Theory of the Growth of the Firm

by Edith Penrose

  • Firms differ from markets in that transactions in markets do not take place within administrative boundaries.

  • Entrepreneurs are in search of profits; firms desire to increase total long-term profits ‘for the sake of the firm itself and in order to make more profit through expansion’ (1959/2009: 26).

  • Resources render (multiple) services. The heterogeneity of services from resources gives each firm its unique character. Effective use of resources and innovation takes place when resources are combined with other resources.

  • Human, and in particular managerial, resources are of the essence, because expansion requires planning and managerial resources able to plan for the firm are firm-specific; they cannot be acquired in the market.

  • The cohesive shell of the firm helps create knowledge. This can be ‘objective’ (transmittable) or ‘experiential’ (hard to transmit). Experience renders managerial services firm-specific.

  • Unused resources always exist; they are released after the completion of an expansion and they are created through experience and new knowledge. They are an internal stimulus to growth and innovation, and determine in part the direction of expansion.

  • Firms are not defined in terms of products, but of resources and (so) ‘diversification’ is the normal state of affairs in firm expansion.

  • There are economies of growth, quite apart from any economies of size.

  • There are limits to growth, but not to size, and these are determined by the rate at which experienced managerial staff can plan and implement plans. The services of ‘inherited’ managerial resources control the amount of new managerial resources that can be absorbed, and thus limit the rate of growth of firms.

  • The external environment is an ‘image’ in the mind of the entrepreneur. Firms’ activities are governed by their ‘productive opportunity’; this involves a dynamic interaction between the internal and the external environment and includes all the productive possibilities that its entrepreneurs can see and take advantage of.

  • In the long run, the profitability, growth, and survival of firms depend on them establishing ‘relatively impregnable “bases” (1959/2009, p. 121) from which to adapt and extend their operations in an uncertain, changing, and competitive world. A new technological base requires the firm to achieve a ‘competence’ in some significantly different area of technology.

  III.b. From Firm Growth, to Industry Organization and Anti-Trust Policy

  The above account is by and large well known by now, and much of it can be found in other contributions (see Penrose and Pitelis 1999, Kor and Mahoney 2000, Pitelis 2002). Less well known is Penrose’s use of these ideas in explaining vertical integration, mergers and acquisitions, industrial concentration, the scope for small firms, and competition policy. Penrose’s ideas on all these are nuanced and hard to present in a short space, but some elements are presented here and elaborated upon in the next subsection (see also Slater 1980a).

  First, vertical integration. For Penrose, firms integrate vertically in part because they may be able to produce more cheaply for their own requirements (Penrose 1956, 1959). However, they have to set this against the diversion of resources from potentially more profitable activities. Mergers and acquisitions can be motivated in part by the need to acquire productive services. Targets are likely to complement or supplement the acquiring firm’s existing activities.

  Concentration in a growing economy emerges when the larger firms as a group grow faster than the smaller firms and (therefore) the economy as whole (Penrose 1956, 1959). Larger and older firms have a ‘competitive advantage’ over smaller firms in terms not only of non-monopolistic advantages (size, experience, access to funds, etc.) but also because of ‘monopolistic power’ (1956, p. 64). In a growing economy, however, and given limits to firm growth, it is unlikely that large firms can take advantage of all opportunities open to them, allowing potentially profitable opportunities for smaller firms. These relatively unprofitable activities for larger firms are the ‘interstices’ of the economy. Limits to the rate of growth of large firms, and big business competition will tend to lead to a decline in concentration, albeit not the absolute size of large firms.

  On competition, Penrose observed that a strong case can be made for the big firm and for ‘big business competition’ especially ‘with respect to the rate of development of new technology and new and improved products’ (1959/2009, p. 229). The ‘basic dilemma’ is that competition induces innovation but ‘competition is at once the god and the devil’ (p. 233) in that the growth of firms may be efficient but the consequent size may lead to industry structures which impede growth.

  Penrose’s nuanced perspective on firm growth and industry organization shows vividly when she considers ‘monopoly and competition’ in the petroleum industry (1964). Echoing critically Schumpeter (1942) and pre-dating Chandler (1962) and Demsetz (1973), she observes that the firms’

  efficiency in production and distribution, in inventions and technological advance, could not account for the dominant position they achieved. Their record in finding, producing and distributing oil and its products is indeed impressive, but efficiency in this respect would not have been enough to secure their dominance. Hence the story of the rise of the great companies deals as much with financial power, commercial and political negotiations and intrigue, with cartel agreements, marketing alliances, price maintenance arrangements, price wars and armistices, mergers and combination, actions to avoid taxes, and the national and international political interests of governments, as it does with the economics of production and distribution. This statement does not necessarily imply any condemnation of the companies (1964, p. 155).

  The above provide a broad picture of what Penrose covered in her early work on the growth of the firm. Penrose’s subsequent work has also been important, particularly her work on the theory of the multinational firm, the international oil industry, and the political economy of international relations and the economics of the Arab world.

  III.c. The Multinational Enterprise and the Political Economy of International Trade and Relations

  Penrose’s flirtation with the multinational enterprise (MNE) and foreign direct investment (FDI) has been long and enduring. Many of her major publications are on this topic. This includes an Economic Journal article in 1956, and interestingly the homonymous entry in the New Palgrave (1987). In all her later writings, notably her Uppsala (1985) lecture on the 25 years since TGF, in her 1995 foreword to the book’s third edition, and in her entry to the International Encyclopedia of Business Management (1996), Penrose includes a section on multinationals.

  Throughout her writings on this topic, Penrose considers the multinational as the natural outcome of the very pressures for growth:

  [T]he processes of growth, the role of learning, the theory of expansion based on internal human and other resources, the role of administration, the diversification of production, the role of merger and acquisition are all relevant.… It is only necessary to make some subsidiary ‘empirical’ assumptions to analyze the kind of opportunities for the profitable operations of foreign firms that are not available to firms confining their activities to one country as well as some of the special obstacles (1995/2009, p. 239).

  The same is emphasized in her 1987 entry to the New Palgrave. ‘There are differences between national and international firms, but the differences are not such as to require a theoretical distinction between the two type of organizations, only a recognition that national boundaries make an empirical difference to their opportunities and costs’ (1987, p. 563).

  The emphasis changes a little in her 1996 paper. ‘International borders make enough difference to justify separate treatment of international firms. The differences arise from the additional obstacles (or advantages) relating to culture, language and similar considerations’ (1996, p. 1720).16

  Penrose’s initial reluctance to acknowledge any fundamental difference in the nature of multinationals, as
opposed to the relative importance of national boundaries, could partly explain the fact that her work on this topic has been less noticed and not linked to TGF.17 One reason for this is that Penrose did not address the question ‘why MNEs’ vis-à-vis, let’s say, licensing or exports; therefore, she did not deal with the ‘nature of the MNE’. This is not very surprising—TGF did not address the issue why (national) firms either. Rather more surprising is the fact that Penrose did not explore in any detail the implications of her TGF contribution for the growth of the MNE either. This is partly because in her early work she chose to treat subsidiaries as independent entities (Penrose 1956).

  However, TGF and Penrose’s other insights have important implications on the theory of the MNE. In particular, Penrose’s knowledge/learning perspective can add cognitive and entrepreneurial elements, missing from extant theory (Pitelis 2007a). These can be highlighted in terms of Dunning’s (1988) well-known triad of Ownership, Location, Internationalization (OLI), which is now widely seen as a general framework on the MNE and FDI. For Dunning, the choice of FDI versus alternatives such as licensing presupposes the coexistence of ownership advantages, internalization (integration) advantages, and locational advantages (see Dunning and Lundan (2008) for a recent restatement and extension).

  Starting with Ownership (O) advantages, in TGF O are efficiency advantages, as they are the result of an endogenous knowledge/innovation process. O advantages only become monopolistic when firms attempt to capture value by, for example, creating ‘relatively impregnable bases’, raising barriers to entry, using restrictive practices, etc. All these are discussed in TGF (mainly Chapter VII). In addition Penrose observes that

  A firm may attempt to entrench itself by destroying or preventing effective competition by means of predatory competitive practices or restrictive monopolistic devises that relieve it of the necessity of either meeting or anticipating serious competitive threats to its position. In such circumstances a firm may grow for a considerable period depending on the demand for its products, harassed neither by price competition nor by the fear that competitive developments will make its products or processes obsolete. Examples of growth over long periods which can be attributed exclusively to such protection are rare, although elements of such protection are to be found in the position of nearly every large firm. (1959/2009, p. 100)

  Monopolistic advantages are in line with Penrose’s claim that while the process of expansion is by definition efficient, the resulting state need not be—as/when MNEs try to capture value through monopolistic practices. The dual nature of O advantages, as both efficient and monopolistic, is in line with subsequent literature (see Dunning and Pitelis 2008). In addition, the Penrosean insight serves to provide an intra-firm, efficiency-based explanation of (endogenous) O advantages. It also introduces the important distinction between process and state-type advantages, the latter being potentially monopolistic as originally suggested by Hymer (1960/1976).

  Penrose did not deal with Location (L) in TGF. As noted in her foreword to the third edition (Penrose 1995), she claimed that all the theory of the MNE requires is to suitably adapt her TGF ideas, and account for the existence of different nations. This would require accounting for international differences in regulatory and tax systems, different laws and cultures, etc. Penrose did not pursue this much further, leaving it to other scholars to do so. (We will return to this later, when discussing I.) Nevertheless, the Penrose an perspective has important implications on resource/asset/knowledge/innovation and institution-seeking and augmenting locational advantages for FDI. As firms are bundles of resources creating knowledge, it is ‘natural’ for them to locate where existing resources/knowledge are such that they can add value to firms’ existing resources, knowledge, and technological bases and (thus) operations. This implication from Penrose’s work is in line with Dunning’s discussion of asset and institution-seeking locational advantages (e.g., Dunning 2001, 2005), and more recent attempts to build a theory of the meta-national (e.g., Doz et al. 2001), which consider MNEs as pursuers of global learning, knowledge acquisition, and upgrading, as well as work by Dunning and Lundan (2008) on institutional advantages.

  Although Penrose did not deal with I advantages in the specific context of the MNE,18 she dealt extensively with integration, which she considered as an earlier (and more accurate) term for ‘internalization’.19 Accordingly, her views on ‘internalization’ should be looked at in her analysis of horizontal and vertical integration. In TGF there are detailed arguments for both. For example, one argument she offers for horizontal integration is the acquisition of valuable managerial resources (partly in response to the ‘Penrose effect’).

  Of especial importance is the fact that a firm can also acquire an experienced management ‘team’ and an experienced technical and labour force. Hence acquisition can be used as a means of obtaining the productive services and knowledge that are necessary for a firm to establish itself in a new field, and the addition of new managerial and technical services is often far more important than the elimination of competition and the reduction of the costs of entry (Penrose 1959/2009, p 112).

  Concerning vertical integration, one reason for it is the superior knowledge and (thus) ability of firms to cater for their own needs, as they have better knowledge of these (Pitelis and Wahl 1998). For example, Penrose states that opportunities arising from the nature of the productive resources of the firm giving the firm an advantage in the production of some of its own requirements, market opportunities in the case of forward integration, competitive pressures of various kinds, special problems arising from the existence of uncertainty, all play a similar role (1959/2009, p 128).

  Applying such ideas to the case of the MNEs would suggest resource/knowledge/institution seeking superior firm capability-induced FDI. The last-mentioned is similar to Teece’s (1977) and Kogut and Zander’s (1993) subsequent ‘evolutionary’ contribution to the MNE (see Verbeke 2003 for a critical account).20

  To summarize, TGF arguments on integration have implications on I, in line with more recent theoretical developments. Importantly, moreover, a Penrose-inspired knowledge/learning-based approach has important implications for the interaction between O, L, and I. In addition, by incorporating cognition, it calls for a more entrepreneurial, forward-looking approach for the MNE, and (more widely) one that (tries to account for) anticipated change and to act on that basis Pitelis (2007a).

  Penrose’s analysis of the political economy of international relations, notably the relation between multinationals and developing countries, is similarly based on dispassionate non-partisan, careful, and dissecting analysis. Her analyses of transfer pricing, dumping, and protectionism are anathema to mainstream neoclassical views, yet extremely modern in the context of ‘new international trade’ and related theories (see for example Krugman (1986, 1990) and Pitelis (2009b) for a recent critical account). To mention just a few points, in Penrose (1962, p. 138) she suggests that ‘restriction on the repatriation of profits under some circumstances may be a useful means of ensuring, for a while, continued foreign investment’. Moreover, in Penrose (1973, p. 8) she suggests that ‘infant firms’, not just infant industries, arguments be ‘accepted as an exception to the doctrine of “free investment”, while in Penrose (1990, p. 185) she suggests that ‘dumping is endemic in the system, an integral part of the competition among large, diversified, research-based, integrated companies’.

  III.d. Epistemology

  Penrose did not deal extensively with the issue of ‘methodology’. Yet her ‘endogenous growth’ approach to organizations and institutions, her insistence that in order to appreciate the external, one has to start from the internal (‘nature’) of the object under investigation, the dynamic interaction between the ‘nature’ and the external, her own experience with research, both at the Hercules Powder Company, and later in the Arab world, her views of mainstream theory, and, lastly, her approach to the link between ‘theory’ and evidence, can all provide scope for
discussion of methodology in social science. She appears to have based her work on the belief of a dynamic interaction between induction and deduction, however, in the context of history-based, path-dependent evolutionary change, shaped by conscious actions by economic actors. She critiqued biology-based theories of the firm, for failing to account for human motivation.

  To treat the growth of the firm as the unfolding of its genetic nature is downright obscurantism. To treat innovation as chance mutations not only obscures their significance, but leaves them essentially unexplained, while to treat them directly as a purposive attempt of men to do something makes them far more understandable (1952, p. 818).

  In her view, ‘there would seem to be a genuine complementarity between theory and history’ (1989, p. 11).

  Without theoretical analysis of cause and consequence one has no standard against which to appraise the significance of any given set of observations, for this significance is a question of what difference the observations make to what might otherwise have been the historical interpretation... Some of the ‘theory’ may be little more than dressed-up common sense deduction from common observations and therefore not even recognized as such, but much of it has a deeper significance (p. 10).

  Last but not least, ‘theory is needed precisely because reality is so complicated’ (p. 11).

  III.e. Edith’s Last Years

  Edith’s main interest in her time at Waterbeach following her retirement was the issue of collaboration, ‘networking’, firm boundaries, and thus the possible ‘metamorphosis’ of the firm (see Penrose 2008). She was impressed by the work of G. B. Richardson, his emphasis on the dense network of cooperation and affiliation, his attempt to distinguish market from integration and from non-collusive forms of cooperation, in terms of complementarity and similarity of activities. Building on her earlier work, she viewed corporate alliances or cooperative arrangements as driven ‘not necessarily by monopolistic intent but as a means of gaining mutual access to resources such as technology, regional markets and information services’ (1996, p. 1722).