Product Innovation, Product Diversification, and Firm Growth: Evidence from Japan’s Early Industrialization

We explore how firms grow by adding products. In contrast to most earlier work on the topic, our conceptual and empirical framework allows for separate treatment of product innovation (vertical differentiation) and diversification (horizontal differentiation). The market context is Japan’s cotton spinning industry at the turn of the last century. We find that introducing innovative products outside of the previously feasible is a key to firm growth. It provides opportunities to capture high-end vertically differentiated product markets when successful while also facilitating the firm’s growth through horizontal expansion in product space. However, this process involves a high degree of uncertainty, so firms tend to introduce innovative products on experimental basis. In long-term outcomes, the right tail of the firm size distribution becomes dominated by firms that were able to expand in both directions: moving first into technologically challenging vertically differentiated products, and then later applying their newly acquired high-end technical competence to horizontal expansion of their product portfolios.