Theory of the Growth of the Firm

by Edith Penrose

  Except for seasonal variations, it is rarely possible accurately to predict fluctuations in demand. The less accurate the firm feels its predictions are, the more uncertain are profit expectations; consequently the firm will give more weight to the possibilities of obtaining a more complete utilization of its resources and a more stable income stream and less weight to the possible restriction on its ability to meet fully the peak demand for its existing product.

  Firms whose products are particularly susceptible to cyclical movements are in this category. The timing and extent of cyclical fluctuations are not reasonably predictable, yet past experience lends force to the expectation that recessions are likely to occur. Firms producing durable goods, and especially durable producer goods, can confidently expect severe fluctuations in demand even in the absence of any severe fluctuations in the general level of activity. They are unable to predict these movements with any precision and they often attempt to diversify into the production of products the demand for which is influenced by circumstances different from those influencing their existing markets. Thus manufacturers of durable goods try to take on less durable products, manufacturers of producer goods try to reach forward towards the final consumer, or producers of ‘luxury’ goods search for products less sensitive to changes in consumers’ incomes.146

  Diversification to deal with temporary fluctuations in demand that are definitely expected but that cannot be estimated with sufficient accuracy to make profit calculations more than informed guesses comes very close to diversification as a device for coping with a generalized uncertainty. The larger and more pervasive effects of uncertainty—which give rise to a feeling that it is somehow safer to maintain a diversified portfolio, and to a general distrust of putting all eggs in one basket, even if that basket is closely watched—are not overcome simply by adjusting net revenue calculations. Many a firm has proclaimed the philosophy that its security is greater if it produces a wide range of products instead of concentrating on those products which, even after all practical allowances for risk have been made, seem to be the most profitable. In other words, diversification becomes a hedge, not against those changes that are definitely expected (although it fulfils that function too) but against changes of any sort which the ‘luck of the game’ may bring. In practice, however, firms recognize that different kinds of products are subject to different types of risk and, within the limits permitted by their productive resources, choose a range of products designed to give the greatest protection against the various definable types of risk.

  Permanent Adverse Changes in Demand

  When a firm’s chief motive for diversification is to ensure an overall stability of earnings in the face of a generalized uncertainty, it is concerned as much with possible long-run adverse changes in the demand for any of its products as it is with possible fluctuations. Indeed the expectation that demand for major products will eventually slacken is a major reason for firms searching for new products. Here the firm that diversifies because it expects the demand for its existing products to decline should be distinguished from the firm that finds the demand for its existing products growing too slowly to satisfy its desire to expand. There is no substantial difference between the actions of the two firms except, perhaps, that the former may be willing to act on less attractive opportunities than the latter for which diversification may be not only a condition of continued growth but even of survival.

  Sometimes the necessity of searching for new products is pressed upon a firm faced with an unexpected and unprepared-for decline in the demand for its basic product which appears permanent. Firms in such circumstances have the greatest need for diversification and often the least ability to effect it. Fundamental changes in demand such as those arising from changes in technology or in consumers’ tastes are rarely so sudden and unheralded that the enterprising firm could not have prepared for them while its position was still strong enough to give it the advantages it needed to enter successfully some new field. The absence of such preparation is prima facie evidence that the resources of the firm are extremely specialized or that entrepreneurial ability is not of a very high order.

  The Direction of Diversification

  Diversification—the production of new products—is the obvious course of action for firms in any of the circumstances outlined above. The one common characteristic of such firms is a motive for diversification which arises neither from the perception of specific opportunities to take on the production of particular new products nor from the pressures of competitive innovation. In other words, for them the desire to diversify precedes the perception of any special opportunities for diversification, and the problem is to find suitable products for the purpose. Once again, however, the search is necessarily circumscribed by the existing productive services available to the firm, of which the so-called ‘intangible’ services of managerial and technical skill may be far the most important. Bold ventures require entrepreneurial imagination, large ventures require managerial talent, entry into highly specialized fields requires some specialized ability, acquisition requires cash or at least sufficient standing in the capital market, or general reputation, to make it profitable for another firm to accept an exchange of shares. For firms with none of these, diversification into products which provide promising scope for the future will be difficult indeed.

  Where firms have no special advantages which will ease their entry into new fields and are not in a position to acquire well-established and successful firms already in the field, they must, like any new and not particularly well-endowed entrepreneur, look for fields where entry is easy and no special skills are required. Given sufficient flexibility of outlook there is nothing to prevent their entry into such fields, even when the technology and markets are completely unrelated to their existing activities, but the attempted diversification may be short-lived, for it is in precisely this kind of field where competition is likely to be intense and disappearance rates high for the existing population of firms, and where few firms without special advantages will succeed in maintaining their footing for long.

  In considering the role of existing resources in determining the direction of diversification that is sought for its own sake, we must make a distinction between the kind of productive services required for internal expansion and the kind required for acquisition. For the former, existing plant, equipment, types of raw materials, skills, knowledge, and original ideas will be much more important forces than they will be for the latter. The task of entry and the task of maintaining the new field against competition is easier if other advantages in addition to entrepreneurial and managerial capacity are available. When it is possible to expand and diversify by buying other firms, the only restriction on the direction or scope of the expansion is that set by the entrepreneurial ability to discover an appropriate firm and to negotiate the acquisition, and by the managerial resources required to effect the necessary integration. The selection of firms to be acquired can be made with little reference to the other productive services available in the acquiring firm but rather with reference to the way in which the new product will supplement seasonally, cyclically, geographically, in market relationships, or in any other relevant way the firm’s existing productive activities. In spite of this relative freedom of choice, however, the truly conglomerate diversification is relatively rare, as was pointed out above, because wherever the firm has other advantages, especially technological and marketing links with the new products, its competitive position is thereby strengthened. For this reason we find that company after company looking for new products stresses its own peculiar productive specialities, although particularly for the large corporation, successful diversification is possible even in fields completely unrelated to existing activities.

  Diversification as a General Policy for Growth

  There are fine distinctions between diversification in response to specific opportunities, diversification to solve specific problems of demand, and diversification as a general pol
icy for growth. In practice they are inextricably intertwined, and often the same act of diversification can be explained with reference to any one of these motives, or to all three together. Many firms proclaim diversification to be the appropriate ‘policy’ for a growing firm—‘policy’ in the sense that the firm should plan to be constantly looking for profitable fields in which to enter. It was suggested above that diversification is one means of protecting the firm as a whole against foreseen and unforseen changes which might adversely affect individual products—in other words, a means of providing a kind of insurance against otherwise uninsurable risk and uncertainty. Firms that diversify primarily for this reason are presumably acting on the conviction that profitable growth over the long haul can be better secured through diversification; but this is not the chief reason why diversification as a policy for growth is so important. There are even more powerful reasons why the enterprising firm may diversify in the interests of growth.147

  In earlier chapters the nature of the internal restrictions on the rate of growth of firms was analysed as well as the nature of the internal inducements to expansion. Among these inducements are to be counted not only the specific opportunities presented by a firm’s resources, but also the unused services of management. If firms are not concerned to ‘maximize’ the rate of return on a given amount of capital, but rather to increase their total profits by increasing their total investment, then clearly whenever a firm’s management feels that the firm’s capacity for growth is greater than that permitted by existing markets and existing products, it will have an incentive to diversify.148 The possibility of producing new products and acquiring new markets frees the firm from the restrictions on its expansion imposed by the demand for its existing products, although not from the restrictions imposed by its existing resources.

  The extensive development in modern times of efficient techniques for decentralized administration as well as the extensive opportunities for expansion through acquisition make possible an extremely rapid rate of growth of firms, at least up to a point. It seems likely that few individual markets can grow as fast as many firms in the middle-size range can grow. It is therefore to be expected that ‘diversification’ will become the slogan of firms that are reasonably well established, possess efficient managerial resources operating in a reasonably well worked-out administrative structure and want to increase their profits at a more rapid rate than their existing products permit. Existing markets may be profitable and growing, but all that is required to induce diversification is that they do not grow fast enough to use fully the productive services available to the individual firm.

  Vertical Integration

  A special form of diversification, which in many cases is of great significance for the growth of the firm, involves an increase in the number of intermediate products that a firm produces for its own use. A firm may integrate ‘backward’, and start producing products it previously bought from others. It may integrate ‘forward’, and start producing new products (including distribution services) which are closer in the chain of production to the final consumer. In this process some of its existing final products may become intermediate products. Both of these processes are methods of growth. I do not want to enter into an extensive and exhaustive analysis of vertical integration here, but merely to discuss some of the important factors affecting a firm’s decision to put its available resources into this type of productive activity rather than into a further expansion of its existing products or into some other products.

  Much of the foregoing discussion of diversification into new final products is equally applicable to vertical diversification; opportunities arising from the nature of the productive resources of the firm giving the firm an advantage in the production of some of its own requirements, market opportunities in the case of forward integration, competitive pressures of various kinds, special problems arising from the existence of uncertainty, all play a similar role.

  We start with the same basic assumption that firms will in general devote their resources to those areas of productive activity which they believe will be most profitable when due allowance is made for risk and uncertainty. In a purely formal sense it follows from this that backward integration will take place only if it is expected to reduce costs, for the decision to integrate backwards is a decision to make instead of buy materials or processes which enter into the costs of production of existing products; in the last analysis, the profitability of backward integration is measured by its effect on the net revenue of the firm. Hence the opportunity to increase profits by integrating backwards is to be treated in the same way as other productive opportunities of the firm—the additional profit expected must be compared with the expected profit from alternative uses of the resources required.149 Consequently, even though firms may well be able to produce more cheaply than they can buy many of the products they use, the diversion of resources to this purpose may be far less profitable than their use in other ways.

  The relevant savings in production that backward integration may bring can be divided into two categories: those relating to the efficiency with which the production of the firm’s existing products can be organized, and those relating to the price that must be paid for supplies. In the first category come all of the problems in obtaining supplies of the required kind, of adequate quality, in adequate amounts, at the required times. Difficulties in obtaining supplies may be particularly apparent when tools and materials must conform to rigid specifications in quality and design, in rapidly growing industries where the different ‘levels’ of the industry do not expand simultaneously,150 where there are close technological links between the various stages of production, where monopolistic squeezes by suppliers take place, or where there are periodical difficulties in obtaining the required materials due to intense supply or demand fluctuations.151 Finally backward integration, like other forms of diversification, is promoted by a desire to avoid the risk of fluctuations and to enhance the security of the firm in the face of a generalized uncertainty. In this latter case, the statement that a reduction in cost is a condition of profitable backward integration is a purely formal one, for ‘cost’ is reduced only because of an arbitrary, non-calculable, and essentially psychological element attributed to the firm’s attitude towards uncertainty.

  The foregoing dicussion of conditions conducive to backward integration relates primarily to integration as a method of ensuring the firm’s sources of supply. But it is not necessary that gross difficulties in obtaining supplies occur or are feared; even minor irregularities in the flow of operations, particularly if they are uncertain in their incidence, intensify the managerial problem of organizing efficiently the production of a firm’s existing products. Hence where efficient management is a scarce resource, there will be a strong tendency to integrate in order to reduce the managerial difficulties not only of planning and controlling existing operations but also, and sometimes especially, of planning future investment. Any cost-savings may be extremely difficult to estimate since the type and amount of managerial service which may be freed for other uses may be virtually impossible to identify, and integration may occur less in response to economic calculations than to engineering calculations of efficiency. Furthermore, since management is itself frequently specialized, a company may well find that opportunities for using their specialized services are greatest in some form of backward integration.152

  In addition, backward integration may appear profitable because the firm believes it can produce some of its requirements so much more cheaply than it can obtain them in the market that the reduction in costs adds more to total profits than any alternative use of resources. The suppliers of an important product to a firm may be organized in a close monopoly which restricts output and raises prices to an extent that makes integration profitable for their customers. Or a firm may have special productive advantages which enable it to produce at exceptionably low cost. In this case, the firm may even produce for sale outside the firm as well as to
meet its own requirements.

  Forward integration, mutatis mutandis, is subject to much the same kind of influences, but unlike backward integration, it may draw the firm into new markets as well as into new types of production. As we have seen, breaking into new markets requires the diversion of resources to selling. In so far as the new products can be sold by the same organization that had been selling the firm’s products before the integration occurred, no new resources may be required. But if substantially new selling techniques must be developed and new channels of distribution created, the tasks of the firm are not essentially different from those discussed with respect to other forms of diversification into new markets.

  Vertical integration is one method by which a firm attempts to maintain its competitive position and to improve the profitability of its existing products. Much integration is directly traceable to the technical efficiency of conducting a sequence of operations in close proximity, and to the maintenance of a smooth flow of supplies and more stable markets; some of it is profitable because of the superior ability of a firm to produce at least some of its own requirements. As is true for other forms of diversification, however, once a firm has resources committed to any type of productive activity, it is often profitable to continue the activity even after the conditions have passed which made the original decision to integrate appear profitable. Occasionally, a firm makes special efforts to promote the development of other firms capable of supplying its needs because it realizes that it can make better use of its resources in other directions. Or when technological advance is rapid in the production of some of the firm’s intermediate products, and technical skills are required which are not closely related to those in which the firm is especially proficient, the firm may well find it not worth while to continue the investment necessary to keep up with the rest of the industry. It is not uncommon, either, for firms to find that an act of integration was originally a mistake, to acknowledge their error and withdraw. This seems the fairly frequent fate of integration that involves a movement from manufacturing to retailing, or from retailing to manufacturing. On the other hand, the managerial economies in the control of operations and the planning of capital investment, even if not important original causes of integration, are sometimes an important reason for maintaining it once it has been effectively organized.153