Theory of the Growth of the Firm

by Edith Penrose

  In an analysis of the expansion of the individual firm the profit-seeking assumption is useful so long as it is possible to set forth in reasonably objective economic terms the considerations that will determine the probability that certain specified directions of expansion will be more profitable than others. But as soon as such factors as the ‘temperament’ of the entrepreneur—the strictly personal characteristics affecting his judgment—are admitted into the picture it makes little difference whether we assume that he is in search of profits or has a multiplicity of motives for action; in both cases economics must give way to psychology.189 All we can do is to note that there are apparently far-reaching differences in entrepreneurial ambitions and to enquire into their significance for the process of growth of firms.

  In a purely formal sense it seems more satisfactory in the framework of this study to treat abnormally expansive behaviour as a personal interpretation of the ‘best’ way to make money rather than to try to substitute for the profit motive a striving for power, prestige, or the mere enjoyment of the game. After all, even though many such entrepreneurs may set little store on the increase of an already adequate personal income and may frankly be in business for the fun, influence, or prestige obtained from it, profits remain the condition of survival, a social (as well as an economic) test of success and of influence, and a means to even more extensive accomplishments. 190 To the extent that entrepreneurs believe this to be true they are unlikely to pursue those courses of action which they think will be less profitable than others, and the assumption is a plausible one, although it is untestable and affords no basis for prediction.

  Empire-Building and Merger

  In any event, I want now to consider the effect of ‘abnormally’ expansive behaviour on the growth of firms, a behaviour which I shall loosely characterize as ‘empire-building’ behaviour. Since we are interested in the growth of industrial firms, we shall consider only that type of empire-building which is ostensibly the expansion of a non-financial corporate firm. Men who acquire sufficient stock in numerous corporations to obtain control or to get themselves elected to the boards of directors may be building personal financial empires for themselves, but they can hardly be considered as growing ‘firms’ in our sense; corporations set up by one or more financiers operating to obtain control of other corporations may be nothing but financial holding companies created largely for the purpose of ‘milking’ a diverse group of businesses, and should be treated as such. On the other hand, where the facts suggest that empire building activity is motivated largely by the desire to obtain monopoly or to create an extensive and powerful firm, it comes within our purview even though the corporate structure may be largely that of a holding company with operating subsidiaries and could not, in the early stages at least, be properly considered an industrial firm.

  In a sense there are two types of empire-building activity here which have different results from the point of view of the economy as a whole. An aggressive entrepreneur may reach for monopoly profits through the establishment of a near-monopoly in a particular market by extensive acquisition of existing firms, or he may be interested in creating a large and powerful firm the success of which does not depend upon the destruction of competition in particular markets but on profits derived from operations in many markets. There may be little connection between either the production or the distribution facilities of the acquiring and acquired firms, especially if the acquiring firm does not intend to change the management of the firms it acquires. Growth of this sort is characteristic of non-operating companies who do not seek monopoly profits particularly (except in so far as the individual firms acquired have monopolies) but who find widespread direct investment a profitable use of funds and of a particular type of venturesome entrepreneurial ability. Such firms grow in response to incentives and require services which are similar to those of investment firms and certain other types of financial institutions. Hence probably most of them are outside the scope of this study, but some of them succeed in establishing extensive, diversified, but adequately controlled industrial empires operating within a co-ordinated administrative framework. Moreover, firms may at different times emphasize one type of empire-building activity or the other and may finally emerge as a cross between the two ‘types’, possessing both strong monopolistic positions and extensive diversification. 191

  From the point of view of the process of growth, the significance of industrial empire-building is greatest for two problems: the role of acquisition and merger, and the nature of the administrative organization of the rapidly growing firm. The reason for this special significance is found in the speed with which growth by merger can proceed. It should be clear from the analysis of earlier chapters that neither extensive acquisition of existing firms, nor entrepreneurs bent on achieving monopoly and dominance are necessary for the explanation of the emergence of large and dominant firms. Even in the absence of much acquisition the more favourably endowed firms possessing the more able and enterprising managers and entrepreneurs can, in time, be expected to grow very large. Furthermore, the well-established and moderately large firms in an economy which are able to maintain their managerial and entrepreneurial competence through successive generations of men have a decided advantage over very young and new firms, and may for long periods grow at a relatively faster rate, thus obtaining dominant positions in the economy without having had any specific policy of so doing. 192

  Nevertheless, internal expansion takes more time than does external expansion, and any entrepreneur who is ambitious to create an extensive firm in his own lifetime will find his opportunity to do so in the acquisition of already existing firms. Hence, in addition to the fact that acquisition may in particular circumstances be the most efficient way for a given firm to expand, it is also the way for the entrepreneur with extensive ambition to achieve impressive results in a relatively short space of time. In other words, if ‘empire-building’ entrepreneurs ‘in a hurry’193 are active in the business world, we may expect the history of the firms with which they are connected to show an abnormally large incidence of merger and acquisition.

  There is no need here to recapitulate the various methods by which the aggressive entrepreneur can, through extensive acquisition, establish a dominant firm or even a ‘monopoly’ in a short time. The details are limited only by the law or, more accurately perhaps, by the extent to which it is deemed practicable to evade the law, and by the scruples and imagination of the entrepreneur. The oft-told histories of the formation of the great ‘trusts’ around the turn of this century in the United States are outstanding examples of the process. It can hardly be questioned that the purpose of these mergers was to obtain strong monopolistic market control. To be sure, some of the participants at least were undoubtedly firmly convinced that such action was consistent with, or indeed even necessary for, a sound economic organization of productive resources. Whether it was or not is another question; the point at issue is that merger was the method chosen and was clearly the only method of achieving the result in a short space of time—in particular, within the lifetime of the men behind the movement.

  To be successful in the sense that the firms sought are actually acquired, an acquisition programme need not involve any serious attempt to integrate the operations of the acquired firms with the operations of the acquiring firm; the result is that many combines in their formative stage hardly fit the definition of a firm set forth in this study. The immediate purpose—the concentration of legal control under one ownership of a very large amount of productive assets—may be accomplished without any of the important characteristics or economic functions of the single firm, as distinct from cartels and pooling arrangements, attaching to the combine. It is for this reason that entrepreneurial services alone are sufficient for an acquisition programme. They are not sufficient for the ultimate successful establishment of a firm, but they are sufficient for the expansion process itself.

  Herein lies one of the really significant differen
ces between internal and external growth. Not only can external difficulties of expansion (costs of and barriers to entry, competitors’ advantages, etc.) be reduced by merger, but internal difficulties as well—at least for an initial period. Successful acquisition of another firm may require no more than financial ability, bargaining skill, aggressive initiative, and a sense of strategy. Such are the entrepreneurial qualities required for an effective programme of acquisition aimed at achieving ‘monopoly’ or at building up a ‘dominant firm’. This stands in sharp contrast to the requirements of a programme of internal expansion where managerial planning and execution cannot be avoided in the very process of expansion and other internal bases for expansion are also usually necessary.

  Thus the significance of entrepreneurial ‘empire-building’ does not lie only in its contribution to the creation of large and dominant firms whose history is inevitably marked by extensive acquisition. It lies also in the way in which entrepreneurs using the industrial corporation as a means of extending their power and the scope of their operations, and relying largely on their financial acumen and their skill or ruthlessness in negotiating with suppliers, customers, or competitors, resolve one of the most important conflicts facing firms with extensive opportunities for growth—the conflict between speed of expansion and the maintenance of efficient managerial co-ordination. The ‘empire-builder’ tends to sacrifice co-ordination and consolidation to the pace of expansion. It is this that brings his activities closer to those of the ‘financier’ than to those of the ‘industrialist’ and that creates special difficulties for the unambiguous definition of an industrial firm.

  Role of Managerial Services

  For the purposes of this study it was necessary to distinguish the industrial firm from financial power groups, combines and holding companies, cartels, pools, and similar loose but in certain respects powerfully centralized, groups. In doing so we examined the function of industrial firms and concluded that the organized administration of productive activities was the distinguishing function of an industrial firm and the chief reason for analyzing it as an economic entity. Hence some standards of co-ordinated administration must be met before we are justified in treating a given collection of economic activities as an industrial firm. The mere fact that ownership or financial control has become centralized is not enough.

  Some of the conceptual and practical difficulties involved in identifying the boundaries of a firm were discussed in Chapter II. One of these difficulties arises from the fact that an industrial empire built up by acquisition and merger, and carried out with little regard for administrative organization is not an industrial firm in our sense until a certain minimum of integration has been achieved. Furthermore, as an industrial firm grows it may reach a point where it has become so large, the decentralization of its activities so great, and the independence of some of its parts so complete, that we must at once seriously question whether the whole should be treated as a single firm. Thus we may be in the anomalous position of treating a particular ‘firm’ as properly a firm in the economic sense only in the middle of its life—in the beginning it may have been only an amorphous combine, and in the later part of its life it may again become a somewhat shapeless organization receiving payments and disbursing funds to numerous virtually independent operating organizations but hardly fulfilling any administrative function as an industrial firm.194 Strange as it may seem, however, this may be a useful way of looking at the matter, especially from the point of view of public policy towards acquisition and size.

  The Necessity of Administrative Integration

  A combine that is formed in one year only to crash in the next year or two cannot be considered to have been successfully established. The question how long a firm must survive and how extensive must be the co-ordination of its administration before it is successfully established is subject to no precise answer. In general, if the disorganization accompanying very rapid growth has been eliminated, and the firm is operating as a profitable well-organized institution whose securities are no longer looked upon as highly speculative in the long run by conservative investors, it is reasonable to conclude that it has been successfully established. Similarly, if an already established firm embarks on an extensive programme of acquisition it may pass through a stage of extreme disorganization, but so long as serious attempts at managerial coordination are being made, the process is properly considered an expansion of the firm rather than merely an increase in its investment portfolio.

  It follows, as we noted in the previous chapter, that much more than entrepreneurial and financial services are required for the successful establishment or expansion of a firm through acquisition. After, or accompanying, the initial entrepreneurial ventures, there is still the managerial task of organization to be completed. 195 If adequate management is lacking and cannot be obtained through reorganization or otherwise, the firm will break up, through bankruptcy or sale, disintegrating into its constituent parts. Hence if the ruling spirits of the firm do not possess the required managerial talents or have not the ability (including the good sense) to place others who do in responsible managerial positions, they will have to be displaced if the firm is to become solidly established as more than a financial holding company.196 Clearly a firm created largely through consolidation or extensive acquisition may fail disastrously from the point of view of its promoters and its backers, yet still emerge as a successfully established industrial firm in the sense that it remains relatively intact as an industrial organization. It may earn relatively low profits or perhaps go through an extensive reorganization, but neither of these conditions necessarily prevents the firm from remaining large nor necessarily precludes a successful future.

  The ‘success or failure of industrial mergers’ has often been analysed in the light of several different criteria of success. From our point of view a merger is ‘successful’ if it creates a larger industrial organization than before and one that survives and provides a basis for future growth. But even on this criterion there have been many failures. Apart from initial entrepreneurial misjudgment regarding the possibilities of achieving particular ends in a given environment (for example, a failure to appraise correctly the basic possibilities of obtaining a monopoly where the success of the merger is known to depend upon the achievement of monopoly market control), it seems clear that financial mismanagement, financial ineptitude, administrative incompetence, or administrative inability to handle the organization problems have been the most important factors in these failures.197 And so it has often happened that a combine, promoted from within or without, survived only after a managerial reorganization which forced a breathing spell or after the administration of artificial respiration through financial reorganization, often under the aegis of bankers.198

  Financial problems can, of course, bring an empire-building expansion programme to grief long before it runs into problems of administrative organization. But once the stage is reached where managerial problems become important it is difficult, if not impossible, to separate financial from managerial failures: the success of operations affects the financial status of the company and the financial status affects operations. Recognizing that the managerial problem can be mitigated if acquisitions are confined to already well-managed companies, firms that cannot afford a drain on their own managerial resources often require that the firms they take over have a high standard of existing management. Though reduced, the managerial problem is by no means eliminated in such cases, for, as we have shown above, the integration of the acquiring and acquired firms still needs to be effected.

  One type of expansion, however, which sometimes escapes the need for administrative co-ordination is expansion through the acquisition of subsidiaries in foreign countries. In the first instance the managerial resources of the parent firm are almost inevitably required, since it is only through the knowledge of existing management transplanted abroad that the firm can make use of the type of productive services from which its own peculiar c
ompetitive advantages are derived. But once established, the new subsidiary can, and sometimes does, operate virtually independently of the parent. Technical services may be drawn on, but if the market of the subsidiary is unconnected with the market of its parent, there may be little scope for, or purpose in, an attempt to co-ordinate the activities of the two firms or even to establish a close financial control. Such subsidiaries may occasionally be permitted to grow using their own retained earnings and to make their own managerial decisions. Except for the technical services required by the subsidiary, and for the payments required by the parent as dividends or for services rendered, there may be little relation between the two firms. These two exceptions are indeed important. The value to the receiving foreign country of the direct investment represented by the new subsidiary may depend almost entirely on the former, while the country may show considerable resentment against the latter. But neither of these relationships is sufficient to bring the parent and its subsidiary within the definition of an industrial firm that we have adopted. In some cases, though probably not in most, expansion that involves the acquisition of foreign subsidiaries should be treated as an expansion of economic influence or simply as an investment akin to other investments in financial assets.199