Theory of the Growth of the Firm

by Edith Penrose

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  PREFACE

  JUST one warning: this book deals with familiar concepts, but in an unfamiliar way and the reader is cautioned not to treat the introductory chapters lightly; they are essential for the analysis to follow. The entire study is essentially a single argument no step of which can be omitted without the risk of misunderstanding later conclusions. Hence, readers interested in particular questions—say diversification, merger, or concentration—cannot safely turn to the chapters dealing with these subjects and ignore the foundations on which they rest. Those who do will find isolated discussions not only unconvincing but perhaps even unintelligible.

  A book, like an invention, embodies the work of many people without whom it could not have been produced. I owe much to the contributions of the students, staff and visitors at The Johns Hopkins University, both in the seminar room and outside it, to discussions with numerous economists in various parts of the world, and to criticism of papers delivered at various meetings. Of the visitors, Mr. Donald Whitehead of the University of Adelaide, Australia, and Dr. Jacob Schmookler of the University of Minnesota were especially helpful to me. Professor Schmookler read and severely criticised several chapters, which gained greatly in clarity of exposition as a result of my efforts to meet his objections. Mr. Whitehead read the entire manuscript and in several places was responsible for extensive revision. Of the staff, my greatest debt is to Fritz Machlup, who went patiently through several drafts, served as a sounding board for the testing of ideas, and again and again forced me to more rigorous thinking and clearer expression. Without his constant encouragement, acute perception of logical weakness, and willingness to discuss difficulties, I doubt whether this book would have appeared at all; certainly it would not have appeared in the present form.

  Last, but by no means least, I must acknowledge not only the general support and encouragement of my husband, Professor E. F. Penrose, and his uncomplaining acceptance of the hardships a husband must bear when his wife is involved in the painful process of fi
nishing a book, but also his active contribution to the study itself, in particular to its English style. I, of course, am responsible for all defects that remain, some of which are undoubtedly due to my own stubbornness.

  I have received financial assistance from various research funds, for which I am grateful. The study was originally undertaken as part of a broader investigation of the growth of firms, directed by Fritz Machlup and G. H. Evans, Jr., and financed by the Merrill Foundation for Financial Research. The first year of work on this study was financed under that project. In addition, I am especially grateful to the John Simon Guggenheim Memorial Foundation for a Fellowship which permitted me to carry on research on the subject in Australia at the Australian National University. Expenses of typing and otherwise preparing the drafts and the final manuscript were defrayed from research funds of the Department of Political Economy at The Johns Hopkins University received from the Lessing Rosenthal Fund and the Ford Foundation.

  EDITH T. PENROSE

  The Johns Hopkins University.

  June 1958.

  I

  Introduction

  The purpose of the study. The nature of the argument.

  SO far as I know, no economist has as yet attempted a general theory of the growth of firms. This seems to me so very strange that I am sure anyone attempting it should indeed watch his (or her) step, for naturally there is always a good reason for what economists do or do not do. Perhaps such a theory is impossible to construct, unnecessary, trivial, or outside the pale of economics proper. I do not know, but I offer this study in the hope that all four possibilities will be rejected.

  We shall be concerned with the growth of firms, and only incidentally with their size. The term ‘growth’ is used in ordinary discourse with two different connotations. It sometimes denotes merely increase in amount; for example, when one speaks of ‘growth’ in output, exports, sales. At other times, however, it is used in its primary meaning implying an increase in size or an improvement in quality as a result of a process of development, akin to natural biological processes in which an interacting series of internal changes leads to increases in size accompanied by changes in the characteristics of the growing object. Thus the terms ‘economic growth’ and ‘economic development’ are often used interchangeably where ‘growth’ implies not only an increase in the national product but also a progressive changing of the economy. ‘Growth’ in this second sense often also has the connotation of ‘natural’ or ‘normal’—a process that will occur whenever conditions are favourable because of the nature of the ‘organism’; size becomes a more or less incidental result of a continuous ongoing or ‘unfolding’ process.

  But this is not the way the size of firms is looked at in traditional economic analysis, which examines the advantages and disadvantages of being a particular size and explains movement from one size to another in terms of the net advantages of different sizes. Growth becomes merely an adjustment to the size appropriate to given conditions; there is no notion of an internal process of development leading to cumulative movements in any one direction. Still less is there any suggestion that there may be advantages in moving from one position to another quite apart from the advantages of being in a different position. It is often presumed that there is a ‘most profitable’ size of firm and that no further explanation than the search for profit is needed of how and why firms reach that size. Such an approach to the explanation of the size of firms will be rejected in this study; it will be argued that size is but a by-product of the process of growth, that there is no ‘optimum’, or even most profitable, size of firm. As we shall see, traditional theory has always had trouble with the limits to the size of firms, and I think we shall find the source of the trouble.

  In addition to the traditional approaches, there have been sporadic attempts to develop theories of the growth of firms using biological analogies and treating firms as organisms whose processes of growth are essentially the same as those of the living organisms of the natural world. There are many difficulties with this type of analysis, one of the most serious being the fact that human motivation and conscious human decision have no place in the process of growth. This alone, I believe, is sufficient ground for rejecting such theories of the growth of firms. All the evidence we have indicates that the growth of a firm is connected with attempts of a particular group of human beings to do something; nothing is gained and much is lost if this fact is not explicitly recognized.1

  In spite of the fact that I depart from the traditional methods of analyzing the behaviour of firms, many of the ideas—indeed some of the basic ones—providing the bricks and mortar with which the analytical structure of this study is built are to be encountered in the literature of both theoretical and applied economics, and many parts of the structure will be easily recognized.2 What I have done is to attempt to build a consistent, self-contained theory of the growth of firms, synthesizing my own ideas and those of others, moulding both into a reasonably formal whole which I hope provides a way of looking at the growth of firms that will be useful for both theoretical and ‘practical’ purposes. Much more can be done than I do here by way of refinement of analytical constructions, exploration of ramifications, and development of the theoretical and political significance of the analysis. Some of the concepts used are not defined with great precision, largely because no highly refined definition is required for my purposes; a more detailed or more precise application of the analysis may well justify further effort in this direction.3

  Although I am primarily concerned with a theoretical analysis of a process, I have tried to modify the impact of the unavoidable abstraction in two ways, for I would like to appeal to a wider audience than that of professional economists only. In the first place, the fundamental assumptions on which the analysis rests are chosen with a view to their applicability in the ‘real world’, and I shall make some effort to justify them, although strictly speaking I suppose no justification of this sort is necessary provided useful results are obtained. Of course, in the process of developing an argument it is often necessary to make patently ‘unrealistic’ assumptions in order to isolate particular problems with which we may be concerned. For the most part such assumptions are, or can easily be, dropped at later stages.

  Secondly, I shall frequently illustrate the argument with concrete examples. Consistent examples are, of course, no more a proof than are inconsistent examples a disproof of a general argument unless the examples are presented in sufficiently large numbers and selected in such a way that they constitute a representative sample. The theory of the process of growth is, on the whole, susceptible to empirical testing against the experience of individual firms, although the examples presented in the following chapters are illustrative only. There is not sufficient systematic information available as yet to enable any comprehensive testing of the generality of the theory. Although there are many business histories and biographies of individual businessmen, only a handful are really good from this point of view;4 annual reports of corporations, journal and newspaper reports, and interviews with businessmen are useful if carefully appraised, but do not yet provide a systematic and comprehensive body of information.5 It is not possible in the framework of this study both to develop a theoretical analysis and to carry out an extensive testing of it in the light of available information, although I have tried at every point to satisfy myself that there is sufficient evidence to justify at least a prima facie case for the hypotheses advanced respecting the processes of growth.

  The analysis of the limits to growth—the factors determining the maximum rate of growth of firms—on the other hand, cannot, in its present formulation at any rate, be tested against the facts of the external world, partly because of the difficulties in expressing some of the concepts in quantitative terms and partly because of the impossibility of ever knowing for any given firm what is, or would have been, its maximum rate of growth. Perhaps some of these difficulties will be overcome in different formulations constructed by ot
hers. At present the validity of the theory of the limits to the rate of growth of firms lies entirely in the extent to which it is consistent with the theory of the process of growth, in its logic, and in its intuitive acceptability.

  The Nature of the Argument

  A comprehensive theory of the growth of the firm must explain several qualitatively different kinds of growth and must take account not only of the sequence of changes created by a firm’s own activities but also of the effect of changes that are external to the firm and lie beyond its control. Not all of these things can be discussed at the same time, however, without creating such a serious confusion between very different types of causal relationships that the discussion degenerates into a generalized description of a sequence of events that appears largely fortuitous and to have been introduced for the convenience of a pre-determined conclusion, like the coincidences of a poorly constructed detective story. Hence the development of the theory must proceed in stages.

  After a discussion of the characteristics of the business firm, its functions, and the factors influencing its behaviour, we shall turn to an examination of the forces inherent in the nature of firms which at the same time create the possibilities for, provide the inducements to, and limit the amount of the expansion they can undertake or even plan to undertake in any given period of time. It will then be shown that this limit is by its nature temporary, that in the very process of expansion the limit recedes, and that after the completion of an optimum plan for expansion a new ‘disequilibrium’ has been created in which a firm has new inducements to expand further even if all external conditions (including the conditions of demand and supply) have remained unchanged.

  In all of the discussion the emphasis is on the internal resources of a firm—on the productive services available to a firm from its own resources, particularly the productive services available from management with experience within the firm. It is shown not only that the resources with which a particular firm is accustomed to working will shape the productive services its management is capable of rendering (where management is defined in the broadest sense), but also that the experience of management will affect the productive services that all its other resources are capable of rendering. As management tries to make the best use of the resources available, a truly ‘dynamic’ interacting process occurs which encourages continuous growth but limits the rate of growth. In order to focus attention on the crucial role of a firm’s ‘inherited’ resources, the environment is treated, in the first instance, as an ‘image’ in the entrepreneur’s mind of the possibilities and restrictions with which he is confronted, for it is, after all, such an ‘image’ which in fact determines a man’s behaviour; whether experience confirms expectations is another story.6 Even ‘demand’ as seen by a firm is largely conditioned by the productive services available to it, and hence the ‘direction of expansion’—the products a firm becomes interested in producing—can be analysed with reference to the relationship between its resources and its own view of its competitive position. This will be discussed in an extensive analysis of the economics of diversification.