Theory of the Growth of the Firm

by Edith Penrose

  If ways of using resources which are not profitable at a given time may nevertheless influence the behaviour of firms, we are justified in adopting a concept of ‘economic resources’ that is wider than the concept traditionally used in economic analysis. Resources or services without value are ‘free’ goods and are universally excluded from any ‘productive’ classification because they have no ‘causal relation to conduct’.77 It is the traditional view that ‘superabundant elements in production’ should be taken ‘absolutely for granted’ and ignored. ‘Only the “possibility” of a situation arising in which a thing would not be superabundant can give it significance or lead to its being consciously considered in any way’.78 Under the assumptions of the familiar equilibrium analysis, and for the purposes for which it is used, this procedure is undoubtedly correct. From the point of view of the present analysis the fact that here are ways of using free goods in production—air is the classic example—has considerable significance for the conduct of the firm. Some materials required in some types of production are in fact obtained from the air. If we assume that the state of the arts is not fixed and, in particular, that knowledge acquired by one firm is not immediately available to all firms, then the fact that a ‘good’ is freely available may encourage innovations which use its services in production. The free resource may never become a valuable good in the economic sense, but it may still powerfully influence economic conduct, partly because the services it can render are not free in the same sense that the resource is free.

  The Creation of New Productive Services

  The import of the above argument is, essentially, that both an automatic increase in knowledge and an incentive to search for new knowledge are, as it were, ‘built into’ the very nature of firms possessing entrepreneurial resources of even average initiative. Physically describable resources are purchased in the market for their known services; but as soon as they become part of a firm the range of services they are capable of yielding starts to change. The services that resources will yield depend on the capacities of the men using them, but the development of the capacities of men is partly shaped by the resources men deal with. The two together create the special productive opportunity of a particular firm. The full potentialities for growth provided by this reciprocal change will not necessarily be realized by any given firm, but in so far as they are realized, growth will take place which cannot be satisfactorily explained with reference only to changes in the environment of the firm.

  The process is one by which new productive services are continually becoming available to a firm, and the new services are not just those of its managerial and other personnel, but also of the physical resources with which a firm works. If these services can profitably be used only in expansion, the firm will have an incentive to expand. Again, it is clear that a firm may be unable to take advantage of all the opportunities that are created by the new services available to it, since the amount of expansion it can plan is limited. But for the enterprising firm, even in the absence of changes in the external world, there is a continuous impelling pressure to expand, arising from the continuous opening up of new areas of profitable expansion.

  To be sure, experience of the external world is part of the experience of a firm’s personnel. We have concentrated on experience and increasing knowledge of the productive possibilities inherent in the resources of the firm; we should not ignore the effect of increased experience and knowledge of the external world and the effect of changes in the external world. Clearly external changes may also become part of a firm’s ‘stock of knowledge’ and consequently they may change the significance of resources to the firm. Knowledge of markets, of technology being developed by other firms, and of the tastes and attitudes of consumers, are of particular importance. Moreover, many developments in technological knowledge become available to firms not simply as new knowledge, but physically embodied in the form of the capital equipment they buy.79

  Many changes in the external world are appropriately treated as environmental changes affecting the rate of growth of firms through their effect on entrepreneurial expectations about productive possibilities. I have placed the emphasis on the significance of the resources with which a firm works and on the development of the experience and knowledge of a firm’s personnel because these are the factors that will to a large extent determine the response of the firm to changes in the external world and also determine what it ‘sees’ in the external world. This is particularly evident when we recognize that changes in the knowledge possessed by the managerial personnel of a firm will not only change the productive services of other resources, but will also change the ‘demand conditions’ as seen by the firm.

  ‘Demand’ and the Productive Resources of the Firm

  Within rather wide limits it is reasonable to suppose that consumers’ tastes are formed by the range of commodities which are available to them or, at least, about which they know. Business firms have believed this for a long time. The really enterprising entrepreneur has not often, so far as we can see, taken demand as ‘given’ but rather as something he ought to be able to do something about. Until the disturbing problems of advertising and sales efforts crept into the framework of formal economic analysis along with the theory of monopolistic competition, this fact was largely ignored. The analytical techniques provided by the later developments in theory enabled economists to deal more readily with the fact that very few industrial firms can be in a position closely approximating that of ‘pure competition’, and led to a clearer realization of the essentially subjective nature of demand from the point of view of the firm. Both when selling expenses are incurred and when possible retaliatory action of rivals is considered, a firm recognizes that the demand for its product can be affected by its own actions. Neither case is of a cumulative expansionary nature. In the former, the cost of selling increases as the firm attempts to reach more and more customers, until the additional revenue no longer justifies further expansion; in the latter, the problem is merely whether there exists a determinate equilibrium price and output or whether fluctuations will occur indefinitely as the firms jockey for position.

  What is the Relevant Demand?

  When we move from the problem of determining ‘equilibrium’ with respect to cost and revenue curves for given products (which represent the ‘firm’ in the ‘theory of the firm’) to the problem of the growth of firms treated as administrative organizations free to produce any products they choose, we must go further into the meaning of ‘demand’. Once it is recognized that the ‘demand’ with which an entrepreneur is concerned when he makes his production plans is nothing more nor less than his own ideas about what he can sell at various prices with varying degrees of selling effort, then we ought to consider what influences the development of those ideas. For if entrepreneurial notions about what consumers ought to like have some influence on what is offered to consumers and therefore on what they do in fact like, or learn to like, a mere inquiry into the ‘state of demand’ will not enable us to understand the productive activity of entrepreneurs and, in particular, their innovating activity.80 In a historical sense it is quite correct, though tautological, to say that consumers’ demand has determined productive activity, since in the end it is consumers’ acceptance of products that decides the matter. For an analysis of the process of change, however, it is necessary to enquire where entrepreneurs get their ideas about what they should produce.81

  ‘Demand’ from the point of view of an individual firm relates not only to the amounts of its given products it could expect to sell at varying prices but also to the kinds of product it could expect to sell profitably.82 The traditional assumption that the first aspect of demand—how much can be sold by the firm—is independent of costs of production for an individual firm has, of course, long been challenged in the theory of monopolistic competition. But even more important for the growth of a firm is the dependence of the second aspect of demand—what products to consider—on the possibilities of
supply, that is, on the resources and productive services available to the firm. It has already been pointed out above that if resources were completely non-specific, a firm could in principle produce anything. In reality no firm does produce just anything that happens to be in strong demand at any time in the economy. It is obvious that the relevant demand for any particular firm is not defined by the entire range of goods and services being bought and sold in the economy, or even in the relevant geographical markets. Each firm is concerned only with a limited range of products and focuses its attention on particular product-markets selected from the total market. The selection of the relevant product-markets is necessarily determined by the ‘inherited’ resources of the firm—the productive services it already has.83 This is true even in the extreme case of the prospective new firm with no resources at all other than the entrepreneur himself and what capital he can raise; the particular productive activities to be undertaken by such a firm must be chosen from among the alternatives suitable to the abilities, finance, and preferences of the entrepreneur.

  There is no doubt that the growth of demand for a firm’s existing products, as expressed through price changes and other sorts of market information, is a powerful influence on the direction of productive activity and on the expansion of firms. The possibilities of expanding such demand by advertising and other sales efforts, and the effect of such efforts on the productive opportunity of the firm are not to be underestimated. Other things being equal, it is usually cheaper and less risky to expand the production of existing products than to enter new fields. When, therefore, the market demand for existing products is growing and entrepreneurs expect continued growth, ‘demand’ will appear as the most important influence on expansion, and current investment plans may be closely tied to entrepreneurial estimates of the prospects for increasing sales in existing product-lines. If expectations are disappointed, a sharp curtailment of investment plans may follow. In an expanding economy, therefore, a large proportion of the growth of existing firms may be closely related to increased demand for their original types of product in much the same market area. Conversely, in periods of contraction, the decline in demand for existing products will show up in curtailed expansion plans: demand for a firm’s existing products will, therefore, have an important influence on the rate of growth of firms,84 and studies of the investment plans of particular firms at particular times would be expected to show that ‘demand’—entrepreneurial expectations regarding the amounts of existing products they could reasonably hope to sell at varying prices—is the controlling influence on expansion.85

  On the other hand, very few of the older and larger firms in the economy have continued to produce the same type of product throughout their lifetime, even when the demand for that product has risen substantially over the period. Conversely, where demand for the original products has fallen or disappeared, firms have still continued to expand. The growth of almost all large firms has been accompanied by far-reaching changes in the composition of the ‘demand’ which the firm has considered relevant for its operations. Somehow or other, in spite of the apparently controlling influence on expansion of demand for existing products in the shorter run, the ‘product-mix’ of firms changes substantially over the longer period.

  When firms get into the production of products about which consumers know nothing, and for which there is no market expression at all of consumers’ ‘wants’, overt demand is clearly irrelevant.86 Ventures into new products or into the development of new uses for old products are originated by entrepreneurs who believe that they could produce products with the uses of which consumers are as yet unacquainted, but which consumers (whether households or other firms) would find useful and would be willing to buy at prices and in quantities that would be profitable to the producer. Steadfast in their conviction that their products are really useful to consumers, firms may even go into production in the face of active consumer resistance.87 To be sure, the anticipation of consumer acceptance is a necessary condition of entrepreneurial interest in any product, but the original incentive to a great deal of innovation can be found in a firm’s desire to use its existing resources more efficiently. The type of product in which the consumer might be interested is in effect very often suggested to the entrepreneur by the firm’s resources, and the possibilities of successfully introducing it largely depend upon them. The general direction of innovation in the firm (including innovation in production) is not haphazard but is closely related to the nature of existing resources (including capital equipment) and to the type and range of productive services they can render. An explanation of the extent and nature of diversification becomes, therefore, an important part of the explanation of the growth of firms, and for this we shall find that ‘demand’ is no more important, and is perhaps less important, than the existing resources of the firm.88

  The significance of all this lies in the fact that ‘demand’, in the sense of the composition of selling opportunities relevant to a firm’s planning, will undergo important changes as the firm grows if growth itself alters the significance and character of the resources of the firm, that is, the productive services they can render. This is exactly what happens, as we saw in the previous section. For demand from the point of view of the firm is highly subjective—the opinion of the firm’s entrepreneurs.89

  The Direction of Expansion

  The emphasis of this chapter has been on the relation between the existing resources of a firm and the kind of expansion it undertakes. In planning expansion a firm considers two groups of resources—its own previously acquired or ‘inherited’ resources, and those it must obtain from the market in order to carry out its production and expansion programmes. At the very least, some services of the firm’s existing management are required, and usually the services of a large number of other ‘owned’ and familiar resources as well. There is a close relation between the various kinds of resources with which a firm works and the development of the ideas, experience, and knowledge of its managers and entrepreneurs, and we have seen how changing experience and knowledge affect not only the productive services available from resources, but also ‘demand’ as seen by the firm. Such changes, together with the various special advantages accruing to a firm because of the availability of unused productive services within it create the special productive opportunity of a given firm. Unused productive services are, for the enterprising firm, at the same time a challenge to innovate, an incentive to expand, and a source of competitive advantage. They facilitate the introduction of new combinations of resources—innovation—within the firm. The new combinations may be combinations of services for the production of new products, new processes for the production of old products, new organization of administrative functions. There is no warrant for assuming, even under unchanging external conditions, that combinations of services that will be effectively available to a firm to-morrow are available to it today. Firms, like individuals, occupy at any moment of time a given position with respect to the external world. This position is not only determined by time and space but also by the ‘intellectual’ horizon, so to speak; it provides the frame of reference from which external phenomena are approached and the point of origin of all plans for action.

  The point of origin for the plans of any firm is circumscribed by the firm’s resources and by the services they can render. Although this follows from our definition—since we include ‘entrepreneurs’ among the resources of the firm and the range of ideas of entrepreneurs among the services rendered—it gains substantive significance from the fact that no resources, not even entrepreneurial resources, are of much use by themselves; any effective use for them is always viewed in terms of possible combinations with other resources. Hence no firm ever perceives the complete range of services available from any resource, because the range of services recognized is for the most part confined by the management’s existing ideas as to possible combinations.

  We have said little about the external influences on a firm
’s choice of product although there can be no question that external influences may be the decisive factor in determining the particular direction of expansion of a given firm. We have ignored them in order to show in what sense they may be decisive. If there are profitable opportunities for increased production anywhere in the economy they will provide for some firm an external inducement to expand. But this alone tells us nothing about their significance for any given firm. New inventions, changes in consumers’ tastes, growing demand for particular products are external inducements to expand only for what might be termed ‘qualified’ firms—firms whose internal resources are of a kind either to give them a special advantage in the ‘profitable’ areas or at least not to impose serious obstacles. On the other hand, there are industries into which entry is so easy that almost any firm can take up production; ‘qualifications’ are minimal, the rate of entry very high—particularly of small firms—and mortality also high. In these cases we have to examine not only the characteristics of firms that enter such industries, but also the factors which determine whether they can remain and grow in the industry.90

  Whether we want to answer the question what external opportunities for expansion are relevant for a given firm, or the question what firm will respond to a given external opportunity, we must examine the productive services available within firms. For in a very significant sense unused productive services are a selective force in determining the direction of expansion.