Theory of the Growth of the Firm

by Edith Penrose

  So-called ‘market imperfections’ as an explanation of diversification rest largely on the declining profitability of existing markets as output expands. This is, of course, one aspect of the matter, but there is no reason to assume that it is generally the most important. It is a special case of the changing opportunity cost to the firm of its own resources. It is not necessary that existing markets become less profitable in themselves, only that they become relatively less profitable for any new investment the firm wants to undertake. This can just as well occur because of the rise of new opportunities for investment as because of the decline of the old, or because markets for existing products do not grow fast enough to provide scope for the firm’s internal capacity for growth. As we have seen, new opportunities are related not only to changes in prices, tastes, and other market conditions, but also to the special kinds of productive services and knowledge developed within a firm.

  Although new opportunities for expansion may be related to changes in external conditions or to changes within the firm itself, competition of a certain kind links these changes together. The expected actions of competitors are a part of the external environment of an individual firm, and the techniques adopted by the firm to maintain its position in the face of competition have themselves a significant influence on the kind of new productive services that are created within the firm. The relationship between competition and the internal supply of productive services is of particular significance wherever the individual firm must keep abreast of new technical developments to compete sucessfully, and where the continued profitability of the firm is likely to be associated with the possibilities of innovation. The result of such conditions of competition has been the almost universal adoption by larger firms of the industrial research laboratory, which immeasurably speeds up the creation of productive services and knowledge within the individual firm. The Schumpeterian process of ‘creative destruction’ has not destroyed the large firm; on the contrary, it has forced it to become more and more ‘creative’.

  In the United States, where the process seems to be most highly developed, a kind of ‘competition in creativity’ has become a dominant motif in the pattern of competitive behaviour in many industries, where consumers and producers alike are caught up in an almost compulsive obsession for that which is ‘new’. In the extreme case the individual firm is forced constantly to remould its products—to create the ‘new’ and ‘improved’ either in performance or design. To a large extent the new products are superior in performance; to a considerable extent they are merely new and different and can be sold only if the consumer can be convinced that the ‘newest’ is the ‘best’. Once this conviction takes hold, an almost senseless circular process can develop in which the consumer must have a new model every year and every producer must therefore produce one. But regardless of the ‘sense’ or lack of it that one may find in such a process when carried to extremes,108 it has considerable significance for the pattern of growth of firms. On the one hand it intensifies the vulnerability and restricts the prospects of growth for firms that confine themselves to a narrow range of products; on the other hand, it compels firms to specialize in a relatively narrow range of basic areas of production and restricts the rate at which they can diversify their fundamental activities. We shall pay considerable attention to the relation between diversification and competition, but before going further we must discuss the meaning of diversification and the kinds of opportunity that induce it.

  Meaning of Diversification

  The ambiguity inherent in the concept of a ‘product’ or an ‘industry’ has often been commented on; the same difficulties necessarily beset the concept of ‘diversification’. It is common for firms to be characterized as ‘single-product’ firms or ‘multi-product firms, as ‘highly’ diversified or as ‘undiversified’ firms, etc. Precisely what the terms mean will depend on the grouping of commodities defined as a single product that is significant for the analysis at hand. Thus for some purposes a firm producing only shoes may be considered ‘undiversified’, while for other purposes, a firm that produces all sizes and varieties of shoes for all ages and sexes of people may be considered significantly diversified. It is not possible, nor indeed desirable, to try to establish any ‘absolute’ meanings for such words. In consequence, not only is a comparison of the ‘extent of diversification’ of different firms likely to be meaningless in itself, but statistical studies of the number of different ‘products’ produced by firms are also of very limited usefulness, especially if one does not know the identity of the firms referred to.

  The Temporary National Economic Committee, for example, produced an extensive study of the product structure of fifty large manufacturing companies in the United States, with elaborate tables giving a variety of different kinds of information about the number of products produced and the importance of each product to each company.109 This study, though giving much useful information, is of no help in our analysis (nor could any such study be) because the ‘number of products’ produced by a firm has no general significance in the absence of detailed information about that firm and its products. The definition of a product is at best arbitrary; to be useful for inter-firm comparisons the criteria for defining a product must have the same significance from one firm to another and must be related to the reasons for discussing the number of products in the first place. Census classifications of ‘products’ cannot possibly satisfy these conditions. In the modified census product classifications used by the T.N.E.C. study, for example, a product was sometimes defined with respect to the type of raw material used (all-wool blankets and 90 per cent wool blankets being different products); sometimes with respect to the type of user (girls’ and children’s shoes being separate products from youths’ and boys’ shoes); sometimes by the process (‘stitch-down’ and ‘welted’ shoes are different products); sometimes by the combinations in which goods are sold (a three-piece suit with extra trousers being a different product from a two-piece suit with extra trousers), and so on.

  If we are told that Firm A produces 20 products and Firm B produces 4 products, can we sensibly conclude that Firm A is the more diversified? And would our judgment be changed if we knew that the 20 products of Firm A were 20 kinds of shoes while the four of Firm B were tractors, radios, airplane engines, and automobiles?

  More recently the Federal Trade Commission has come out with a comprehensive report on product diversification in the 1000 largest manufacturing companies in the United States in 1950.110 For these companies the report presents statistics on the diversity of their activities measured by the number of ‘product-classes’ produced. Some useful information about the differences between companies of different size is presented; but again, because of the ambiguity and non-comparability of product classes, one cannot appraise the significance of the comparative diversification of different companies.111 Difficulties of this sort interfere with attempts to compare statistically the ‘product-structure’ of different firms, but they do not interfere with an analysis of the economics of diversification so far as it is concerned with the process taking place within firms, or even with the significance of diversification for an analysis of market and production relationships, provided we know the kind of firm we are dealing with.

  For the purpose of analyzing the process of diversification we can say that a firm diversifies its productive activities whenever, without entirely abandoning its old lines of product, it embarks upon the production of new products, including intermediate products, which are sufficiently different from the other products it produces to imply some significant difference in the firm’s production or distribution programmes. Diversification thus includes increases in the variety of final products produced, increases in vertical integration, and increases in the number of ‘basic areas’ of production in which a firm operates. This last type of diversification is of especial importance, and cannot be measured by the number of different kinds of final or intermediate products produced. If a fi
rm previously producing air brakes of various kinds, for example, enters the production of electronic equipment, it is certainly diversifying its productive activities (provided it does not abandon its air brake production entirely), although at the same time it may reduce the varieties of air brakes produced and in consequence the absolute number of different kinds of products. This points out once again the futility of attempting to measure the ‘extent’ of diversification as such, for there is no single all-purpose measure. Is the air brake-electronics firm less diversified because the total number of separate products is reduced? Clearly the type of diversification is different, and for a study of the growth of firms the type of diversification and the reasons for it are of more relevance than the ‘amount’ of diversification, whatever that may mean.112

  ‘Areas of Specialization’

  Diversification may take place within a firm’s existing areas of specialization or it may result in a firm going into new areas. At all times a firm has a foothold in certain types of production and in certain types of market, both of which are here called ‘areas of specialization’ of the firm.

  Each type of productive activity that uses machines, processes, skills, and raw materials that are all complementary and closely associated in the process of production we shall call a ‘production base’ or ‘technological base’ of the firm, regardless of the number or type of products produced. A firm may have several such bases, and even when they are related to each other by common elements or knowledge or technology, they will be treated as different bases if there are substantial differences in their technological characteristics. The particular group of activities to be treated as a single production base will vary for different firms. The significance of distinguishing such groupings lies in the fact that a movement into a new base requires a firm to achieve competence in some significantly different area of technology.

  A firm may sell in a variety of different markets even though it has only one production base. Markets, from this point of view, are conveniently classified according to the kind of buyer they serve, since some of the most important opportunities for diversification arise as a result of the relation between a firm and its customers. Each group of customers which the firm hopes to influence by the same sales programme is called a ‘market area’, regardless of the number of products sold to that group. Thus occupational groups (such as housewives, farmers, or industrial firms), distributive organizations (such as different types of retailers, or wholesale houses), geographical groups (for firms whose existing markets are geographically limited), different income and social groups, etc., may each be a different ‘market area’ if different selling programmes are required to influence them. The appropriate criteria for the delimitation of market areas are different for different firms; the significance of the boundaries lies in the fact that a movement into a new market area requires the devotion of resources to the development of a new type of selling programme and a competence in meeting a different type of competitive pressure.

  A wide variety of products may be produced for each market; and a wide variety of markets may be served from the same production base. Diversification within the same area of specialization refers to the production of more products based in the same technology and sold in the firm’s existing markets. Diversification that involves a departure from the firm’s existing areas may be one of three kinds: (1) the entry into new markets with new products using the same production base; (2) expansion in the same market with new products based in a different area of technology; and (3) entry into new markets with new products based in a different area of technology.113 These categories do not, of course, include diversification by increasing the number of products produced for the firm’s own use, a category that is best discussed separately.

  Many firms have diversified in all of these ways both within and beyond their existing areas of specialization, others in only one or two ways. There are very few, if any, completely undiversified firms if ‘product’, and especially ‘intermediate product’, is defined narrowly. In any given circumstances, including the state of technology and the existing organization of competing firms, much diversification is almost a necessity, in the sense that no firm would expect to compete successfully if it did not produce at least a minimum product line or a minimum of its own intermediate requirements, the number of products involved depending on the circumstances.

  There are a few studies in which the ‘causes’ of diversification are listed; such lists provide convenient classificatory boxes into which any given collection of examples can be sorted, but they are of limited usefulness for an analysis of the relation between diversification and the process of growth. Here we shall link diversification with the changing internal and external circumstances which affect the productive opportunity of the firm, discussing not only the forces promoting diversification but also those limiting the firm’s freedom of action in this respect.

  The Specific Opportunities for Diversification

  Opportunities to produce new products arise from changes in the productive services and knowledge available in the firm of the kind we have explored in earlier chapters, and from changes in external supply and market conditions as perceived by the firm. A single ‘opportunity’ in the sense used here is merely one of the components of the whole productive opportunity of the firm as defined earlier. In other words, it is one of a number of possible uses of the resources of the firm, in each of which the firm believes it could make profit, ‘profit’ being calculated without reference to the ‘opportunity cost’ of its resources (that is to say, the firm calculates the possible profit for each opportunity without reference to whether it is more or less profitable than available alternatives). Thus, any specific opportunity to diversify is merely an opportunity, not yet the most profitable course of action—the firm may pass it over, believing other things would be more profitable or considering that the action required is not worth the risk or does not justify the amount of resources that would have to be committed.

  There is no need here to repeat our earlier analysis of the pervasive existence of unused productive services within firms and of the process by which they are continually created by the normal operations of the firm. It is easy to understand, in the light of that process, how and why a firm may find it profitable to alter and add to the kind of products it produces. In the following discussion we shall explore the characteristics of some of the more important general sources of new opportunities for diversification.

  The Importance of Industrial Research

  Industrial research, the deliberate investigation of the as yet unknown properties of the materials and machines used in production (or as yet undeveloped ways of using them) for the express purpose of improving existing or creating new products and productive processes, has probably existed in some form wherever industry has existed. But the systematic and extensive development of the industrial research laboratory is of very recent origin, and only in this century has it reached such proportions that the normal activities of large firms cannot be discussed without reference to it.114 Many entrepreneurs very early on perceived the possibilities for improving the long-run profitability of their own firms through systematic research into the properties of the materials and equipment they dealt with, partly because they dreamed of new things, partly because they saw in such research a way of improving their existing products and widening their opportunities.

  But quite apart from the dreams or motives of entrepreneurs or the actual historical processes which led to the development of the industrial research laboratory, it is the logical response of the individual firm to the challenge inherent in the Schumpeterian ‘process of creative destruction’. After all, the specialized firm is vulnerable. Its profitability and very survival as a firm are imperilled by adverse changes in demand for the type of products it produces and by increased competition from other producers. Its growth is limited by the growth of the market for its existing products or by the share of the exis
ting market it can succeed in obtaining. On the other hand, as we have shown, its opportunities are largely determined by its existing resources. Its entrepreneurial and managerial personnel work within the framework provided by these resources and their interests and abilities are conditioned by them. Except in those instances where firms are dominated by entrepreneurs of the roving ‘empire-building’ sort, there is a strong tendency for each firm, in the first instance at least, to concentrate on the profitable development of what it has.

  A firm may attempt to entrench itself by destroying or preventing effective competition by means of predatory competitive practices or restrictive monopolistic devices that relieve it of the necessity of either meeting or anticipating serious competitive threats to its position. In such circumstances a firmmay grow for a considerable period depending on the demand for it sproducts, 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, 115al though elements of such protection are to be found in the position of nearly every large firm.