Theory of the Growth of the Firm

by Edith Penrose

  It is in this necessarily gradual process that new men brought in and the existing personnel of the firm all gain further experience. Not only is there likely to be a generalized improvement in skill and efficiency, but also the development of new specialized services. As was noted above, when men have become used to working in a particular firm or with a particular group of other men, they become individually and as a group more valuable to the firm in that the services they can render are enhanced by their knowledge of their fellow-workers, of the methods of the firm, and of the best way of doing things in the particular set of circumstances in which they are working.55 Individuals taking over executive functions new to them will find that many things are problems merely because of their relative unfamiliarity. As executives become more familiar with their work and succeed in integrating themselves into the organization under their control, the effort required of them will be reduced and their capacity will therefore become less completely used, while at the same time that capacity will itself have increased through experience and general growth in knowledge.

  The experience gained is not only of the kind just discussed which enables a collection of individuals to become a working unit, but also of a kind which develops an increasing knowledge of the possibilities for action and the ways in which action can be taken by the group itself, that is, by the firm. This increase in knowledge not only causes the productive opportunity of a firm to change in ways unrelated to changes in the environment, but also contributes to the ‘uniqueness’ of the opportunity of each individual firm.

  Knowledge comes to people in two different ways. One kind can be formally taught, can be learned from other people or from the written word, and can, if necessary, be formally expressed and transmitted to others. The other kind is also the result of learning, but learning in the form of personal experience. There is no easy way of sharply distinguishing these forms of knowledge in the abstract nor is there a satisfactory way of labelling them. The first form is what might be called ‘objective’ knowledge. It is knowledge about things which is, conceptually at least, independent of any particular individual or group of individuals. It is, if you like, the ‘state of the arts’ as well as the state of knowledge about markets, prices, tastes, etc. If the processes for the transmission of knowledge are not perfect, different groups of individuals may possess this knowledge in different degrees, but if so, it is due to the imperfection in what sociologists would call the ‘communication system’ and is not inherent in the nature of the knowledge itself which, by its very essence, is transmissible to all on equal terms. In this it differs from the second form in which knowledge appears—the form I have called experience. Here emphasis is placed on the change in the services human resources can supply which arises from their own activity. Experience produces increased knowledge about things and contributes to ‘objective’ knowledge in so far as its results can be transmitted to others. But experience itself can never be transmitted; it produces a change—frequently a subtle change—in individuals and cannot be separated from them.

  Increasing experience shows itself in two ways—changes in knowledge acquired and changes in the ability to use knowledge. There is no sharp distinction between these two forms because to a considerable extent the ability to use old knowledge is dependent on the acquisition of new knowledge. But it is not exclusively so dependent; with experience a man may gain in wisdom, in sureness of movement, in confidence—all of these become part of his very nature, and they are all qualities that are relevant to the kind and amount of services he can give his firm. Much of the experience of businessmen is frequently so closely associated with a particular set of external circumstances that a large part of a man’s most valuable services may be available only under these circumstances. A man whose past productive activity has been spent within a particular firm, for example, can, because of his intimate knowledge of the resources, structure, history, operations, and personnel of the firm render services to that firm which he could give to no other firm without acquiring additional experience. Let us imagine by way of illustration, that a man’s productive services are A, B, C, D, E, F, and G. F and G may be useful only in a particular firm; C, D, and E only to a particular group of firms, B only in the manufacturing industry, while A may be of such a general character that it would be useful in any type of productive activity.

  Many of the productive services created through an increase in knowledge that occurs as a result of experience gained in the operation of the firm as time passes will remain unused if the firm fails to expand. Thus they provide an internal inducement to expansion as well as new possibilities for it. The unused services created in old as well as in newly acquired personnel through increases in both ‘objective’ knowledge and experience do not often exist in the open form of idle man-hours but rather in the concealed form of unused abilities. If there is not scope for the full use of the capacity of individuals in the firm to perform administrative services, to plan and execute production programs, to sell the firm’s products, to test new ideas, a pressure to expand will be exerted on the firm.56 A more complete use of the services of individuals is supposed to be made possible by promotion in rank, but this will eventually require enlargement of the firm’s activities. While machinery after a point becomes less valuable and is ‘down-graded’, managerial resources may become more valuable and be ‘promoted’. That promotion does not fully take care of the increase in services thus created is the common experience of many firms in periods when growth is slow. Pressure from younger executives for advancement sometimes even creates for the firm a problem of maintaining the morale of personnel and cannot be entirely explained by the hypothesis that individuals tend to over-estimate their own ability.

  The Receding Limit and the ‘Static’ Approach

  We have shown that there is a limit to the amount of expansion possible in any given period and that in this sense the productive opportunity of a firm can be considered ‘fixed’. Thus a ‘static’ analysis can be an appropriate method of exploring the conditions of ‘equilibrium’. The productive opportunity of the firm will be fixed if we assume that no change takes place in external conditions, nor any change in knowledge and, as a consequence, no change in the internal supply of productive services.

  These are the traditional static assumptions and by themselves they guarantee that increasing costs of production for all products produced by the firm must at some point set in. So-called managerial diseconomies must eventually come into play if it is assumed that there is no change in knowledge and hence no change in the quality and type of managerial service; for it is widely agreed that the only reason managerial diseconomies do not arise is because it is possible for firms to effect a progressive subdivision of function and decentralization of operation. Such a subdivision and decentralization is equivalent to a change in the input of managerial services, and some of these services become available only after experience has been gained of a given organization. The assumption that there is no change in knowledge or the state of the arts rules out any change in the quality of managerial services through experience as effectively as it rules out changes in ‘objective’ knowledge, for both changes have the same type of significance for the productive services effectively available to the firm. Hence among the unchanged conditions postulated by the static assumptions is the given level of experience of businessmen. The supply of managerial services is thus fixed. The new and unique types of service that come only with experience in a given environment cannot arise. In a static analysis they must be dealt with, in effect, as changes in the parameters of the system.

  The assumption of ‘complete rationality’ or ‘perfect knowledge’ does not change the matter. This assumption has never been held to mean that all men have experienced everything, or that all is known that ever will be known, but only that men ‘are supposed to know absolutely the consequences of their acts when they are performed, and to perform them in the light of the consequences.’57 In addition, perfec
t knowledge implies that what we have called ‘objective’ knowledge is uniformly accessible to all. This is all, and under such conditions managerial services unaltered by experience become a fixed factor and diminishing returns must eventually set in.

  Once it is recognized that the very processes of operation and of expansion are intimately associated with a process by which knowledge is increased, then it becomes immediately clear that the productive opportunity of a firm will change even in the absence of any change in external circumstances or in fundamental technological knowledge.58 New opportunities will open up which did not exist at the time expansion plans were made. The factors determining the nature of these opportunities and therefore the direction of expansion will be examined in the next chapter. But first we must analyze the relation between the managerial limit on expansion and the existence of uncertainty and risk, for these are among the most widely accepted explanations of the limits to the expansion plans of firms.

  The Effect of Uncertainty and Risk

  The fact that the future can never be known with accuracy means that the planning of business firms is based on expectations about the future which are held with varying degrees of confidence; furthermore, the expectations are themselves essentially estimates of various possible outcomes in the future of a given action or series of actions. ‘Uncertainty’ refers to the entrepreneur’s confidence in his estimates or expectations; ‘risk’, on the other hand, refers to the possible outcomes of action, specifically to the loss that might be incurred if a given action is taken.

  The question therefore arises what is the effect of uncertainty and risk on the expansion plans of a firm. The most common simple approach to this question assumes that entrepreneurs merely make allowances in their cost and revenue calculations by deliberately and somewhat arbitrarily using lower estimates of demand or higher estimates of costs than those they consider most likely to prevail. Such allowances can deal with both risk and uncertainty, for the estimates on which action is finally taken may take into consideration not only the chance of failure as the entrepreneur sees it, but also the effect of the uncertainty with which he views his estimate of the chance of failure. The result is a reduction of expected profit at every level of output, and in consequence a reduction of planned expansion.59 If the allowances for either risk or uncertainty increase as the size of expansion plans increases—as they may do if more predictions about the future or longer-range predictions are implicit in the plans—then any tendency for expected revenues to increase or cost to fall as output is expanded is at least partly offset by the effects of risk and uncertainty.

  ‘Risk’ includes both the chance of loss and the significance of whatever it is that might be lost. Thus the ‘risk’ to me of gambling $1 is less than that of gambling $100 even though the chance of losing my gamble is the same in both cases, not simply because $100 is more than $1, but because the loss of $100 endangers something other than money that is not endangered by the loss of $1. If I were a millionaire, for example, I might feel as indifferent to losing $100 as to losing $1, and the ‘subjective risk’ of the gamble would be the same in both cases—merely my estimate of the probability of loss. But since I am not a millionaire the loss of $100 would endanger my ability to pay my debts, my ability to borrow more funds, or the feeling of security a bank account gives me. I ‘can’t afford’ to lose $100 for it would endanger my financial position as a whole, whereas if I lose $1 I am not going to care much one way or the other. In the one case the ‘risk’ to me is higher than in the other even though the chance of loss is the same.

  This is essentially the ‘principle of increasing risk’ which has been put forward in different forms in the literature.60 As a firm expands its investment, the risk to it of a given chance of loss becomes more serious with each increment of investment—its ‘wealth’ position becomes endangered if it operates on borrowed money; its liquidity, or ability to meet unexpected demands for cash, becomes precarious as it depletes its own reserves and if its ability to raise money is affected by its heavy illiquid investment. Hence it is concluded that a firm’s expansion plans are restricted by ‘increasing risk’.

  Thus, unless a firm is willing to bear an indefinite amount of risk and cares nothing about uncertainty, risk and uncertainty will, according to accepted theory, necessarily restrict the expansion plans of the firm. In this approach the entrepreneur is treated as a passive ‘risk bearer’, for it is implicitly assumed that there is nothing he can do to reduce the uncertainty or risk attached to any course of action; he is faced with it and must bear it or shrink from it depending on his temperament. Uncertainty and risk become a limit to expansion which is ‘given’, as it were, and to which the entrepreneur must adjust but which he cannot affect; they therefore become the same type of explanation of the limits to expansion as those which stress the state of demand or the availability of capital.

  But is this passive acceptance of risk and uncertainty the only possible entrepreneurial response? Are there not ways open to the entrepreneur of reducing uncertainty and avoiding risk which will enable him to use fully all of the managerial resources at his disposal? If there are such ways, uncertainty and risk, though affecting the amount of expansion that a firm will plan, will affect it only to the extent that managerial resources are unavailable to deal with it. If we admit that uncertainty and risk can limit the amount of expansion and if we agree that managerial resources can also limit the amount of expansion, which one of these provides the effective limit will depend on which comes into operation first. To postulate risk and uncertainty as the fundamental limit on expansion, we should have to show that these alone could be expected to force firms to use their managerial resources at less than full capacity. We shall look first at uncertainty.

  Uncertainty and Information

  If one is concerned with the effect of uncertainty on the behaviour of a firm, one is concerned with ‘subjective’ uncertainty—with the state of mind of the entrepreneur—and with subjective estimates of the risk of disappointment. Subjective uncertainty about the future and, in particular, about the weight to be given to various possible outcomes, can be traced to two sources: ‘temperament’ (for example, self-confidence), and an awareness on the part of the entrepreneur that he possesses insufficient information about the factors which might be expected to determine the future course of events. Uncertainty resulting from the feeling that one has too little information leads to a lack of confidence in the soundness of the judgments that lie behind any given plan of action. Hence one of the most important ways of reducing subjective uncertainty about the future course of events is surely to obtain more information about the factors that might be expected to affect it; and it is reasonable to suppose that one of the most important tasks of a firm in an uncertain world will be that of obtaining as much information as is practicable about the possible course of future events.

  To obtain information requires an input of resources, and to evaluate the information requires the services of existing management. Therefore one of the important effects of subjective uncertainty is to induce a firm to devote resources to what might be termed ‘managerial research’.

  Clearly the amount and kind of information required to instil sufficient confidence will vary between firms according to the temperament and even competence of their management (whether entrepreneurs are optimistic or pessimistic by nature, hesitant or self-confident, careless or calculating), but will not necessarily reflect their ‘aversion to risk’. A firm requiring a great deal of information may still be willing to accept considerable risk once it believes it has evaluated a situation reasonably accurately. But only the incompetent and thoughtless will act before making an attempt to acquire information on which to base judgments. Similarly there will be differences in the extent to which managerial groups will be willing to act on the advice of ‘outsiders’ without examining it. Both general reasoning and discussions with businessmen lead to the conclusion that, unless his own judgment has been i
nvolved, a businessman does not like to take responsibility for action in areas heconsiders within his competence; on other matters he may accept the judgment of people he knows and trusts and who can explain the basis of their judgment, especially if these people also share a general responsibility for the outcome. This is one of the functions of management as a ‘team’. The smaller the team and the smaller their combined area of competence, the smaller will be the total of the activities they will be willing to undertake; conversely, the larger the group and the more they are willing to accept each others’ judgment and to subdivide areas of competence, the greater can be the absolute amount of activity planned.