Theory of the Growth of the Firm

by Edith Penrose

  The explanations can, for the most part, be grouped into four general categories: (1) Some kinds of activity are unsuited to large firms, for example, those requiring quick adaptation to changing conditions, close personal attention to detail, the whims of customers, etc.; or those where small plants are required (transport costs may be high) and the supervision of many small plants uneconomic for large firms. (2) Under some circumstances large firms as a matter of public relations permit and protect the existence of small firms, sometimes under a price ‘umbrella’ held over the industry. (3) In some industries entry is very easy and many hopeful would-be businessmen set up shop every year; this leads to the existence at any time of many small firms which, however, are on their way out. (4) Finally, in the development of some industries some small firms get a start because the bigger firms have not got around to mopping them up; in time such firms will be driven out.

  Opportunities for Growth

  These general explanations, with their numerous possible variants, do account for the existence of large numbers of small firms (perhaps for the majority) and for the fact that small firms are particularly numerous in certain kinds of activity. Prospective entrepreneurs whose primary asset is a small amount of capital, and whose chief claim to entrepreneurial status is a desire to set themselves up in business, are of necessity confined to those fields where the only requirements for getting some kind of a start are a little capital and perhaps a training or skill which is widespread among the non-professional working population. 219 It is in this type of field where we find the peculiar combination of circumstances characterizing the position of firms that cannot be expected to grow—a high rate of entry, and a high rate of exodus, low profit rates and a low level of technical progress. These are not conditions that would be attractive to enterprising entrepreneurs, and only those whose abilities and resources are both extremely limited would in general be expected to enter such blind alleys—fields of activity in which opportunities for further development are most unpromising.220

  If the existence of all small firms could be accounted for by the explanations advanced, we should expect a shifting population of small firms and a steady expansion of large firms without any significant increase in the numbers of the latter. In fact, however, we find that as an economy grows the number of firms classed as ‘large’ also increases, even in an advanced economy. How does this come about if existing older and larger firms have such powerful competitive advantages over newer and smaller firms that the latter are confined to areas where they cannot grow very much? To a considerable extent the survival and growth of a small and new firm depends on superior entrepreneurial ability, and just as prospective entrepreneurs with considerable financial resources have a wider choice of possible activity than do those without capital, so prospective entrepreneurs with unusual ability, original ideas, and considerable versatility have a wider choice of activity than does the ‘average’ citizen. The more favoured entrepreneurs might be expected to search for fields where the prospects of return are reasonably commensurate with their notions of what they ought to be able to get. Since their choices are wider they would not be attracted in large numbers to fields where profit rates are low and where there is little chance for even the more able to carve out a special position for himself.

  But do such fields exist for the new and small firm? And if they do, is it only in special cases, for example where patent protection can be obtained or where the large firms, for some fortuitous reason, fail to see profitable opportunities for expansion? Or are there more fundamental forces at work?

  Let us assume that existing large firms do have a competitive advantage over small and new firms in any field they care to enter, and are under no legal or moral pressure to permit the survival of small firms. Under such extreme circumstances what would be the prospects for small firms? We have seen that even under the most favourable external conditions imaginable the rate of growth of an individual firm is limited, and that no firm can take advantage of all possible profitable opportunities for expansion. It follows from this that the fact that large firms have a competitive advantage over small firms in every type of production is not sufficient to ensure that they will actually be in a position to act on their advantage. If, therefore, the opportunities for expansion in the economy increase at a faster rate than the large firms can take advantage of them and if the large firms cannot prevent the entry of small firms, there will be scope for the continued growth in size and number of favourably endowed small firms, some of whom will themselves enter the ‘large’ category in time.

  I propose to call these opportunities for small firms the interstices in the economy. The productive opportunities of small firms are thus composed of those interstices left open by the large firms which the small firms see and believe they can take advantage of. If enough small firms judge their prospects reasonably correctly and act accordingly, then the rate of growth of the economy will exceed the rate of growth of the large firms. And if the existing small firms are unable or unwilling to fill all the interstices, there will be scope for the successful creation of new firms. Plainly, we have here a variant of the long-familiar principle of comparative advantage: given limited resources, a firm that has an advantage over others in numerous fields of activity will find its most profitable expansion in those fields where its advantage is greatest. Essentially the interstices are created because there is a limit on the rate of expansion of every firm, including the larger ones; the nature of the interstices is determined by the kind of activity in which the larger firms find their most profitable opportunities and in which they specialize, leaving other opportunities open. 221

  ‘Interstices’ in a Growing Economy

  Population growth and technological advance leading to increasing productivity, to the development of new resources and of new industries, and to shifts of consumers’ tastes and expansion of their wants are, together with the increased flow of savings and capital accumulation which accompany rising incomes, generally considered to be the most powerful forces stimulating the growth of an economy. Where demand is expanding rapidly for all sorts of products, existing firms may well find their most profitable opportunities for expansion in increasing the output of their existing products. It is under these conditions that the managerial effort required for expansion is, in general, lowest, particularly if there are economies of larger-scale production to be obtained from a more extensive use of capital. In consequence, the growth of existing firms in their existing fields may be very rapid indeed, with the largest firms growing faster than the rest in those fields where entry is most difficult because of capital requirements, patent or other protection of technology, early capture of consumers’ preferences by branding or advertising, etc.

  If growth is accompanied by the creation of important new industries and new technologies which are not in their inception under the control of the existing large firms, there will be scope for the entry of new firms, with the more favourably endowed earlier established ones soon obtaining a dominant position in the industry. In the earlier stages of rapid industrial development the interstices may be very wide and numerous simply because the established firms are so few and because many new industries are coming into being. There seems considerable evidence, however, that very quickly each of the major industries tends to become dominated by a few large firms and a high degree of concentration develops early. 222 This is partly the result of the competitive advantages of older and larger firms, partly the result of merger and acquisition, and partly the result of the power of the large firms to set up barriers against the entry of smaller competitors. For the moment I want to ignore merger and restrictions on entry and to analyse the course of events on the assumption that all growth is internal growth, for the significance of merger and restricted entry can best be appraised with reference to their impact on a situation in which they are presumed not to be present.

  As the larger firms expand, their very growth opens up new opportunities f
or investment, both because of the concomitant expansion of incomes and because of the increased demand for various kinds of producers’ goods. As technological knowledge grows and becomes increasingly diffused it will inevitably create innumerable and unpredictable opportunities for smaller firms. There is no reason to assume that these opportunities will be found only in fields where entry is extremely easy and competition so intense that profitable growth is difficult to maintain. Each of the larger firms will be guided in its expansion programmes as much by the nature of its own resources as by market demand, for every firm is, as we have seen, a more or less specialized collection of resources and cannot move with equal ease in every direction; indeed, a contraction of the sphere of activity of the larger existing firms often takes place as markets widen.

  In those industries where the growth of demand exceeds the growth of the largest firms by an amount sufficient to permit new competitors to establish plants taking advantage of the technological economies of production available to the existing occupants, several smaller firms may grow into the ‘large’ class. The ensuing struggle of the leading firms to maintain their competitive position against their compeers tends to induce innovation in the processes of production, in marketing, and in the quality and variety of products. The changing productive services created within firms together with their changing position in relation to the market for their products, is apt to induce diversification, much of which will be directly related to the actual and anticipated actions of competitors.

  The Principle of Comparative Advantage

  Let us consider now an economy where the rate of growth has been sufficiently high in relation to the rate of growth of the earlier established dominant firms to permit more than one large firm to develop in each of the major industries. We shall examine the nature and development of the interstices, starting at a point in time where the capacity to grow of the larger firms in the economy is more than sufficient to keep up with the rate of growth of opportunities in their existing fields of activity; and since we maintain the assumption that large firms have an absolute competitive advantage over small firms in all respects, direct competition from newcomers is impossible. We assume that the economy continues growing; the nature of the interstices will therefore depend on the kind of opportunities the large firms take advantage of, for it is unlikely that they can take advantage of every opportunity for investment that arises in the economy.

  The greatest advantage of the large firms over smaller ones will lie in those areas where large-scale operations are most effective, where large-scale production, marketing and research are easiest to introduce and maintain, and where managerial resources can be most effectively economized. This type of advantage is commonplace and need not be elaborated; it leads to the kind of specialization between small and large firms that was mentioned in connection with the earlier discussion of the persistence of small firms in certain types of activity, a specialization that will exist so long as the large firms continue to find opportunities for extending large-scale operations.

  In addition, once a firm has reached a point where ‘competition in innovation’ becomes necessary if it is to maintain its position vis-à-vis other large firms, the effect of this competition on the nature of its expenditures will deter the firm from entering fields where it competes with other firms not having to incur the same type of expenditure. For any given product larger firms probably do require a larger margin over direct cost for profitable operations, not because of a larger administrative overhead as is sometimes alleged, but because of the kind of oligopolistc competition in which they become engaged.223

  This kind of competition forces a firm to undertake extensive research, experimentation, market testing and similar activities the cost of which cannot easily be allocated between requirements to maintain its existing position and requirements to prepare the groundwork for further expansion. To a considerable extent the costs of such activities are properly investment costs, but they are of a hybrid variety which often cannot be separated from current costs and for this reason many of them will be classed as general overhead and allocated to current output even though they are in fact incurred largely for the preparation of future expansion. ‘Current’ costs will consequently rise as more and more of this kind of activity is demanded of the firm. In other words, more and more concealed investment, that is, the use of resources for future output, becomes written off as current costs, and the rate of profit on the net worth of the firm will be lower than it would have been if such expenditures had been treated as investment out of current profits.224 The only expenditures of this sort that one sometimes sees separated on the books of firms are those for ‘research and development’, but even here it is impossible to disentangle the expenditures that must be carried on in order to maintain the competitive position of existing product-lines from those that are exclusively for future expansion and not directly related to the maintenance of the current position of the firm.

  In these circumstances the large firms would not find it profitable to compete in the market with small firms producing the same products at low cost and willing to put them on the market at a lower price. If a given product of a large firm cannot bear its share of the research, development, and other ‘necessary’ investment expenditures, that is to say, cannot be sold at a price that will permit a substantial margin over direct costs (whether this margin be hidden in the average cost figure or treated as profit), that product will be ‘unprofitable’ for the firm, whose comparative advantage lies precisely in its ability to undertake such expenditures. At the same time the product may be very profitable for a small firm.

  The fact that a proportionately greater part of the total expenditures of large firms than of small firms is likely to be of the nature of investment expenditures, regularly written off as current costs, is a further consideration leading to a kind of specialization between large and small firms with respect to the nature of the products produced. The larger firm will be interested in those areas in which it has a substantial degree of monopolistic control over price or in those products which small firms cannot well produce (except perhaps with the consent or under the price protection of large firms), and where therefore the chief competitors are similar large firms with similar concealed investment costs.

  The rate at which large firms can take advantage of opportunities to enter new fields and produce new products will, as we saw in the analysis of the economics of diversification, be severely restricted by the continued effort and investment which are required for the maintenance of their competitive position in the ‘areas of specialization’ they choose to make their own. As they grow larger and larger, their rate of growth will tend to decline for the reasons analysed above. The decline may be very slight, with growth going on continuously and in very large jumps from time to time; but if the rate of growth of the economy remains at a high level, the proportion of the total opportunities for investment that the large firms will be able to take advantage of will fall, and the smaller firms will then find the scope for their own expansion widened in the absence of restrictions on their ability to expand into the interstices.

  The assumption we have made that large firms have a competitive advantage over small firms in any field they care to enter is not, of course, wholly valid, although if one includes monopolistic advantages arising from the power and the willingness to use unfair competitive practices of various kinds, it has considerable application. On the other hand, if there are activities in which large firms would be at a positive disadvantage because of their size, the small firms have their own peculiar place. But such activities will not, by definition, permit small firms to grow very large.

  The ability of small firms to seize on profitable opportunities in which they can grow will be destroyed if barriers are erected against their entry; their growth in the areas they can enter may be cut short by acquisition. Even if small firms have opportunities in which they can protect themselves against large firms—for e
xample, through the possession of unusual ideas or ability which cannot be imitated, or through patents on technology or on products—it will often pay them, as we have seen, to sell out to large firms who may be able to offer extremely attractive terms.

  The development and persistence of industrial concentration in a growing economy depends on the number and type of interstices created, and on the ability of small firms to enter and grow in them. The former depends largely on the nature and extent of competition among the large firms; the latter on barriers to entry and the extent of acquisition. These questions will now be explored.

  XI

  Growing Firms in a Growing Economy: The Process of Industrial Concentration and the Pattern of Dominance

  Barriers to entry. General effect on investment in the economy as a whole. The importance of ‘Big Business’ competition. Capital requirements and consumer loyalty. Artificial barriers and the interstices. Merger in a growing economy. Consolidation of many firms. Merger in relation to indices of business activity. The effect on the interstices of natural limitations on acquisition. Interstices and the business cycle. The process of industrial concentration. Measurement of concentration. Concentration and growing firms in a growing economy. Some shaky evidence. Concentration within industries. Concentration and dominance. The continued dominance of large firms. Conclusion.

  EVEN in a highly industrialized private-enterprise economy where productive activity is extensively ‘dominated’ by large firms, competition in the open market is, in principle at least, still held by large and small businessmen alike to be the most powerful force pushing the economy to higher levels of achievement, increasing efficiency in the use of resources, protecting consumers against exploitation, and ensuring reasonable opportunities for men to make the most of their abilities and assets. At the same time, the possible evils of ‘unrestrained competition’ are recognized by all, and the provision of ‘rules of the game’ is an accepted function of government.