Theory of the Growth of the Firm

by Edith Penrose

  When the organization of a firm is such that the profitability of its various specialized lines of activity can be appraised separately, that is to say, when an estimate can be made of the resources of the firm absorbed by each activity as well as of the new investment required over time, then a rate of return can be calculated which can be compared with rates of return on other activities open to the firm for the use of the resources and of the finance which would be freed if the firm sold out. Clearly, when such a comparison shows that the firm could make better use of its resources, it would pay the firm to sell. Hence the various businesses of a firm may be evaluated in much the same way as individual products are evaluated, being added or dropped according to their performance, with the difference that in general a larger collection of assets is involved in the decision to add or drop a specialized activity than in a similar decision for an individual product, and more of the resources are likely to be more completely specialized.

  If, however, a field of investment can be considered unprofitable when opportunity costs of the resources used in it are counted, and profitable only when they are not counted, it is implicitly assumed that there is a limit on the expansion of the firm—that the firm is unable to take full advantage of other opportunities for the use of its resources unless it contracts their use in the activity in question. Since both funds and managerial services become available when a business is sold, the significance of the price that could be obtained from a business depends on the relative importance of capital and management as a restriction on the firm’s ability to expand.

  If both capital and management are in abundant supply, that is to say, if the firm has unused managerial services available of the same kind as are absorbed in the business in question, and if it can easily obtain all the capital funds it needs for expansion, it will not be willing to sell any of its businesses except at a price above the present value of the expected gross profits, for here the opportunity cost of the resources employed in the business approximates their market price, that of management being zero.

  If, on the other hand, management is fully absorbed in existing operations and would have a high opportunity cost, either in expansion of some of the businesses in which the firm is engaged or in new businesses that look especially attractive, the firm may find it profitable to sell an existing business which absorbs important managerial services and yields only a relatively low profit net of the high opportunity cost of managerial services. This would be true also if capital funds within the firm were so abundant that the funds obtained from selling out would be of little significance.

  If capital funds are not abundant in the firm but have a high opportunity cost, while management services are in abundant supply, the firm may find it profitable to sell out one of its business for the sake of the funds received and released. In this case, however, the business most profitably sold will, ceteris paribus, be one from which the firm can obtain the largest supplies of capital: hence the price at which it can sell will have a greater influence on the profitability of selling out than in the case where the supply of management was the more significant factor.

  If both capital funds and management are scarce and the firm would have profitable uses for both liquid funds and released managerial services, it would pay to sell one of its businesses even at a relatively low price, the lowest price at which it would sell being determined by the relative opportunity cost of managerial services and free capital funds.

  This brings us back to the factors discussed in the preceding chapter which force a firm to specialize in a few broad areas. It was argued there that diversification is promoted when firms have the ability to expand faster than the markets for their existing products, and that the direction of diversification will to a large extent be determined by the existing resources of the firm. These resources may be of many types, and many different opportunities may appear to promise success. But ‘success’ is not simply a question of making an accounting profit; to be deemed successful a new activity must turn out to have been a better use of the resources of the firm than any alternative use; and it remains successful only so long as it continues to be the most profitable use, not only of whatever new funds are required to maintain the competitive position of the new business, but also of the managerial and other resources absorbed by it. Clearly, with limited managerial services and with incompletely versatile resources, the number of things a firm can profitably get into is much more limited if it counts the opportunity costs of its resources in any one use than if it merely considers whether it can successfully compete with other firms in particular markets.

  When firms are engaged in a number of different lines of business but are actively attempting to use their resources in the most profitable manner, they will be continually reappraising the profitability of their different activities as changes occur in external conditions and in the quality and quantity of the productive services internally available. Furthermore, to the extent that diversification is promoted because firms are actively seeking new fields in which to expand, and hence pursuing ‘diversification for growth’, a great deal of their diversification will be experimental in nature. Thus there are always likely to be firms who want to withdraw from given lines of activity: expectations of profit may have been too optimistic and the actual results disappointing; or new opportunities may have arisen as a result of developments within the firm or in the outside world. On the other hand, we cannot assume that businesses unprofitable for their existing owners will also be unprofitable acquisitions for others. Under these conditions, we should expect the rise of a ‘market’ for those separable activities of firms that are no longer desired by their existing owners, the market being governed on the supply side by the factors outlined above, and on the demand side by the same factors that influence the acquisition of independent firms.

  Effect on the Process of Growth

  The existence of this kind of market has an important effect on the process of growth of firms: it both promotes and helps to eliminate ‘excessive’ diversification. It facilitates the correction of ‘mistakes’ and thereby reduces the risk of loss when a firm experiments with new lines of activity, thus encouraging such experimentation.

  In the absence of such a market less fundamental diversification would undoubtedly take place. It is difficult to imagine how such a market could be eliminated under modern conditions, for it is difficult to see how a prohibition on firms selling out entirely or in part could be effectively enforced without an inconceivably drastic alteration in the size and structure of firms which would virtually push them back to extremely small and specialized entities. But be that as it may, if one can imagine the kind of economy we have to-day without such a market, it is clear that the rate at which firms could enter new fields would be reduced substantially. Internal expansion (which is the alternative to acquisition) takes longer and is often more expensive; and the penalty for mistakes would be higher since firms could only liquidate their mistakes by selling off individual assets piecemeal rather than as part of a going concern. In such circumstances firms would have to be more careful in planning expansion programmes than they now have to be, for now they can dispose of their mistakes at relatively little loss and sometimes at a profit. Consequently the premium on conservative attitudes is reduced under the present system, and experimentation, not only with new products but with whole new lines of business and even with expansion into new geographical areas, is encouraged.

  It is not surprising that at times some firms appear to be going somewhat wild in attempting diversification of all kinds. There have, of course, always been firms whose grandiose plans have led them into trouble, and there is no implication in the present analysis that the excessively optimistic and careless firms will always be able to pull through simply by taking advantage of the opportunities to sell a business injudiciously acquired, especially if their expansion is essentially of the empire-building type. But it does imply that the relatively conservative well-esta
blished firms can afford to take more chances, and the less conservative and aggressive newer firms can grow very fast and successfully establish themselves in spite of serious failures of some parts of their total business.

  The Appropriateness of Diversification

  Finally, the growing importance of the sale and purchase of businesses that are not firms affects the economic appraisal of merger activity in the economy. To the extent that the rate of merger is raised by the purchase and sale among the larger firms of parts of their business, this clearly does not in itself indicate a further concentration of economic activity in the hands of the large firms at the expense of small firms, although it may, and very likely will, be accompanied by an increase in the concentration of particular types of activity in the hands of fewer firms. 186 Industry or product concentration will increase if a few firms already established in particular types of activity have a competitive advantage in the production of related products and, in the process of swapping, end up with the bulk of the businesses sold in that type of activity.

  In spite of this consequence the swapping process may well promote an appropriate pattern of diversification among firms, that is, an efficient use of resources from each firm’s point of view. For if the ease of selling out encourages experimentation, some of which turns out to be inefficient, it provides at the same time a method by which mistakes can be corrected. For so long as sales are not fully matched by inappropriate acquisitions, a more efficient distribution of productive activities from the point of view of the use of resources of individual firms will be brought about. At least this will be the result unless it is assumed that entrepreneurs are so stupid or so unlucky that when they enter new fields or acquire new businesses they take action which turns out to have been a mistake from their own point of view more than half of the time—an assumption that would leave a great deal of economic analysis of the behaviour of firms and of the processes of resource allocation in the economy in a rather regrettable quandary. If at least half of the total sales and half of the total acquisitions are appropriately made, the tendency over the long haul will be towards a progressive redistribution of productive activities between firms which, on balance, would lead to an appropriate pattern of diversification from the point of view of the use of resources of individual firms, even though any given firm at any given time may have been led into excessive or inappropriate diversification.

  If we could assume that the private gain which is associated for a particular firm with a competitive advantage in any line of activity was also a social gain, we could identify an ‘appropriate pattern of diversification’ from the point of view of the firm with a more efficient use of resources from the point of view of society as a whole. This assumption is clearly warranted in some cases (for example, where the competitive advantage flows from a superior technical competence in a competitive market, or from the availability of particular productive services which would otherwise be unused); clearly unwarranted in other cases (for example, where the competitive advantage flows from a monopoly of some scarce natural resource or from power to apply financial or other pressure on suppliers or competitors); and uncertain in still others (for example, where the advantage rests on a patent or on a well-cultivated reputation with consumers). Hence we cannot in general say what net effect the ‘swapping’ process has on the efficiency of the economy as a whole.

  It has generally been recognized that an acquisition which involves an improvement in the efficiency with which a business is managed, or avoids capital losses resulting from an unnecessary breaking up of a going concern, is on balance a benefit to the economy if it does not reduce the competitive performance of the economy. Similarly, the reshuffling of particular types of businesses among existing firms can be presumed to improve efficiency so long as the competitive performance of industry is unimpaired. But this statement does not take us very far, partly because it is difficult to define what is meant by an ‘impairment’ of competition when ‘competition’ includes not only price competition but also product improvement and fertility in innovation, and partly because it is possible that impairment of competition in whatever sense it is defined may under some conditions be quite consistent with an improvement in economic efficiency, that is, with an increase in economic product in a given period greater than would have occurred under more competitive conditions. But further discussion of questions of this kind is reserved for our final chapter.

  The Role of Entrepreneurial Services

  Since entrepreneurial services are among the productive services available in firms, an analysis of the economic basis of acquisition and merger which starts from an examination of the significance of differences in the productive services firms possess must pay special attention to the nature of entrepreneurial activity. After all, when I say ‘Alpha can plan a larger or more profitable expansion than Beta can plan’, I really mean to say that the entrepreneurs of Alpha believe they can do certain things that the entrepreneurs of Beta either do not believe they can do or perhaps never even thought of. Beta may be efficiently operated under existing management in the sense that Alpha would not expect to perform the managerial functions better than Beta, but at the same time Alpha may see opportunities for innovation or expansion that Beta does not see. In other words, among the productive services available to Alpha must be counted a type of entrepreneurial service not possessed by Beta. Whether the actual ability of Alpha turns out to have been overestimated is irrelevant to what Alpha attempts, but the reasons for this difference in appraisal do not all fit comfortably within the framework of an analysis based upon relatively simple psychological assumptions regarding the economic behaviour of human beings.

  Entrepreneurial Temperament and the Profit Motive

  A distinction was drawn earlier between entrepreneurial and managerial services, managerial services including the services required to operate a concern and to draw up and execute plans for expansion, and entrepreneurial services including those required for the creation or acceptance of proposals for innovation and for initiating and making decisions on proposals for expansion. The desire to create a dominant firm is a product of entrepreneurial energies and ambition. Such energies and ambition are as much productive services from the firm’s point of view as are entrepreneurial abilities which are devoted to improving and extending the efficient use of the internal resources of the firm. Both types of ability may be combined in the same man; such men are indeed hard to ‘hold down’, and much extensive merger activity can only be understood in the light of an entrepreneurial drive spurred by the vision of organizing and controlling the use of economic resources on a grand scale. For such a task the industrial corporation is only one means to the end; it has proved to be the most effective one, partly for legal reasons, but probably also because of the reduced scope for unauthorized action by the constituent parts.

  With respect to this question, I have so far done little more than note that a distinction must be made between growth which proceeds in accordance with sober calculations and comparisons of the more profitable ways of using resources, and growth which is stimulated largely by the desire of entrepreneurs to build widespread industrial ‘empires’, or to use the corporate device as a means of extending financial power. There can be little doubt that such a distinction can be found in reality. Business history, and in particular the early history of many of the large successful firms in the economy today, is dramatically punctuated by the activities of men with grandiose visions of what they wanted to do, although the less obtrusive and more sober contribution of entrepreneurs whose style was workmanlike, but perhaps lacking in excitement, is probably more important for the interpretation of the meaning of the historical record.187

  Nevertheless the explanations I have advanced with respect to the origins of entrepreneurial ideas or the limits to the expansion planned by entrepreneurs do not account fully for the direction, method, or extent of the expansion of firms in instances in which the entrepreneurs are in sear
ch of power and of a widespread area over which to exercise it—when careful economic calculations are subservient to an abnormally enterprising and expansive ‘temperament’. I have placed emphasis on considerations such as the ‘inherited’ resources of firms, the way in which new internal productive services develop, and the emergence of certain types of market opportunity, all of which are more amenable to economic analysis than is ‘temperament’. To be sure, I have assumed that entrepreneurs of successful firms are ambitious and enterprising, and that they will try to make as much profit as seems feasible—that given a choice of actions and making due allowance for uncertainty they will not choose those courses of action they think will be the less profitable.

  No doubt sociological research can and does throw some light on the environmental factors determining the kind of thing entrepreneurs consider appropriate in a given environment, on the conditions under which they will be shamelessly aggressive in search of profits, and on the influence of custom and tradition on their view of the external world and thus on the kind of productive opportunity they perceive; but economic analysis is not equipped to analyze these non-economic determinants of entrepreneurial ideas and behaviour.188 Consequently, we make the simple assumption that firms are in search of profits. This assumption has always created difficulty for many, partly because in an uncertain world there is no single objectively identifiable road to the greatest profit and different entrepreneurs with different temperaments choose different roads, and partly because money profits do not encompass the whole of entrepreneurial ambition. These two difficulties reinforce each other. For example, the entrepreneur who desires above all to build an industrial empire can at the same time insist that he has chosen the best way to make the most money; and who is to gainsay him before the event?