Theory of the Growth of the Firm

by Edith Penrose

  The Firm as a Pool of Resources

  The discussion of the role of diversification in the process of growth perhaps brings out more clearly than would anything else the significance of the statement made in an earlier chapter that a firm is essentially a pool of resources the utilization of which is organized in an administrative framework. In a sense, the final products being produced by a firm at any given time merely represent one of several ways in which the firm could be using its resources, an incident in the development of its basic potentialities. Over the years the products change, and there are numerous firms today which produce few or none of the products on which their early reputation and success were based. Their basic strength has been developed above or below the end-product level as it were—in technology of specialized kinds and in market positions. Within the limits set by the rate at which the administrative structure of the firm can be adapted and adjusted to larger and larger scales of operation, there is nothing inherent in the nature of the firm or of its economic function to prevent the indefinite expansion of its activities.

  The continual change in the productive services and knowledge within a firm along with the continual change in external circumstances present the firm with a continually changing productive opportunity. Not all firms, to be sure, possess the qualifications which will permit them to take advantage of such opportunities, but it is sufficient for our purposes to have outlined the qualifications, to have analysed the factors determining the direction of expansion of those firms possessing the requisite qualifications, and to have shown that there is no necessary limit to growth as time passes.

  The adaptations and adjustments that are required of the firm as it expands are directly influenced by the external resistance to its expansion. We have shown how the necessity of maintaining a competitive position in its basic fields restricts the rate of diversification of a firm, and how the innovating activities of competitors restrict and sometimes shape the pattern of diversification, although we have touched only lightly on other considerations affecting the rate of growth of firms.

  In spite of the opportunities and pressures which lead firms into the production of a wider range of products, it seems likely that most firms still derive the bulk of their income from a relatively few closely related products. That this should be true of the small and medium-sized firms is not surprising in view of the difficulties attendant upon extensive diversification, but it seems also true of many of the larger firms.154 No comprehensive and detailed empirical study of all aspects of the diversification of firms has ever been made; the information is not available from published figures and individual firms are reluctant to provide the quantitative and qualitative information required, even if they have it, which most of them probably do not for earlier periods.155 We know that diversification is widespread today;156 we do not know how widespread it was earlier in the century. We know from the annual reports of corporations that most of the large firms lay great emphasis on the possibilities of diversification, and we know that the speeches and writings of management experts, business executives, and ‘informed commentators’ extol its virtues.157 It may be that diversification as a method of growth is becoming increasingly important; it seems likely, but the impression may be wholly false. In any event, it follows from our analysis that any change in circumstances that widens the productive opportunity of firms or increases their managerial capacity for growth in relation to the growth of demand for their existing products will tend to increase diversification.

  It is perhaps reasonable, therefore, to assume that the development and dissemination of the techniques of decentralized managerial organization, the rise of a professional management class, government actions (especially tax policy) which create favourable conditions for acquisition, the extensive development of industrial research and the consequent widening range of knowledge of chemistry, mechanics, electronics, and other fundamental aspects of industrial science which create within the individual firm an industrial technology suitable for a broad range of products, will all tend to raise the rate of growth of firms. We have yet to discuss the factors influencing changes in the rate of growth; before doing so we must analyse, more systematically than has so far been possible, the process of acquisition and merger.

  VIII

  Expansion Through Acquisition and Merger

  The corporation and merger. The economic basis of acquisition. Personal considerations and special situations. Critical points in the process of expansion. The competitive expansion of Alpha. Where Beta blocks the expansion of Alpha. Combination. The purchase and sale of ‘businesses’ that are not firms. Economic basis for the sale of a ‘business’. Effect on the process of growth. The appropriateness of diversification. The role of entrepreneurial services. Entrepreneurial temperament and the profit motive. Empire-building and merger. The role of managerial services. The necessity of administrative integration. Merger and the dominant firm.

  UNTIL recent times the rise and eventual decline of individual business firms in a competitive economy was often treated as almost a law of nature.158 So long as the fortunes of firms depended on the fortunes of individuals or families on whom rested a personal responsibility for their firms’ operations, both the rate of growth and the size of individual firms were severely restricted. The widespread adoption of the legal device of incorporation substantially affected not only the possible size of firms and their rate of growth, but also the process of growth.

  There can be no question that the corporation has many advantages over the unincorporated individual proprietorship or partnership in raising capital, but this alone would not have changed the nature of the expansion process. The more important consequence of the introduction of the corporate form of enterprise for the process of expansion was the easy legal transfer of the ownership of firms which in fact accompanied it, in particular the ease with which one incorporated firm was permitted to acquire or merge with another.159 The absorption of other firms, though possible, is more difficult, at least on a large scale, for the unincorporated firm, and new methods of expansion spread rapidly as more and more firms adopted the corporate form. In addition, opportunities in the industrial field for the activities of ‘promoters’ and ‘captains of finance’ were widened.

  This last consequence has been partly responsible for a distinct tendency in the literature to treat merger and combination as almost a study in economic pathology. Haunted by the ghosts of financiers and hard-hitting industrialists like Morgan, Gary and the elder Rockefeller, inextricably associated in the public mind with the more mysterious machinations of high finance, and surrounded by an aura of monopoly, collusion, and exploitation, corporate merger, combination, and acquisition have seldom been given a respectable place in the economists’ models of economic activity.160 The rudimentary biological theories of the growth of firms break down over merger: life-cycle analogies make no provision for abrupt discontinuities and changed identity in individual development; ecological analogies have trouble with sudden unpredictable changes in the very nature of individual organisms and the consequent changes in their relation to their environment. But the inadequate theoretical attention to the processes of merger and combination is only another aspect of the lack of any developed theory of the process of the growth of firms. In the traditional ‘theory of the firm’ it is only the competitive or market position of the firm that is relevant, not how or why the firm came into that position—indeed, as has been pointed out, the economists’ formal models of firm behaviour are not often concerned with a firm’s position as a whole but only with price and output policy regarding particular products. Thus, in the literature of economics the question of merger is treated most extensively in connection with studies of monopoly and competition, market structures, the degree of concentration, etc., although recently the relation between merger and size has received considerable attention.

  In spite of the anomalous position of merger and acquisition in the theoretical literature of e
conomics, however, economists have not denied that these processes are normal and natural consequences of profit-seeking in a competitive economy in which the corporation is the dominant form of business organization and the law permits one corporation to acquire another. They are thoroughly consistent with the nature of the actors and the possibilities for action existing in such an economy. The fact that fixed capital, ‘market position’, or even ‘good will’, once created, persist in time means that there is always a choice between recombining the old and building anew. If legal institutions permit one going concern to purchase or merge with another, then, whether expansion takes place through the building of new plant or through the acquisition of another firm will, in any particular case, depend on which appears to be the more profitable course of action. 161 Whenever merger is considered to be the most profitable way to expand, there will surely be a tendency for merger to occur. Economic analysis that treats it only as a means of reducing competition, or establishing monopolistic dominance, is placing the wrong emphasis on one of the most significant characteristics of the firm in the modern economy.

  In this study the term ‘merger’ is used to denote any method of combining existing firms, whether it be the acquisition of one firm by another, the combination of two firms on equal terms, or the reorganization of an entire industry through a consolidation of its component firms. Merger as a method of expansion of an individual firm is of the first type only, and when it is useful to identity it specifically I shall speak of acquisition. The other two forms of merger involve more than simple expansion and I shall call them combination and consolidation respectively. Sometimes the second is almost indistinguishable from the first, the difference being largely one of name; and sometimes through a successive series of simple acquisitions the same result—a reorganization of an entire industry—is obtained by the first type of merger as by the third. But this absence in practice of a clear separation of the three types of merger need not worry us at this point.

  Finally, we shall deal with a still different form of acquisition which has become of increasing importance in recent years, but is still largely neglected in the literature—the acquisition of one of the ‘businesses’ of another firm (for example, the purchase by Illinois McGraw Electric of the home appliance ‘business’ of General Mills mentioned in the preceding chapter). Often the large firms organize their various types of business in separate divisions or subsidiaries, and in many ways the purchase of such a business is little different from the purchase of an independent firm.

  The same general procedure will be followed in this analysis of growth by merger as was followed in the analysis of the process of growth without merger. Except for illustrative purposes, no attempt will be made to describe particular mergers, or to discuss in detail the course of merger in any country or at any period. There is a large body of literature on this and related subjects, including statistical studies of the occurrence of merger in the economy as a whole as well as studies of the merger activities of particular firms. From these studies have emerged lists of the incentives for merger, about which there is little disagreement, and of the consequence and significance of merger, about which there is considerable disagreement. I do not intend to review this literature in whole or in part, for in this chapter I am concerned not with the detailed problem of interpreting a particular series of events in history, but rather to present a general analysis of the relation of merger to the process of expansion of the firm.

  The Economic Basis of Acquisition

  In principle there are two methods of expansion open to the individual firm: it can build new plant and create new markets for itself, or it can acquire the plant and markets of already existing firms. If a planned expansion is considered profitable regardless of any change in the existing position of other producers or in the distribution of the ownership of existing industrial assets, then the firm will choose to expand through acquisition only if acquisition is considered cheaper than internal expansion.162 If, on the other hand, a change in the position of existing producers is sought (for example, a reduction of competition) or a change in the distribution of control over existing industrial assets (for example, over patent rights or monopolized supplies of raw materials), acquisition may be the only way of achieving these objectives. In either case, acquisition will occur only if there are firms who are willing to part with their assets, including their ‘good-will’, at a price equal to or less than their value to potential buyers. For acquisition to occur there must be a seller as well as a buyer both of whom expect to gain by the transaction.163

  Regardless of the type of merger, however, the first and fundamental question to begin with is the question why acquisition should be a ‘cheap’ method of expansion. The mere fact that one firm wants to acquire another in order to limit competition, to facilitate entry into a new field, or for any other reason, does not yet explain why acquisition should be ‘cheap’, that is, why the price at which the other firm can be acquired is less than the value of that firm to the acquirer. What is it that depresses the value of some firms to themselves below their value to another firm, or raises their value to another firm above their value to themselves? In the general case, that is to say, in the absence of special individual circumstances, should we not expect the price of existing firms (i.e., their value to themselves) to be, if anything, above their value to other firms?

  The economic value of any firm can be looked upon as the present value of the stream of gross profits expected over the period relevant to the calculation.164 Hence no firm would, in the absence of special circumstances, set a price on itself less than the present value of this expected stream of profits. Clearly, unless the firm has made mistakes and expanded productive capacity so far that prices no longer cover average costs (i.e., the firm is ‘unprofitable’) capitalized expected profits will not be lower than the initial investment outlay required to earn them.165 If existing firms in an industry have some advantage over outsiders, profits will be increased by the costs of entry, and the value of the firm will be correspondingly higher. On the other hand, whenever the purchase of another firm is considered the cheaper method of expansion, it follows that the price of this other firm is less than the investment outlay (including the opportunity cost of all resources) required for the expanding firm to build the necessary plant, markets, and trade connections. An economic analysis of acquisition requires, therefore, an analysis of the causes of this divergence, and the interesting question is whether the prevalance of growth by merger can be explained only by special individual considerations in each case, or whether there are important general considerations, in particular, considerations relating to the expansion of firms of different sizes.

  In the following discussion the acquiring firm will be called Alpha; the firm to be acquired, Beta. We shall now consider the several kinds of circumstances which will cause the price of Beta to be less than its value to Alpha, beginning with particular personal considerations, on which we need spend little time, and proceeding to the more general considerations related to the growth of Alpha and Beta.

  Personal Considerations and Special Situations

  At all times there are firms ‘on the market’—firms whose owners want to sell out—where the initiative for merger comes from the seller.166One does not have to seek far to discover why this would always be so, even if one were to assume that costs and demand conditions were the same for all sizes of firm. There is nothing in the basic propositions of economics that asserts or implies that all men view the future with the same degree of optimism, or that the value of a given cash payment is the same to both parties to a transaction, or that the same income will call forth the same effort from all men and regardless of the time of life. On the contrary, it is well recognized that some men are more optimistic and more willing to take risks than others, in which case the expected net income from operating a given firm will be greater for the more optimistic and less discounted for the risk of not getting it. Or the worth
of a present cash payment may be greater to the recipient than to the giver, the former placing a relatively lower value on future income.

  In small firms where the owner and manager are one, the income from the firm may no longer be sufficient to call forth the effort required to run it—the owner may want to retire from business and there may be no adequate successor in his firm or family; or he may want to acquire cash or easily marketable securities to increase the liquidity of his estate in preparation for his final retirement from the world. In these and similar circumstances owners may be willing to take less than the capitalized value of the profits they could be expected to earn.167 In other cases a firm’s existing management may be simply inefficient and the firm doing badly for that reason. Here the profits anticipated by the firm’s present managers will be less than those anticipated by other and better managers appraising the value of the firm. Thus the very existence of firms that are not very successful or of firms owned by people who want to leave the business is in itself conducive to merger.168