Theory of the Growth of the Firm

by Edith Penrose

  As the managerial group becomes larger with the growth of a firm, the influence of the ‘temperament’ and personal attitudes of individual men tends to decline as the role of ‘group action’ rises in importance. The amount and type of information required often becomes relatively standardized and planning becomes subject to defined procedures. The requisite level of confidence in the information and judgments embodied in plans for action become a question of how adequately they meet fairly well-defined standards of planning techniques known and accepted by all members of the managerial group. The improvement of methods of collecting and analyzing information and the emergence of consultant organizations specializing in this type of work and in giving advice to the management of industrial firms not only reduces the managerial effort required of an expanding firm but also goes far to reduce subjective uncertainty.61

  In principle, therefore, uncertainty which a firm’s entrepreneurs refuse to tolerate because it arises from a lack of confidence in the completeness of planning, and which they believe could be eliminated by further information and more detailed planning, will limit expansion only to the extent that managerial resources are limited. When more resources become available, more information can be obtained, more uncertainty eliminated, and more expansion planned. Yet no amount of obtainable information can completely eliminate uncertainty for any expansion plan; and information has no effect on risk. Hence, we have to examine risk and unavoidable uncertainty.

  Risk and Unavoidable Uncertainty

  As planning proceeds, the point will be reached where a firm believes it is either impossible or too expensive to attempt to obtain further information.62 At this point the firm must decide how far, if at all, it should commit resources to the activity in question in the face of the irreducible uncertainty and of its estimates of risk. There is little question that for any given direction of expansion there will be some reasonably definite limit beyond which the firm will not feel that the chance of gain really justifies the risk.

  But the expansion plans of a firm are not necessarily limited to any particular type of product or market. Having decided how much it wants to expand in one direction, there is nothing that necessarily prevents it from turning attention to other types of activity, and then to still others. Each new activity requires an increased input of managerial services, not only to obtain sufficient information and develop sufficiently well-worked-out plans to reduce uncertainty to the required level, but also to organize and execute the expansion.63 As the new activities become less familiar, more effort is required of management, and there is no reason at all to presume that the enterprising firm will reach the point where it refuses to take further action because of the risk of expansion before it has exhausted the capacity of management to deal with new things.

  There remains, however, the problem of the increasing risk to the financial position of the firm as expansion proceeds. For the analysis of this problem it is important to distinguish two broad types of response to risk and unavoidable uncertainty. One type leads a firm to adopt conservative financial policies and to restrict its expansion programmes to the extent permitted by funds obtainable from specified sources; the other leads a firm to arrange its expansion plans to minimize the risk. ‘Risk-avoidance’ is the goal of the entrepreneur in both cases, but the effect on the expansion programme of the firm is very different.

  The methods of handling risk and unavoidable uncertainty often become more or less part of the tradition of a firm, changed only rarely under the impact of special circumstances. Some firms are known for their preference for large liquid reserves, others for their refusal to borrow outside funds, but still others for the boldness of their financial and expansion policies. Characteristic ways of handling risk often tend to persist in the same firm through generations of managers, although occasionally ‘new blood’ may be brought in when a firm lets its tradition stultify its enterprise to such a degree that its standing in the business world deteriorates.

  If a firm accumulates and retains liquid reserves to enable it to bear the financial strain should events turn out unfavourably, or if it voluntarily limits its access to capital by refusing to borrow above certain amounts, the amount of capital funds is restricted, sometimes even to those generated within the business itself. But in such cases there is no more reason to attribute the firm’s financial conservatism to risk than to the quality of enterprise, provided that there are alternative methods of dealing with risk. It makes little difference, for example, whether a firm refuses to borrow because it is conservative and dislikes risk or because it believes the running up of debts is immoral. The effect on expansion is the same in both cases. We have already seen that for many reasons the quality of enterprise will have a significant effect on the expansion plans of firms. Enterprise and attitude towards risk are, in this context, opposite sides of the same coin, for enterprise includes the willingness to take risks. But enterprise includes much more than this; it also includes the willingness to search for ways of avoiding risk and still expand.

  Any individual firm may insist on financial policies which will restrict its expansion plans, even refusing to take on the most promising ventures if borrowed money is required, but this is essentially lack of enterprise. On the other hand, even the most enterprising entrepreneur (if he is reasonable) will at some point baulk at accepting further risk, but he will proceed to search for ways of expanding without increasing risk. There are a variety of ways in which firms can arrange the composition of their expansion plans such that the chance of loss is less for a larger programme as a whole than for any part of it. They can, for example, diversify their activities to spread risk, or protect themselves by backward or forward integration; or they can adopt short-run flexible programmes easily changed when conditions change;64 or they may, as a means of limiting their own liability, set up subsidiaries able to borrow money on their own account to take on some of the more speculative activities.

  Practically all of the various ways of reducing risk have the same effect on the demand for managerial services as do the ways of reducing uncertainty. The greater is risk or uncertainty, the more difficult will be the managerial task. Hence the expansion plans of a firm are necessarily restricted by the capacity of management to deal with the increased problems with which they are confronted. But as the management group increases in size, more can be undertaken. Thus it is not easy to untangle the effect of risk and uncertainty on the amount of expansion from the effect of the limited availability of managerial services. A distinction is possible only when it can be shown that managerial services are inefficiently used because expansion is held up not only by attitudes towards risk which are themselves responsible for extremely conservative financial policies, but also by an absence of enterprising attempts to reduce the risk of further expansion. The same ‘unwillingness to bear risk’ has a different effect on expansion depending on the other qualities of enterprise with which it is associated.

  A firm has a given amount of experienced managerial services available at any one time. Part of these are needed for ordinary operations; the rest are available for planning and executing expansion programmes. The effect of uncertainty is to require that some of these available services be used to gather information, digest it, and reach conclusions about the possibilities of action in which the firm has confidence. These conclusions will include estimates of the risk and unavoidable uncertainty attached to the various courses of action. If this is so high that the firm refuses to act, or acts only in a very limited way, then the managerial services which would otherwise have been used in perfecting and executing expansion plans either remain unused or are devoted to alternative plans, including plans for programmes which reduce total risk. If managerial services are fully used, clearly their limited supply is just as much a limit on expansion as is risk and uncertainty. If they are not fully used (and there are no other ‘bottlenecks’), then, but only then, can risk and uncertainty alone be identified as the final limiting factor.r />
  Risk and uncertainty clearly do affect the amount and variety of managerial services required for expansion, both because they force firms to obtain certain types of information before acting and because they affect the composition of its expansion plans—the variety of products, the time ‘structure’, even the type of process used. Thus, for any given amount of experienced managerial services, risk and uncertainty will effectively limit expansion. On the other hand, for any degree of uncertainty, the supply of managerial services will determine the amount of expansion undertaken by the enterprising firm. The overcoming of uncertainty has its cost, which could conceivably be expressed in terms of the managerial services required for the task. But its restraining effect on expansion depends on the resources available to meet it.

  V

  ‘Inherited’ Resources and the Direction of Expansion

  Types of inducement to expand. The continuing availability of unused productive services. Indivisibility and the ‘balance of processes’. The specialized use of resources. The heterogeneity of resources. Interaction between material and human resources. The creation of new productive services. ‘Demand’ and the productive resources of the firm. What is the relevant demand? The direction of expansion.

  THE emphasis of our analysis now shifts from the limits on expansion to the direction of expansion. At any time a firm will have a variety of inducements to expand in one or more specific directions; but at the same time there will be a variety of difficulties to be overcome in planning and executing an expansion programme in any given direction. The inducements as well as the difficulties may be outside the firm, in the external world, or within the firm—in the ‘internal world’ so to speak. They create conditions enhancing or restricting the profitability or practicability of expansion in particular directions.

  The external inducements to expansion are well known and require little discussion. They include growing demand for particular products, changes in technology which call for production on a larger scale than before, discoveries and inventions the exploitation of which seems particularly promising or which open up promising fields in supplementary directions, special opportunities to obtain a better market position or achieve some monopolistic advantage, and similar conditions and opportunities. They also include changes which might adversely affect a firm’s existing operations and against which it could protect itself through expansion in particular directions, for example through backward integration to control sources of supply, diversification of final products to spread risk, or expansion of existing or allied products to preclude the entry of new competitors.

  External obstacles to expansion are equally well known. They include keen competition in markets for particular products which makes profitable entry or expansion in those markets difficult or necessitates expensive selling efforts and the acceptance of lower profit margins; the existence of patent rights and other restrictions on the use of knowledge and technology; high costs of entry into new areas; or difficulties of obtaining raw materials, labour, or specialized technical or managerial personnel.

  While external inducements and difficulties have been widely discussed, little attention has been paid, in a systematic way at least, to the equally important internal influences on the direction of expansion. Internal obstacles arise when some of the important types of specialized service required for expansion in particular directions are not available in sufficient amounts within the firm—in particular when not enough of the managerial capacity and the technical skills required for the planning, execution, and efficient operation of a new programme can be had from among existing experienced personnel. Internal inducements to expansion arise largely from the existence of a pool of unused productive services, resources, and special knowledge, all of which will always be found within any firm. Most of this chapter will be devoted to the explanation of why there will always be unused productive services within a firm, and to a discussion of the significance of the existence of such services for the ‘external’ opportunities for expansion as perceived by the firm.

  We should note in passing that it is important to discuss separately the nature of the inducements and obstacles to expansion instead of simply ‘net inducements to expand’, because different kinds of inducements and difficulties influence differently both the direction and the method of expansion chosen. If, for example, the external inducement to expand is the profitability of a new and growing market, but there is an external obstacle to entry in the form of, say, patent rights, the external inducements and obstacles may both be high and the only feasible method of expansion may be acquisition of another firm. Or, if the incentive to expand is the fear of adverse changes in the external world the effects of which might be offset by diversification, the problem will be one of finding suitable fields in which neither the external nor the internal obstacles to expansion are great. On the other hand, a firm may have a strong internal inducement to expand provided by the presence of an energetic and ambitious entrepreneur with many ideas, but if at the same time the firm lacks the managerial abilities or technical skills to carry his ideas into action, a significant internal obstacle to expansion exists which again will influence the direction, and in particular, the method of expansion chosen. This type of problem will be taken up in the chapters on diversification, merger, and the factors affecting the rate of growth of firms.

  The Continuing Availability of Unused Productive Services

  Resources were defined in Chapter II to include the physical things a firm buys, leases, or produces for its own use, and the people hired on terms that make them effectively part of the firm. Services, on the other hand, are the contributions these resources can make to the productive operations of the firm. A resource, then, can be viewed as a bundle of possible services.

  For any given scale of operations a firm must possess resources from which it can obtain the productive services appropriate to the amounts and types of product it intends to produce. Some of the services will be obtained from resources already under the control of the firm in the form of fixed plant and equipment, more or less permanent personnel, and inventories of materials and goods in process; others will be obtained from resources the firm acquires in the market as occasion demands. Although the ‘inputs’ in which the firm is interested are productive services, it is resources that, with few exceptions, must be acquired in order to obtain services. For the most part, resources are only obtainable in discrete amounts, that is to say, a ‘bundle’ of services must be acquired even if only a ‘single’ service should be wanted.65 The amount and kind of productive services obtainable from each class of resource are different, and sometimes, particularly with respect to personnel, the amount and kind of service obtainable from each unit within a resource-class are different. Having acquired resources for actual and contemplated operations, a firm has an incentive to use as profitably as possible the services obtainable from each unit of each type of resource acquired.

  It follows, therefore, that as long as expansion can provide a way of using the services of its resources more profitably than they are being used, a firm has an incentive to expand; or alternatively, so long as any resources are not used fully in current operations, there is an incentive for a firm to find a way of using them more fully. Unused productive services available from existing resources are a ‘waste’, sometimes an unavoidable waste (that is to say, it may not pay to try to use them) but they are ‘free’ services which, if they can be used profitably, may provide a competitive advantage for the firm possessing them.

  The next question to explore is whether or not it is likely that a firm will ever reach a position in which it will have no incentive to expand in order to use the productive services available from its existing collection of resources more profitably than they are being used. In the language of traditional theory, can we say that a firm will ever reach an ‘equilibrium position’ in which there is no further internal incentive to expand?

  The attainment of such a ‘state
of rest’ is precluded by three significant obstacles: those arising from the familiar difficulties posed by the indivisibility of resources; those arising from the fact that the same resources can be used differently under different circumstances, and in particular, in a ‘specialized’ manner; and those arising because in the ordinary processes of operation and expansion new productive services are continually being created.

  Indivisibility and the ‘Balance of Processes’

  The ‘balance of processes’ or the ‘principle of multiples’ has been explicitly discussed by economists for over 100 years with respect to the optimum size of plant.66 It is an application of the principle of the ‘least common multiple’. If a collection of indivisible productive resources is to be fully used, the minimum level of output at which the firm must produce must correspond to the least common multiple of the various maximum outputs obtainable from the smallest unit in which each type of resource can be acquired. The principle has usually been applied to machines, and even in this case it has been pointed out that it may be necessary to plan production on a very large scale in order to use all machines at their most efficient level of operation.67

  If we consider the full range of resources used in any firm of even moderate size, including its various grades of management personnel, its engineers and other technical specialists, the minimum sales force needed to reach its market and sell its products, its financial specialists, and even its research personnel, it is clear that this ‘least common multiple’ may call for an enormously large and varied output. This is, of course, the result of the indivisibility of the units in which resources can be acquired; even though a firm may not need a full-time salesman, engineer, or ‘trouble shooter’, it is often impossible, or at best difficult and disproportionately expensive, to acquire a part-time one, and for a given scale of operations it may be preferable to acquire a resource and use it only partly than to do without it.