Theory of the Growth of the Firm

by Edith Penrose

  The profitability and even survival of a firm which fails to concentrate on the intensive development of any of its existing fields, and instead jumps from one type of production to another in response to changes in external conditions, depends entirely on the ability of its entrepreneurs to make shrewd financial deals, to judge correctly market changes, and to move rapidly from one product to another in response thereto. Individual fortunes have been made in this manner, but no enduring industrial organization is ever maintained by this type of adaptation or growth, although it may have been a characteristic of the early years of some firms. Sooner or later such ‘firms’ either break up or settle down to the exploitation of selected fields. The force responsible is that of competition. Although opportunities to enter into the production of new products may be a strong incentive for the firm to diversify its productive activities, and the prospects of acquiring profitable firms in unrelated fields may be extensive, actual and expected external competitive pressures have to be reckoned with.

  The Role of Competition

  Neither the attainment of a monopolistic market position nor technological progressiveness—the two ways in which a firm specializing in given products can meet the threat to its existence from competitors producing the same products—reduces the vulnerability of the firm to adverse changes in total demand for the products it produces. It might seem, therefore, that a firm could best protect itself from both types of vulnerability by trying to produce as wide a variety of products as possible, thus reducing the impact on the firm as a whole not only of changes in total demand for individual products, but also of changes in its competitive position with respect to individual products. The notion that the production of many products is the most effective ‘hedge’ against all kinds of adverse changes, and therefore the most appropriate method of offsetting the vulnerability of the firm to such changes, is extremely widespread.137 It has, of course, a significant element of validity, but at the same time carries with it significant dangers, for the completely non-specialized firm is almost as vulnerable as the completely specialized one in the face of intense competition, especially when this competition is associated with rapid innovation.

  The Necessity of Continued Investment in Existing Fields

  In a competitive and technologically progressive industry a firm specializing in given products can maintain its position with respect to those products only if it is able to develop an expertise in technology and marketing sufficient to enable it to keep up with and to participate in the introduction of innovations affecting its products. If this proposition is valid for firms specializing in given products, then it is equally valid regardless of the number of products a firm produces. Thus if a firm chooses to produce a large number of products not closely related in technology and marketing, it must be in a position to devote sufficient resources to the development of each type of product to maintain its competitive position in the market for that type of product. In other words it must continue to invest in each of the several fields or be prepared to withdraw.

  Withdrawal is often costly in the sense that the sale or scrap value of existing resources, or their value in some alternative use, may be considerably less than their value in their existing uses. Hence if their earning power is only maintained by additional new investment the return on that increment of investment may be high indeed, for all income over direct expenses obtained from the use of existing resources in existing uses may be attributed to the new investment.138 Firms have therefore a strong incentive to continue investment in their existing fields so long as the gross profit earned exceeds the gross profit that could be obtained from alternative uses of the new investment funds together with whatever the firm could realize from the sale of the resources or from their adaptation to other uses. This does not mean that a firm will try to maintain the profitability of every product it produces for every market. Many resources may be fairly easily shifted from one use to another within any given production base and between groups of closely related bases, and within the limits of the mobility of resources a firm may add or drop product lines at little cost.139 But this, too, requires investment in experimentation, research, and innovation.

  Not only is new investment in existing fields likely to be required if cost and quality improvements of competitors are to be met, but expansion is also often necessary in a growing market because a firm’s ‘share in the market’ is sometimes itself an important competitive consideration. In some industries, for example in the production of certain types of durable consumer goods, consumer acceptance of the product is influenced by whether the producer can reasonably claim to be one of the ‘leading’ producers. It is under these conditions that growth is often said, and with good reason, to be a necessary condition of survival.

  A firm may go into many fields, but to maintain itself against competitive pressures it must be prepared to continue putting new funds into each field. This need for continuous new investment will restrict the number of fields a firm can support at any given time. The further from its existing areas of specialization it goes, the greater the effort required of the firm to attain the necessary competence not only in dealing with present production and market conditions, but also in making the adaptations and innovations necessary to keep up with competition.140 After extensive periods of growth through acquisition, a reappraisal of product-lines is often called for, and considerable pruning and retrenchment may be required in order to maintain the profitability of each line the firm chooses to stay in.

  Full-Line Diversification

  Considerable diversification is often virtually forced on a firm as it tries to maintain its position in a given field. We have seen that much of the research responsible for the development of opportunities for the production of new products is itself a response to the exigencies of competition. The same competition will force a firm to take advantage of many of the opportunities thus created, not only to reduce costs and improve quality, but also to add new products. Whenever a firm has an opportunity to add new products which, together with existing products, would enable it to serve a wider variety of needs of its customers, it will have an incentive to add them because the convenience to consumers may well give it an advantage over competitors and enable it to attract new custom apart from any inherent advantages of the product itself. Thus the prospective profitability of a headstart, together with the expectation that the innovation might well be undertaken by some other firm at some other time, will encourage the firm to go ahead. If the new ‘line’ is successful, other firms will be forced to follow suit; the necessity of carrying a ‘full line’ then becomes an important reason for diversification.141

  When customers expect to obtain a group of commodities from the same producer it becomes extremely difficult for a firm to maintain a position in the market unless it, too, carries the expected collection of products, and for an undiversified firm to break into any part of it. It was once reasonable in the United States for a firm to specialize in the production of washing machines; today few housewives would be willing to buy their automatic washing machine and their dryer from different companies. Matching models are required. Thus the combination of opportunities resulting from technological research and market standing may lead to diversification which is in the first instance a voluntary response to opportunities for the use of productive services and knowledge to better advantage. Such a diversification, once established, may create a customary and accepted relationship of complementarity in marketing which forces all other firms regardless of their particular productive abilities to conform. The basic areas of production in which a single firm must be competent widens in industries where this process is significant, and difficulties in the way of new firms desiring to enter the industry increase.

  Much of the diversification of firms can be traced to this process, which varies in importance from industry to industry. It seems to be especially important in industries where there are a few large competing firms and also in in
dustries producing durable consumers’ goods. Diversification to meet innovations of competitors does not necessarily give rise to the kind of complementarity discussed above, for firms may introduce substitutes for their own products in order to attract the customers of other firms. For example, the introduction by a firm of a new form of cigarette—‘king size’ or ‘filter tip’—may cause consumers to switch their allegiance from competitive brands, and all producers may have to follow the innovator in order to keep their own customers. Nevertheless, the firm first to innovate may obtain a lead which permanently attracts a number of new customers to its products.142

  Competition and Diversification into New Areas

  Although it may be profitable for a firm to continue to invest, and even to expand in its existing fields in order to ensure that its committed resources earn as large a return as possible, it does not follow from this that it will be profitable for the firm to attempt any significant improvement of its position when the improvement entails a significant additional commitment of resources. Having attained a satisfactory and reasonably secure position in its areas of specialization, a firm with resources available for expansion over and above those required to maintain its position in those areas may well find that opportunities for expansion into new areas look more promising than further expansion in its existing areas. Provided that the firm’s position is sufficient to ensure it the important economies of production and marketing as well as the advantages of widespread consumer acceptance and confidence, the incremental investment required to obtain a larger output of existing products may be considered relatively unprofitable when new and attractive opportunities for the use of its funds are available.

  In entering any new field, a firm must consider not only the rate of return it might expect on its new investment but also whether or not its resources are likely to be sufficient for the maintenance of the rate of investment that will be required to keep up with competitors’ innovations and expansion in its existing fields as well as in the new one. Even when a firm enters a new field armed with a revolutionary innovation and is able to ward off competition with patent protection or other restrictive devices, it must expect that in time it will be overtaken if it fails to continue to develop its advantage.

  If entry is effected through internal expansion, more of the existing managerial and technical resources of the firm will be required to establish and maintain the firm’s position in the new area than will be required if entry is effected through the acquisition of a profitable and well-managed concern already in the field. In the latter case the firm may frequently expect that the new acquisition will sustain itself, in the sense that any new investment required will be generated by its own successful operations. But to discover, acquire, and subsequently to effect the necessary administrative integration of other firms, calls on the services of existing resources in the various ways we have already mentioned. The limit thereby set to the rate of expansion through acquisition, together with the fact that the firm must expect to meet competition in each of its basic areas, tends to encourage a considerable measure of specialization in broadly defined areas of operation.

  Firms, for the most part, do ‘specialize’, but in a much wider sense than the ‘logic’ of industrial efficiency would suggest, for the kind of ‘specialization’ they seek is the development of a particular ability and strength in widely defined areas which will give them a special position vis-á-vis existing and potential competitors. In the long run the profitability, survival, and growth of a firm does not depend so much on the efficiency with which it is able to organize the production of even a widely diversified range of products as it does on the ability of the firm to establish one or more wide and relatively impregnable ‘bases’ from which it can adapt and extend its operations in an uncertain, changing, and competitive world. It is not the scale of production nor even, within limits, the size of the firm, that are the important considerations, but rather the nature of the basic position that it is able to establish for itself.

  A superficial look at the collection of products produced by many large corporations to-day might appear to contradict this analysis. Yet if one examines closely the established firms with a long history of successful growth, and in particular, the genesis of their product diversification, one will find that their strength lies in the fact that they have established and maintained a basic position with respect to the use of certain types of resources and technology and the exploitation of certain types of market.143 Although they have rarely confined themselves to a narrow range of products, they have exploited the economies of production, organization, and growth, and have taken advantage of monopolistic and quasi-monopolistic market positions, in a small number of fairly well defined areas. The characteristic strength of the large, well-established firm does not derive from a miscellaneous collection of resources in many fields, but from the fact that it has ‘defences in depth’, as it were, in a few special fields. Nevertheless, just as there is a limit to the rate of growth of firms but not to their absolute size, so there is a limit to the rate at which they can enter new fields of production but not to the number of fields they can enter given only time. After all, the process of corporate growth and diversification has only in the past few decades become well developed; although extreme diversification is characteristic of some firms, specialization broadly defined is more the rule than the exception.

  Diversification as a Solution to Specific Problems

  Even in a growing economy where major recessions in general economic activity are prevented, demand for particular products may be unstable, may grow at a very slow rate, or may even decline. In addition, the demand for the products of particular firms may be seriously depressed by the successful inroads of competitors. Diversification is widely seen as a solution to some of the problems that may be created for the individual firm by unfavourable movements in demand conditions.

  Temporary Fluctuations in Demand

  Seasonal and cyclical fluctuations in demand, the typical ‘bunching’ of demand for many types of durable goods, fluctuations due to the temporary popularity of new products, etc., give rise to periodic under-utilization of resources and to extreme fluctuations in earnings for firms producing products subject to such influences. These conditions stimulate firms to search for new products which will permit a fuller utilization of their resources and reduce the fluctuations in their profits. But if we assume that firms are primarily interested in total profits, neither the full use of resources nor the stabilization of earnings is sufficient to justify diversification unless total expected profits are increased thereby.144

  There is no question about the profitability of diversification if a firm is able to find products which it can produce in those periods when demand for its major product is low and which do not conflict with its ability to take full advantage of its opportunities when demand is high. Firms whose products are subject to seasonal fluctuations, for example, can sometimes find other products that they can produce in the ‘off season’, using some of their existing resources, and which they can abandon in the peak season in favour of their major product.145 Demand for the new product may fluctuate inversely to that of the existing products, the market may be easy to enter and leave, or the firm may be able to produce for inventory in the slack period. Under these conditions the new product will not conflict with the maximum exploitation of the old and will be a clear gain.

  The problem becomes more complicated when the output of the new product cannot be appreciably varied over short periods but must be maintained and perhaps expanded even when demand for the basic product is high; the firm, for example, may not be able to neglect its new customers, even for short periods, without running the risk of losing them entirely. If the new product uses some of the resources required for the old—as it must do if part of the purpose of the diversification is to permit a fuller utilization of the firm’s fixed resources and help meet overhead costs—then the production of the new product may
conflict with the desired production of the old when the demand for the old product is high; and the firm, in filling up the valleys, will have to shave off the peaks. To the extent that a firm can predict with reasonable accuracy the magnitude of the fluctuations and can compare the profit gained in the valleys with the cost of giving up gains at the peaks, its plans to even out fluctuations in the use of resources and in earnings can take explicitly into account the effect on total earnings. If they are not increased, the carefully calculating firm would forgo the diversification, for fluctuations in earnings are not particularly significant as such, except perhaps over fairly long periods, if both the timing and extent of the fluctuations are sufficiently predictable to enable the firm to calculate its total earnings over a period. Unless there are special circumstances (for example, tax issues, community responsibility), a firm should not sacrifice higher earnings for lower earnings merely because the latter are more evenly distributed in time.

  The real difficulties arise when fluctuations in demand are not easily predictable; in this case not only are the problems of financial management intensified, but the unknown profitability of the peak periods and the unknown duration of the lean periods, forces the firm to calculate earnings over a ‘cycle’ with a heavy discount for uncertainty. Other things being equal, it is reasonable for a firm to choose a more certain over a less certain income. There is a presumption that earnings from products in steady demand are likely to be easier to forecast than earnings from products the demand for which fluctuates unpredictably. Uncertainty alone, therefore, will bias a firm in favour of producing products that will yield a more stable income, a bias that will be overcome only if the most confidently expected earnings from the products in unstable demand are sufficiently high to offset the necessary discount for the uncertainty with which the expectation is held.