Theory of the Growth of the Firm

by Edith Penrose

  Thus, as we have seen before, there are necessary limits to the rate of growth of a firm through merger as well as to the rate of growth through internal expansion, in both cases the ultimate limits being set by managerial capacity. The difference is in the shape and position of the growth curves, so to speak. In principle internal growth must be either a reasonably smooth curve or a step-like curve in which each step bears a close relation to the base from which it rises. Growth through acquisition, on the other hand, can proceed in very large steps relative to the base, but the ‘plateaus’ after periods of extensive expansion will tend to be longer.200 If, however, we accept the view that in both cases growth can continue indefinitely, although perhaps, after a point, at a slower rate as external resistance to expansion in a given line encourages diversification (where internal obstacles are greater), what significance should be given to acquisition and merger as a ‘cause’ of established and continued dominance and of high industrial concentration?

  Merger and the Dominant Firm

  An analysis of the relationship between merger, the emergence and persistence of dominant firms, and the level of industrial concentration involves three different, though related, problems: (1) the role of acquisition in the process of growth and its contribution to the size of individual firms at any given time; (2) the significance of merger for the relative sizes (size distribution) of firms at any given time; and (3) the importance of merger as a means of maintaining a dominant position once acquired. The preceding analysis is directly concerned only with the first of these three problems.

  Empirical analysis will never be able to tell us the quantitative contribution of merger to the growth and size of firms. Even if one could measure accurately the exact proportion of total assets that a given firm had acquired by merger, the effect of the acquisitions on the present size of the firm must remain unknown. Not only does a firm inherit the potentialities for growth of the firms it acquires, but a merger tends also to leave pools of unused productive services available to the combined firm which would not have been available in the independent firms. These provide a basis for a further growth much of which might not have been possible for either firm before the merger. A particularly important source of such unused services is often found in the personnel who had to be taken over with the acquired firm but who could be efficiently used only in an expanded programme of operations. Furthermore, since external expansion draws on the existing productive services of the acquiring firm, the more extensive the external expansion in any given period of time the less can existing resources be used for internal expansion in the same period. Since an attempt to measure the effect of acquisition must relate to a particular period, one cannot assume that the growth of a particular firm in that period would have been reduced by an amount equal to the amount of acquisition.

  Nevertheless, it follows from the comparison of the processes of internal and external growth that, except under special circumstances, a greater rate of expansion is made possible by merger. Hence so long as merger is a feasible and profitable method of expansion, we can safely assume that firms that have grown by merger will in general be larger than they otherwise would have been. Were merger prohibited, the size and scope of operations of the larger firms in the economy would almost certainly be less than they are to-day. There is, however, no conclusive reason for thinking that to-morrow they would not reach the position through internal growth that they have obtained today with the help of merger. The mere fact that a given firm chose the merger path does not mean that this was the only path open to it and leading to the same goal; but it is reasonable to presume that it was the shortest path.

  The other two aspects of the relation between merger and dominance are concerned not with the growth processes of individual firms but with the relative position of firms in relation to the structure of the economy as a whole. The emphasis in this study so far has been on the individual firm; in the next three chapters we take up some aspects of the growth of firms as it relates to the economy as a whole. This involves us first in an examination of the factors that determine the relative rates of growth of different firms.

  IX

  The Rate of Growth of a Firm Through Time

  Special assumptions. Measurability. The fundamental ratio. Managerial services available for expansion. Increase in the administrative task with growth. Impact of changing environmental conditions. Managerial services required for expansion. Character of expansion. Relation to existing activities and market conditions. Method of expansion. Changes in the rate of growth with increasing size. The ‘growth curve’.

  WE are now in a position to examine the relation between the analysis so far developed and the purpose of studying the growth of firms as set forth in the opening pages of this book. The growth and size of firms is of significance for the economy as a whole largely because the organization of production within the administrative framework of the individual firm is substantially different from the organization of production brought about through the operations of the open market.201

  Markets and firms are interacting institutions, each being necessary to the existence of the other. The function of both is ‘resource allocation’—the portioning out of the resources of the economy among the various demands on them for production or consumption. But the way in which this function is fulfilled and the pattern of resource allocation in space and time depends very much upon the way in which market forces impinge on the firm, and this in turn depends not only upon the size of an individual firm’s supply of (or demand for) a given product in relation to the total supply of (or demand for) that product in the market, but also on the kinds and amounts of productive services with which the firm is already operating. Most of the discussion so far has been directed to the latter point and we have paid but passing attention to the way in which the process of growth of individual firms and the movement through time of the economy as a whole affect the relative position of different firms vis-á-vis ‘the market’.

  In particular, does the proposition that there is a tendency, ceteris paribus, for individual firms possessing appropriate managerial services to expand continuously and without practical limits, imply the further proposition that older and larger firms will tend to absorb ever larger proportions of an economy’s resources? Much of the significance of the first proposition for the working of the economy depends upon the answer to the second. If, in all stages of industrial development, each individual firm grew at much the same rate on the average as industry as a whole, thus leaving the relative position of all firms largely unchanged, many of the problems of economic policy which exercise the talents of economists today would not have arisen.

  In this chapter we shall examine the factors causing changes in the rate of growth of firms as they get larger and larger. The chief purpose of this and the following chapter is to lay the foundation for the subsequent discussion in Chapter XI of the significance of our analysis of the growth of firms for some aspects of the performance and structure of the economy as a whole.

  Special Assumptions

  The analysis of any general economic problem in which labour and real capital are important components suffers severely from the inability of economists (thus far at least) to invent a method of taking adequate account of the essential and significant heterogeneity of each of these factors of production while at the same time preserving a manageable analytical framework. Extreme simplification of concepts may be justified for carefully specified purposes, but it may also lead to an analysis which conceals more than it reveals of the essential characteristics of those aspects of the world that it is designed to explain; insufficient simplification, on the other hand, will prevent the development of any general analysis at all. To consider capital or labour as homogeneous factors is a severe abstraction which, nevertheless, has its uses for certain purposes; such concepts, for example, as the capitallabour ratio or the capital-output ratio are valuable tools of analysis in a rough-and-ready sort of way. I shal
l make use of a similar simplification and with a similar justification—that of enabling us to isolate and understand certain relationships fundamental for our problem.

  Measurability

  We shall be concerned with the productive services available to firms and the productive services required for expansion, specifically, unless otherwise stated, with entrepreneurial and managerial services. I have stressed over and over again that one of the most significant characteristics of such services is their heterogeneity, their uniqueness for every individual firm. The productive services that the entrepreneurs and managers of any given firm are capable of rendering to that firm are not reducible to any common denominator and are therefore incapable of quantitative treatment.202 Yet, for the present analysis I shall assume for expository purposes that such services can be measured in comparable units, that qualitative differences can in some manner be expressed as quantitative differences, for I think that the relationships we will discover exist regardless of the statistical impossibility of accurately measuring them.

  We are also concerned with increments to the size of firms—with amounts of expansion. Again, even apart from the practical accounting difficulties, there is no way of measuring an amount of expansion, or even the size of a firm, that is not open to serious conceptual objections.203 Monetary measures of the capital investment involved cannot easily make allowance for differences in relative prices, for differences in the proportions of the various factors of production employed, or for technological differences which affect the capital-output ratio. Similarly, physical measures, for example workers employed, are distorted by differences in the proportion of factors used—an expansion involving a high proportion of machinery to workers would be underestimated relative to an expansion with a significantly lower proportion of machinery if workers employed were taken as the measure of the expansion. Total sales do not take sufficient account of the degree of integration, and ‘value added’ is an income concept and not an asset or ‘size’ concept. These are all familiar and serious difficulties, but each measure has its own special significance. Nevertheless, for the purpose of this chapter I shall ignore these difficulties and assume that expansion can reasonably be measured in constant monetary units of investment.

  The following analysis will proceed with reference to the entrepreneurial and managerial services available and required per dollar of expansion; of these, managerial services are in some ways the most important for the analysis, and to avoid the repetition of a long phrase I shall speak of managerial services’ to include both unless I indicate otherwise.

  The Fundamental Ratio

  Of the managerial services available to a firm, some will be required for current operations; the amount required will depend on the size of the firm and on external conditions. The rest will be available for use in an expansion programme; but the same amount of expansion may require different amounts of these services in different circumstances. Under given circumstances, therefore, the maximum amount of expansion will be determined by the relevant managerial services available for expansion in relation to the amount of these services required per dollar of expansion. The factors determining the availability of managerial services and the need for them in expansion will therefore determine the maximum rate of growth of the firm, where rate of growth is defined as the percentage rate at which the size of the firm increases per unit of time.

  The larger the firm, the larger must be the absolute amount of expansion if any given rate of growth is to be maintained as the size of the firm increases. In Chapter IV it was shown how the productive services available to a firm increase as the firm grows. If we assume that a firm is fully using its capacity to grow, the maintenance of any given rate of growth over time requires that the supply of the managerial services available for expansion increase at a rate at least equal to the rate at which the managerial services required per dollar of expansion increase; an increased rate of growth can be achieved only if the former are increasing at a rate greater than the latter; a reduced rate of growth must follow if the relevant services become available for expansion at a slower rate than the requirement for those services per dollar of expansion is increasing.

  For the purpose of examining the factors affecting the rate of growth of a firm as it grows larger we shall assume a simplified stylized model of a growing firm. By implication, therefore, our firm when it starts out must have a special productive opportunity which it can exploit and which enables it to establish a solid foundation from which further growth takes place; it neither finds itself in a position where it prefers to sell out, nor runs into competitive conditions which preclude further growth. Such a firm may not be characteristic or ‘typical’ of firms in general; on the other hand, it is schematically characteristic of some; there do exist firms that have started out on a moderate scale and have grown into the large-firm class. Although for expository purposes I shall describe a firm that is very small in the beginning, the analysis is applicable regardless of the size at which the firm begins. A firm starting out fairly large as the result of a merger, or for any other reason, merely enters our picture in the middle, so to speak, and, with minor changes, the analysis will be equally applicable to it.

  We have set out the hypothesis that the factors determining the rate of growth of firms can usefully be analyzed with reference to the ratio between the managerial services available for expansion and the managerial services required per dollar of expansion. We shall now enquire if any change in this ratio can reasonably be expected to take place as a firm grows. Of the relevant managerial services, those of particular interest for this analysis are the unique services that can be rendered by personnel already experienced in the firm. The following section deals with changes in the managerial services available for expansion, by far the most speculative aspect of the problem and the one about which least can confidently be said.

  Managerial Services Available for Expansion

  The services available for expansion are the difference between the total services available to the firm and those required to operate it at the level of activity appropriate to its existing circumstances. From the analysis in Chapter IV of the growth of managerial services in a growing firm, we may conclude that the total supply of managerial services will in general be growing at a rate somewhat faster than that of the firm. The fact that as a firm grows it gains new personnel, it adopts techniques for using personnel more efficiently, and at the same time its existing personnel gain new experience, means that the firm continually gains additional managerial services. It has been demonstrated that both the processes of normal operations and the process of growth create new services which can be fully used only in expansion, if at all. Except in the unlikely case where the total services needed to operate a firm declines as it grows larger, the capacity of the firm to grows depends upon a rate of growth of total services which is larger than the rate of growth of the firm, although there may at times be lags of considerable proportions.204

  Of this growing total of managerial services, the amount required to operate the firm will be affected by changes in the nature and size of the administrative task as the firm grows larger and by changes in environmental conditions that the growth of the firm may itself bring about.

  Increase in the Administrative Task with Growth

  In the larger firm, there will be a greater number of administrative tasks, a larger number of different activities, and a larger number of people whose activities must be co-ordinated. Presumably, therefore, a larger supply of managerial services will be required for the larger job. Yet, of the total services available, the proportion absorbed by the administrative task need not rise for two reasons.

  First, there is greater scope in the large firm for an increased division of managerial labour, making possible the more efficient use of the services available, as well as greater scope for the use of equipment which saves managerial time and reduces the input of managerial services relative to the size of the task to be
accomplished.

  Second, the administrative task need not always grow proportionately to the growth of the firm, particularly when the larger firm employs more capital-using methods of production. The use of machinery and large-scale mechanized plants results in a substitution of capital for labour in the productive processes. In these circumstances the managerial task is not likely to be increased proportionately; with everything else equal, the co-ordination of productive activities is in general a simpler process when large machines instead of many people do the work. The saving of managerial effort in this direction may, of course, be more than offset by an increase in the marketing and other managerial functions required to deal with the larger-scale of output, but it need not be so offset under all conditions.205

  On the other hand, it seems reasonable to deduce from the mere fact that organization and co-ordination become such a central topic of discussion and concern for the larger firms that such a stage of increasing returns, if it exists, does not last very long; and that after a point the firm has constantly to be alert to prevent a strong rise in the proportion of managerial services required to conduct current operations efficiently. There seems no evidence that the problems of administration become progressively easier as a firm grows bigger and bigger. From this, however, we cannot conclude that the ratio between total available services and those required for operating purposes must rise at some point. For equally, there is no convincing evidence that firms using the best administrative techniques have found that they must devote an increasing proportion of their total managerial services to current operations merely because the administrative task has become more complex.206