in the quantity and quality required by the new
capital-intensive industries. Distributors were often slow in returning sales
revenues to the manufacturer or in providing necessary marketing services and
information. But the initial move forward into distribution and marketing by
entrepreneurs in the new industries of the Second Industrial Revolution was
that often suppliers and distributors had neither sufficient knowledge of the
novel and complex products nor the facilities required to handle them
efficiently.
This is why so many of the new companies met their needs by building
almost immediately a national marketing and distribution network staffed by
their managers and workers. These organizations either marketed directly to
the industrial customer or, where the customers were more numerous, by
creating a wholesale network. They rarely moved, however, into retailing, for
reasons to be discussed in a moment. In the most technologically complex of
the new industries—particularly chemicals, electrical equipment and nonelec-
trical heavy machinery—industrial customers had little or no knowledge of how
to install, maintain, and repair or even use the new machines or materials.
Here the new companies relied on direct sales.
88 Journal of Economic Perspectives

In volume-produced light machinery, including agricultural, sewing and

business machinery (and a little later automobiles), the companies created
wholesale networks. In these industries, the demonstration, repair and other
marketing services were as essential as they were in heavy machinery but less
complex. But the credit arrangements and collection from a much greater
number of customers were more complex. The companies' wholesale network
not only assured regular deliveries to retailers, but also monitored the ability of
the retailers to provide demonstration and after-sale service and to assure a
steady flow of payments from the retailers back to company headquarters. Both
direct marketing and wholesale organizations were sources of information on
changing short-term market demand and broader knowledge about long-term
customer needs, competitors' goods and the characteristics of markets served.
The new enterprises also required a large-scale investment in physical
facilities. For example, petroleum and vegetable oil companies needed special-
ized railway tank cars and sea-going tankers; chemical companies required a
variety of railway tank cars; and meat-packers used hundreds of refrigerated
cars and a network of refrigerated warehouses. Existing distributors had little
incentives to make large investments in these facilities. The manufacturers had
more knowledge than the distributors about highly specific requirements of
these facilities. Moreover, the distributors realized that if they made such
investments they would be captive of the small number of producers of these
products.
Because their wholesaling or direct sales organizations met the distribution
requirements essential to maintain a steady throughput, few capital-intensive
firms felt the need to take on the financial and managerial costs and risks of
building their own retail network. The investment in the facilities and then the
administrative costs of building one's own national and international retail store
network was far greater than setting up wholesale offices and warehouses in 10
to 15 commercial centers. So the manufacturers relied instead on contractual
arrangements with franchised dealers who sold their produce exclusively or
independent dealers with whom they made contractual arrangements. For
much the same reason, new large retailers—department stores, mail order
houses and chains—which concentrated on mass marketing goods produced in
labor-intensive industries developed strong purchasing organizations to buy
directly from the manufacturers. They only entered manufacturing, usually
temporarily, when they could not acquire goods in the volume and quality
desired. Thus, transactions cost analysis is of great value in analyzing why
volume producers rarely entered retailing, and why mass marketers rarely
entered manufacturing. But because such costs varied with the specific facilities
and skills, as well as the requirements of the parties involved in the reduction of
such information costs, the changes by internalizing or externalizing activities
can be more fully understood within the context of the firms' organizational
capabilities.
Just as the demands of maintaining high volume throughput led to
forward integration, they also brought backward integration. But that
 Alfred D. Chandler 89

integration again should be seen in terms of the enterprise's specific capabilities

and needs at the time of the transaction. For example, Williamson (1985,
p. 119) notes that: "Manufacturers appear sometimes to have operated on the
mistaken premise that more integration is always preferable to less." He
considers backward integration at Pabst Brewing, Singer Sewing Machine,
McCormack Harvester, and Ford "from a transaction cost point of view would
appear to be mistakes." But when those companies actually made this invest-
ment, the supply network was unable to provide the steady flow of a wide
variety of new highly specialized goods essential to assure the cost advantages of
scale. As their industries grew and especially as the demand for replacement
parts and accessories expanded, so too did the number of suppliers who had
acquired the necessary capabilities.
Once such goods were available from a sizeable number of suppliers, the
need for vertical integration through direct ownership lessened. Thus, Ford,
who became the industry's first mover by building the Highland Park plant in
the first years of the 1910s, became a highly integrated enterprise. By the
1920s, General Motors aimed at owning about a third of its parts and accessory
suppliers, in what its managers considered an "insurance policy." Chrysler,
which moved into the low-priced market with its production of the Plymouth in
1929, enjoyed ample sources of supplies during the Depression and made a
most limited investment in suppliers. But when demand boomed after World
War II, however, Chrysler found it necessary to acquire large suppliers. On the
other hand, Ford's decision in the mid-1920s to build a huge works with steel
and glass-making facilities on the River Rouge was indeed a costly mistake. The
point is that an understanding of the changing boundaries of the firm required
an awareness of the specific capabilities of the firm and the characteristics of the
industry and market in which it operates at the time the changes were made.
Many of the first-movers in the new capital-intensive industries which
integrated forward into distribution and marketing and backward into control
of supplies did so on an international scale. Knowledge gained in the creation
of a wholesaling or direct marketing organization at home led to building a
comparable one in foreign markets. When such markets grew to the size that
permitted the establishment of plants of minimum efficient scale, firms used
their learned skills to build new facilities.
The basic technological characteristics of an industry in which the firms
operated at the time of overseas investments were more important than
imperfect information costs in determining the number and location of plants
built abroad. When the minimum efficient scale of production was very high, as
it was in steel, copper and aluminum, building abroad was rare. Such construc-
tion would crowd and so bring overcapacity in that market, resulting in the
higher costs of operating well below full capacity. For chemicals and heavy
machinery, where the cost advantages of scope required concentrating produc-
tion of a number of outputs within a single facility, branch plants usually
carried out only one or two of the final processes. In light machinery, such as
sewing, agricultural and business equipment, plants were usually built to meet
90 Journal of Economic Perspectives

the needs of a major region—Europe, Asia, or the Far East. In consumer

products such as food, drink, and over-the-counter drugs, where the technol-
ogy of production is relatively simple, minimum efficient scale was low, local
suppliers were available, and tastes varied, plants usually were built to serve
smaller national markets, rather than one or two for all of Europe or the Far
East.

The Historical Experience

The ability to gain and maintain market share and profits tests the
efficiency of a capitalist enterprise, particularly in foreign markets where
different laws, customs, working habits, and availability of supplies tend to favor
domestic producers. If so, then the swift and dramatic success of the German
and American integrated companies over their less-integrated British rivals in
the last decades before World War I demonstrates how the creation of organi-
zational capabilities through the initial investment in production and distribu-
tion permitted first-movers in the new and the transformed industries of the
Second Industrial Revolution—chemicals, electrical equipment, light and heavy
machinery and metals—to conquer world markets quickly and to raise power-
ful barriers to subsequent entrants.
The chemical industry was the most technologically advanced of the new
industries, and provided the widest range of new industrial and consumer
products including man-made dyes, medicines, fertilizers, textiles, film, and
other materials.
The first major products of this industry were synthetic dyes, and here
British entrepreneurs were the pioneers. An Englishman, William Perkin,
invented the first such dyes. The world's largest market for man-made dyes
remained, until after World War II, the huge British textile industry. Dyes are
made from coal, and Britain had the largest supplies of high quality coal in
Europe. In the 1870s, the new dye industry in Britain had almost every
advantage. By any economic criterion the British entrepreneurs should have
quickly dominated the world. But they failed to make the essential investments
in production, distribution and management. Bayer, BASF, Hoechst and three
smaller German enterprises did.
In the 1880s and the 1890s, these pioneering German firms became the
industry's first movers. They began to build one or two giant works along the
Rhine, carefully planned to utilize economies of scope. Where the British works
produced only 30 or 40 dyes, the Germans were making 300 to 400. While the
British continued to rely on jobbers to distribute the product, the Germans
created a worldwide sales force; for every user of dyes in the production of
cloth, leather, paper, and other materials had to be taught how to apply the
new products. For example, by the time Bayer had completed its works at
Leverkusen, its sales force of trained chemists was working worldwide with
 Organizational Capabilities and the Economic History of the Industrial Enterprise 91

more than 20,000 customers. By the turn of the century Bayer and the other
German chemical leaders had created the largest and most carefully defined
industrial managerial hierarchies the world had yet seen. These organizational
capabilities permitted Bayer and the other first movers to commercialize and
market worldwide several hundred different dyes and a wide range of new
man-made pharmaceuticals and films.
The resulting German competitive advantages quickly demolished Britain's
economic comparative advantages. In 1913, 160,000 tons of dyes were produced
worldwide. The German firms made 140,000 tons (72 percent of this output by
the Big Three); 10,000 more were produced by Swiss neighbors up the Rhine.
Total British production was 4,100 tons. The story was much the same for
pharmaceuticals, films, agricultural chemicals, and electro-chemicals.
The electrical equipment industry, while employing a smaller number of
professionally trained technicians and scientists, transformed economic life even
more than chemicals. The new industry provided new sources of light and
power that altered urban living and transportation, and also changed the
workplace. Moreover, a new electrolytic process transformed and greatly re-
duced costs of producing copper, aluminum, and several chemicals.
In the first years of this industry, British pioneers were as active as those in
Germany and the United States. But within a decade after the establishment of
Thomas Edison's first central power station in 1882 in New York City, two first
movers in the United States (General Electric and Westinghouse) and two in
Germany (Siemens and Allgemeine Elektricitäls Gellsellschaft, AEG) had made
the investments in production, distribution and management to exploit
economies of scale and scope. Nothing comparable occurred in Britain, even
though Sir William Mather, senior partner of Mather & Platt, one of the largest
British textile machinery manufacturers, had obtained the Edison patents at
the same time as had Emil Rathenau at AEG.
As a result, by 1913, two-thirds of the electrical equipment made in British
factories by British labor was produced by subsidiaries of General Electric,
Westinghouse and Siemens. AEG sold more products in Britain than did the
largest British firm. Mather & Platt had become a minor producer of electrical
equipment for factories. From the 1890s on, continuing research and develop-
ment that improved existing products and developed new ones in this critical
science-based industry was carried out in Schenectady, Pittsburgh, and Berlin,
but not in Britain.
What was true of chemicals and electrical equipment was also true in steel,
copper and other metals and in heavy and light machinery. In metals the
British pioneered, but the Germans and Americans made the necessary invest-
ments that quickly drove the British from international markets. In machinery
the British did not even try. The Germans quickly dominated the production of
heavy processing machinery and equipment, while the Americans acquired a
near global monopoly in light machinery produced in volume by the fabricat-
ing and assembling of standardized parts, a process that by the 1880s had
already been known as "the American system of manufacturing."
92 Journal of Economic Perspectives

In office machinery, such first movers as Burroughs Adding Machine,

National Cash Register, Remington Typewriter Company, and the
Computing-Tabulating-Recording Company (renamed International Business
Machines in the early 1920s) dominated their industries worldwide. In sewing
machines the Singer Sewing Machine and in agricultural equipment
McCormick Harvesting Machine (it became the core of International Harvester,
a 1902 merger) were the world leaders. Indeed, in 1913, the two largest
commercial enterprises in imperial Russia were Singer and International Har-
vester. By then Singer produced 79,000 machines annually in its Moscow
factory with a work force of 2,500 wage earners and 300 salaried employees;
while its salesforce of more than 27,000 covering the vast territory from the Sea
of Japan to the Baltic. At the same time, Harvester distributed through a
network of branch offices in 11 cities that encompassed 80 percent of the
implement dealers in Russia. For both companies, their Russian operations
were smaller than those of their other European business based on Singer's
factories in Scotland and Germany and Harvester's major plant in Germany. By
World War I, American firms had achieved comparable global competitive
power in the production of elevators (Otis Elevator), pumps (Worthington
Pump), boilers and other steam equipment (Babcock & Wilcox), printing
equipment (Merganthaler Linotype), and heating equipment (American
Radiator).
Why did British pioneers fail to make the investments necessary to develop
the organizational capabilities required to compete with German and American
firms? The answer is enormously complex, involving economic and noneco-
nomic institutions, class and cultural considerations, and historical timing. It
cannot be examined here. The point of recounting this bit of history is to
document that, unless investments were made essential to utilize the cost
advantages of scale and scope, the enterprises and the industries and national
economies in which they operated lost out in international markets to foreign
enterprises that made them. Moreover, without such a base for organizational
learning, company- and industry-specific capabilities in production, distribu-
tion, R&D, purchasing, and labor relations, the necessary competitive strength
could not be developed.

Continued Growth Through Utilization and Expansion of

Organizational Learning

In the years following World War I, the first movers and a small number of
challengers continued to grow by entering markets abroad and those of related
industries. Such growth was more important to the history of the modern
corporation than that of vertical integration. The latter came in response to
specific technological and market situations. Growth into new markets
 Alfred D. Chandler 93

remained a far more continuing long-term strategy of expansion. Such growth

was driven much less by the desire to reduce transaction, agency and other
information costs and much more by a wish to utilize the competitive advan-
tages created by the coordinated learned routines in production, distribution,
marketing, and improving existing products and processes. In geographical
expansion that utilized the capabilities honed in exploiting the economies of
scale, the firm usually concentrated on a single line of products. In entering
related product markets which reflected knowledge acquired in utilizing the
economies of scope, the firm often entered more than a single line. Such
expansion abroad and into related industries became itself a learning experi-
ence as to the ways of capturing of new markets and of managing an enlarged
multi-market enterprise.
After World War I, leaders in these major capital-intensive, oligopolistic
industries continued to expand existing foreign beach-heads and to enter new
territories. In the context of this strategy, the primary impact of World War I
was to weaken German industrial leaders. During the war, their subsidiaries in
Allied nations were expropriated and usually turned over to their competitors
in those countries. Moreover, the German firms were kept at a distance in
international markets during the decade of war, defeat, occupation of industrial
areas and hyperinflation. Nevertheless, in the brief period between 1925 and
the onslaught of the Great Depression, the learned knowledge and skills of the
German enterprises in chemicals, electrical equipment, machinery and metals
permitted the German enterprises to by 1929 regain their earlier position in
world markets. Their competition came less from British and French compa-
nies and more from firms in neutral nations who had benefitted from the
hiatus of German dominance to expand their capabilities. These included such
firms as Sandoz, Ciba, Geigy in chemicals and Brown, Boveri in electrical
equipment in Switzerland; Philips in electrical equipment in Holland; and
Ericsson in telephone equipment in Sweden.
For U.S. companies, the war and German's postwar difficulties boosted the
growth of overseas sales for chemical, machinery and metal companies. The
diversification in chemical companies in the new products (to be described
shortly) helped to make them significant players in world markets. In electric-
ity, the two U.S. first-movers began to pull ahead of the Germans. By 1929,
General Electric dominated the world's electrical equipment market. Its sub-
sidiaries in Britain and France were the largest producers in those nations. It
held 25 percent of the stock of Germany's AEG and had comparable invest-
ments in leading electrical manufacturers in Mexico, South Africa, and Japan.
In Japan, GE controlled Tokyo Electric and had a minority interest in Shibaura.
(These two companies merged in 1937 to become Toshiba as the Japanese
began to take over American enterprises.)
In telephones and related equipment, the international division of AT&T's
Western Electric (and its successor ITT) remained the world's largest producer.
And in automobiles, the great new transforming and growth industry of the
94 Journal of Economic Perspectives

interwar years, the first mover, Ford, and its two challengers, General Motors
and Chrysler, quickly dominated world markets. In 1929, American manufac-
turers turned out 85 percent of the world's production. Subsidiaries of Ford
and General Motors were leading producers in Germany, Britain, Australia and
Japan.
Makers of branded packaged food, drink, drugs, and paints expanded
even more energetically than had those in light volume produced machinery
before 1914. During the interwar years, IBM, Remington Typewriter and
Timken Roller Bearing went abroad in the ways in which Singer, Harvester,
and other machinery companies had done earlier. Of the leading food and
drug firms during the interwar years, Quaker Oats, Heinz, Coca Cola, Ameri-
can Cotton Oil, Parke-Davis, United Drug and Sherwin-Williams all had sub-
stantial investments overseas before 1914. After the war Borden, Carnation, Pet
Milk, Corn Products Refining, National Biscuit, California Packing (Del Monte),
Wrigley (chewing gum), American Home Products, Sterling Drug, Procter &
Gamble, and Colgate-Palmolive-Peet all had built manufacturing establishments
abroad.
Growth into new product markets was more complex than expansion
abroad, because it almost always required new investment in complementary
physical and human assets. That is, it required the creation of new capabilities.
For example, a move based on the economies of scope in production required
the building of a new marketing organization. A move based on utilizing those
in distribution usually called for an investment in new production and often
research and development facilities and skills.
The expansion into related product markets came first in science-based
industries, where opportunities were greater for exploiting economies of scope
in production and R&D. The German dye makers began in the 1890s to
produce a wide variety of pharmaceuticals and a little later of film. Bayer's well
known aspirin was one of several sedatives and barbiturates developed before
1900. In 1892, Hoechst brought on the market one of the first serums for
diphtheria, followed by Novocaine and other pain killers; fever-depressing
drugs and vaccines for cholera and tetanus; and one of the earliest chemothera-
peutical drugs, Salvarsan, the first effective remedy for syphilis. The smaller
AGFA, besides producing pharmaceuticals and specialty dyes, led the way in
photochemicals. These companies quickly created a separate worldwide mar-
keting organization for each of their new lines.
The U.S. chemical companies waited until World War I to embark on
comparable strategies of diversification, but then they entered into new product
markets even more energetically than did the Germans. In the 1920s, Du Pont,
Union Carbide, Allied Chemical, Dow and Monsanto all diversified into a wide
variety of products that reflected their specialized major technological base. Du
Pont relied on its nitrocellulose chemical capabilities; Union Carbide on its
experience in electrochemicals and carbides and then on its pioneering in
petrochemicals; Allied on its knowledge of coal tar based chemistry; Dow on
 Organizational Capabilities and the Economic History of the Industrial Enterprise 95

chloride and other salt-based chemicals; and Monsanto on saccharin-based

ones. Although the production of these products were scope-related, their
marketing called for the creation of new organizations. For example, produc-
tion of cellophane at Du Pont used much the same capabilities as those of
rayon, but the product went to a completely different set of industrial cus-
tomers with very different needs. In the United States, the chemical firms were
among the first to adopt a multidivisional structure—that is, to set up au-
tonomous divisions to integrate production and distribution of major product
lines with a central corporate headquarters, which in turn monitored the
performance of and planned and allocated resources for the divisions.
The German and American first-movers in electrical equipment—Siemens,
AEG, GE and Westinghouse—also quickly used their specialized skills and
facilities to enter a variety of markets. In the years before World War I they
produced equipment not only to generate and transmit electric power and
light, but also made street railway and subway equipment, electric motors for
industrial purposes, and (the Germans more than the Americans) produced
electrochemicals and telephone and telegraph equipment. And again, the
Germans more than the Americans concentrated production in huge works to
exploit more effectively the economies of both scale and scope. In the 1920s,
these firms developed first-mover advantages in X-rays and other equipment
(that helped to transform medical practice), in electrical appliances (stoves,
refrigerators, washing machines, heaters and the like that helped transform
household living) and radio (that helped to transform communication, enter-
tainment and politics). RCA, the first mover in radios in the United States, was
a joint venture of GE, Westinghouse and AT&T. Its European counterpart
Telefunken was a joint venture of Siemens and AEG. At GE, the lines whose
operating results were accounted for separately rose from 10 in 1900 to 193 in
1930 to 282 in 1940.
In nonelectrical machinery, the early organizational learning shaped later
growth. The German heavy machinery firms that began by utilizing scope
economies had a broader line and lower volume; while the producers of
American light machinery which concentrated on exploiting those of scope
produced only a relatively small number of product lines. Thus in the 1920s,
Maschinenfabrik-Augsburg-Nürnberg (MAN) used scope economies to manu-
facture in three works an extraordinary variety of machines for the mining,
metal, metal-processing, metal-fabricating, ship-building, chemicals, food, tex-
tile, lumber, and printing press industries and also for utilities; while Singer
and the business machine companies continued to concentrate on a small
number of closely related product lines for much the same markets.
Even in less research-intensive industries, opportunities existed for expan-
sion into new markets. The meat packers, for example, used their distribution
network to market butter, eggs, poultry and fruit. By 1900, Armour was the
nation's largest seller of butter. Again, these new businesses required invest-
ment in new processing and purchasing facilities and personnel. The producers
96 Journal of Economic Perspectives

of branded, packaged, consumer food products such as soap and other toi-
letries moved into the production of food. Even before the 1920s, Procter &
Gamble in the United States and Lever Brothers in Britain had become leading
producers of cooking oil and margarine. So too, food companies such as
Quaker Oats, Borden and Corn Products Refining developed chemical prod-
ucts, usually by setting up joint ventures with chemical companies. On the
other hand, before World War II, the oil companies explicitly turned down
opportunities to enter petrochemicals because their capabilities lay in handling
a huge volume of a single line of products and not in a wide variety of goods for
different markets. Thus Union Carbide, the first to build large petrochemical
plants in the United States, did so by constructing one next to Standard Oil of
Indiana's Whiting Refinery and South Penn Oil Company's refinery in Char-
leston, West Virginia. In all these moves into related product markets, the
competencies of the existing companies clearly shaped the direction, timing
and methods of diversification. Before the 1960s, industrial enterprises in the
United States and Europe rarely moved into markets where their learned
capabilities did not give them a distinct competitive advantage.

Organizational Learning and the Creation of New Industries

The ability of large established firms to use learned routines and integrated
capabilities to enter related product markets helps to explain a significant
change in the ways in which major new industries are coming to be created. In
earlier years, entrepreneurs like Rockefeller, Carnegie, Coffin (of GE), Ford,
and Eastman created the enterprises that became the first movers in oil, steel,
electrical equipment, automobiles and cameras. More recently firms like Xerox
and Polaroid have made the three-pronged investments essential to become
first movers in somewhat more specialized industries. But in others, first
movers have been established enterprises. This has been true not only in radio
and TV, but also in the therapeutic revolution that in the 1940s and 1950s
transformed the U.S. drug industry, the polymer revolution of the same years
that transformed the chemical industry by creating new types of man-made
fibers, rubber and other materials, and the mainframe computers that in the
1960s sparked the information revolution.
Until World War II, U.S. drug companies concentrated on two lines of
products—those produced in bulk to be retailed or mixed into prescriptions by
pharmacists and to be sold over the counter without prescriptions. The devel-
opment of sulfa, penicillin, and other antibiotics reshaped the industry's ways of
production, distribution and research. Production became a complex chemical
process rather than a single mixing one. Marketing turned from selling over-
the-counter products to reaching doctors who wrote the prescriptions and
hospitals where they were used. Research became far more science-based. But
the well-established firms knew the basic market and understood testing
 Alfred D. Chandler 97

procedures to meet quality and safety demands of customers and government

regulations. They invested in and continually learned the new ways of product
development, scaling up and marketing. Those companies that made the
transformation into the new prescription drugs in the 1940s and 1950s—
including Merck, Abbott, Pfizer, Eli Lilly, Upjohn, and Parke-Davis (now the
pharmaceutical branch of Warner-Lambert)—are still today's industry leaders.
With the exception of Control Data, long-established firms were the first
enterprises to commercialize mainframe computers. They included IBM, which
became the industry's first mover with the development of the Series 360 in the
1960s; the other leading business machinery companies like National Cash
Register, Burroughs Adding Machine and Remington Rand (all three were first
movers in their industries in the 1880s); and Honeywell, an established pro-
ducer of heat control systems, that (like cash registers and adding machines)
lent themselves to computer control. They had the competitive advantage over
other mainframe pioneers in their long experience in the huge new potential
market of business enterprises. While they were expanding at home and
abroad, entrepreneurial start-ups such as Digital Equipment and Data General
developed a different architecture for more specialized educational and scien-
tific markets. They were quickly challenged by the well-established firms. By
1980, Digital Equipment and Data General were second and fourth in size of
sales in minicomputers with IBM first, Burroughs third, and Hewlett-Packard
fifth.
Then microcomputers offered a new architecture for a new market, the
individual user. In the late 1970s three first movers—Apple, Tandy, and
Commodore—accounted for 72 percent of U.S. dollar sales. By 1982 IBM,
NEC and Hewlett-Packard had moved in and captured 35 percent of the
market, driving down the entrepreneurial start-up firm's share to 48 percent.
Nearly all the major chemical products developed in the past decades have
been commercialized (though certainly not invented) by long established firms.
These include fibers based on polymer chemicals (by 1985 cotton, wool, silk
and other natural fibers accounted for less than 30 percent of fibers consumed
in the United States) and such specialties as additives, catalysts, industrial
coatings, electrical chemicals, medical systems and devices based on chemical
technology, advanced materials such as fiber and metal matrix composites,
engineering plastics, ceramics and new electronic materials. Even in the emerg-
ing field of biogenetics, large firms, both chemical and pharmaceutical, are
playing a major role in commercializing these new products.
Established firms in recent years have played a greater role in the creation
of new industries than entrepreneurial start-ups because the time and cost of
commercializing technologically complex new products and processes is not in
invention or research. It is in development—in the long and complex course
required to produce goods in large enough quantity and with high enough
quality to be purchased by a substantial number of customers in national and
global markets. The commercializing of a new product or process, in itself a
98 Journal of Economic Perspectives

continuing learning experience, rests on cumulative organizational learning in

the development, production and marketing of earlier products. Moreover,
large industrial multi-market firms—be they American, European or Japanese
—have throughout this century used retained earnings (the profits from
products earlier commercialized) to fund the high cost of developing new ones.

Conclusion
This brief review of the beginning and growth of the modern industrial
enterprise suggests how the evolutionary theory of the firm, which emphasizes
continuous learning that makes a firm's assets dynamic, provides an under-
standing of why in the past new firms began through the process of integrating
production and distribution and why and how they grew by expanding into
new markets. I believe that a similar analysis of today's industrial enterprise,
particularly the relative competitive success and failures of the U.S., European
and Japanese firms, requires much the same type of analysis, but that is a
subject for another paper. Here, I make only two points about the relevance of
organizational learning and capabilities to explain today's competitive strengths
and weaknesses.
First, the full impact of the international competition that began a century
ago was held back by world events. Two world wars and the intervening Great
Depression weakened the competitive strength of the U.S. firms' most powerful
rivals, particularly the Germans. The international competition which had been
developing before 1914 did not become a full-fledged reality, therefore, until
the 1960s. It did so after the economic health of the European nations had
been fully restored and after their companies had returned to international
markets, and after Japan, following a large-scale transfer of new technology,
began to industrialize rapidly. Interindustry competition also intensified in the
postwar years, as the great increase in research and development expenditures
indicates.
Secondly, the response of U.S. firms to this competitive challenge delin-
eates the ways in which a firm's core competence helps to determine successful
paths of, as well as limits to, growth. Many U.S. firms did not respond to the
intensified competition and the resulting decline in their rate of return on
investment by reinvesting in maintaining and expanding existing capabilities.
Instead, they used the retained earnings to acquire facilities and personnel in
other existing business, in which their own capabilities did not give them a
competitive edge. In most cases, they were in time forced to pull back in and to
concentrate on businesses that were closer to their core competencies. Indeed,
one of the most significant and historically unique stories of the past three
decades in American industry has been this expansion, the resulting discovery
that competencies determine the limits of growth and then the following
contraction. Today the product lines of large multimarket industrial firms have
become far more focused on their core capabilities (Scheifer and Vishny, 1991).
 Organizational Capabilities and the Economic History of the Industrial Enterprise 99

Just as I find the earlier growth of the industrial firm difficult to explain
fully in terms of transactions, agency and other information costs, so I find it
hard to explain the recent process of expansion and contraction with these
same concepts. Nor can they explain why firms in American industries such as
chemicals, pharmaceuticals, computers, aircraft and aerospace, oil refining and
food processing continue to be global leaders, whereas others in automobiles,
tires, semiconductors, consumer electronics and machine tools have fallen
behind. The answer requires a consideration of how the enterprises evolve
their organizational capabilities and how their long-term competitive strength
and weakness reflect these learned capabilities as well as those of their competi-
tors from abroad and related industries.
Besides providing tools for historical analysis and explanation, evolu-
tionary theory raises significant questions for study. How precisely were the
learning processes carried out? How and why did industry-specific and particu-
larly company-specific characteristics vary? Why were some capabilities more
easily transferred to different geographic and new product markets than
others? What were the contents of the routines developed to evaluate and
capture new markets and move out of old ones? Why has functional and
strategic competition in modern capitalistic economies played a larger role in
changing market share and profit than price? What are the determinants of
competitive success in national industries and even national economies?
In pursuing these questions, I am convinced that the unit of analysis must
be the firm, rather than the transactions or contractual relations entered into
by the firm. Only by focusing on the firm can microeconomic theory explain
why this legal, contracting, transacting entity has been the instrument in
capitalist economies for carrying out the processes of production and distribu-
tion, for increasing productivity and for propelling economic growth and
transformation. Only by focusing on the firm can theory predict the firm's
continuing role as an instrument of economic growth and transformation, and
assist in developing policies and procedures for maintaining industrial produc-
tivity and competitiveness in an increasingly global economy.

• Unless otherwise documented, the factual information in this piece comes from Scale
and Scope and my own ongoing research on post-World War II developments of U.S.
industrial enterprises. My thanks go to the several scholars who read this paper—Richard
Rosenbloom, Richard Langlois, Michael Jensen, Bruce Scott, Richard Nelson, and most
of all, Takashi Hikino. I am particularly grateful for the careful, detailed, and searching
reviews by the editors of this journal, Joseph Stiglitz, Carl Shapiro and Timothy Taylor
and for Gavin Wright's suggestion that I write this piece.
100 Journal of Economic Perspectives

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