Theory of the Growth of the Firm

by Edith Penrose

  Theory of Growth

  In undertaking an analysis of the growth of firms in the 1950s, the question I wanted to answer was whether there was something inherent in the very nature of any firm that both promoted its growth and necessarily limited its rate of growth. Clearly a definition of a firm with ‘insides’ was required—a definition more akin to that used by economists working on the structure of industry, such as Alfred Marshall or E. A. G. Robinson, and those from other disciplines treating the firm as an organization.

  The core of the theory of the growth of the firm can be very simply stated. We start with the function of the firm and from this derive the appropriate definition of the firm. The analysis was confined to industrial firms (although it may apply to other types of firm as well). The economic function of such a firm was assumed simply to be that of acquiring and organizing human and other resources in order profitably to supply goods and services to the market. It was defined, therefore, as a collection of resources bound together in an administrative framework, the boundaries of which are determined by the ‘area of administrative coordination’ and ‘authoritative communication’. If such a firm should become so large that it reached the point at which coordination became unfeasible, the definition would no longer hold and the growth of the organization would have to be analyzed differently, as we shall see. It is not clear that the theory of the growth of an industrial firm is applicable to financial holding companies or other similar groupings, but it may be.

  I was not impressed by the reasoning behind, nor the evidence to support, the assumption that the managers or directors of large corporations in the modern economy saw themselves in business largely for the benefit of shareholders. After all, in the 1950s the phenomenon of the firm run by the type of owner-managers who were not committed to the firm was not as evident as it seems to be today; it seemed to be a reasonable assumption at the time, it is now, some 40 years later, clearly inadequate. The role of financial institutions as shareholders can now be seen to require much careful analysis, as does the role of directors in their financial managerial functions who, as Lazonick (1992) has so clearly shown, may well be more interested in their own financial rake-offs through high salaries, stock options, golden handcuffs, bonuses, etc. than in the growth of their firms. This seemed not so prevalent then and I therefore elected to deal with what was called the ‘managerial firm’—a firm run by a management assumed to be committed to the long-run interests of the firm, the function of shareholders being simply to ensure the supply of equity capital. Dividends need only be sufficient to induce investment in the firm’s shares.

  Following upon the same assumption, I also assumed that managers qua managers were primarily interested in the profitable expansion of the activities of their firm. Profits were treated as a necessary condition of expansion—or growth—and growth, therefore, was a chief reason for the interest of managers in profits. Moreover, the more profits that could be retained in the firm the better, for retained earnings are a relatively cheap source of finance; management had no desire to pay out to shareholders more dividends than were necessary to keep the capital market happy.

  Assumptions such as these were an essential part of the theory of the growth of the firm as I developed it and to the extent that these are not as applicable today as they then were, which seems to be the case in a number of very large firms, at least in the Anglo-American context, a new managerial restraint on the rate of growth of firms arises.

  Following from the definition of the firm as a coherent administrative organization, I argued that managerial resources with experience within the firm are necessary for the efficient absorption of managers from outside the firm. Thus the availability of ‘inherited managers’ with such experience limits the amount of expansion that can be planned and undertaken in any period of time. Such managers, by definition, cannot be acquired from the market but are a necessary input in expansion.

  Once a substantial increment of growth is completed, however, the managerial services devoted to it become available for further expansion. There was no obvious and inevitable limit to this process and therefore the limit to its rate of growth would not necessarily limit the ultimate size of a firm. Furthermore, the growing experience of management, its knowledge of the other resources of the firm and of the potential for using them in different ways, create incentives for further expansion as the firm searches for ways of using the services of its own resources more profitably. The firm’s existing human resources provide both an inducement to expand and a limit to the rate of expansion. Even growth by acquisition and merger does not escape the constraints imposed by the necessity of using inputs from existing managerial resources to maintain the coherence of the organization. This is the essence of the so-called ‘Penrose curve’, which has been applied in a number of contexts, and even, to my surprise, to agricultural enterprises.

  External Productive Opportunities

  In the development of the theory of growth of firms the influence of the ‘environment’ was put on one side in the first instance in order to permit concentration on the internal resources of the firm. The relevant environment, that is the set of opportunities for investment and growth that its entrepreneurs and managers perceive, is different for every firm and depends on its specific collection of human and other resources. Moreover, the environment is not something ‘out there’, fixed and immutable, but can itself be manipulated by the firm to serve its own purposes.

  The relation of the firm to ‘demand’ can be illustrated if one asks the question why the growth of a firm endowed with productive resources that can be used in many ways and can be increased by the acquisition of additional resources should be confined by existing demand. I saw no reason why a firm should see its prospects of growth, its productive opportunities, in terms of its existing products only; there are many reasons why it should see them in terms of its productive resources and its knowledge and should search for opportunities of using these more efficiently. From this follows a theory of the diversification of the firm as its existing markets become less profitable or the prospects of new ones more attractive.

  The analysis of the process of diversification combined with the analysis of the costs of growth on the supply side, seems to have stood up reasonably well to the passage of time. Many of the most important extensions and modifications made by others over the past few decades owe a great deal to the superb historical discussion of the growth of major American firms by Chandler, to which I did not have access in writing my own work somewhat earlier, but which provided strong evidence, at least in the United States environment, of the applicability of the theoretical analysis while at the same time demonstrating the importance of environmental changes.

  The Cumulative Growth of Knowledge

  One of the primary assumptions of the theory of the growth of firms is that ‘history matters’; growth is essentially an evolutionary process and based on the cumulative growth of collective knowledge, in the context of a purposive firm. In recent years there has been a tremendous revival of discussion of the role of knowledge and of evolution in both applied and theoretical economics. In a magnificently argued theoretical work, Equilibrium and Evolution: An exploration of connecting principles in economics, Brian Loasby (1991) discusses my theory of the growth of the firm (Ch. 4) in relation to the role of knowledge and describes the administrative structure of the firm as providing an equilibrium structure of theory and policy within which individual knowledge can evolve without threatening organisational coherence; but that equilibrium itself is the consequence of an evolutionary process during which managers learn to operate effectively together with in a particular environment. It is the evolutionary process which generates the growth of managerial services—or reduction in governance costs—which is so important to her analysis, and also shapes the content and scope of those services. (p. 61)

  Thus he seems to see the growth of knowledge within a framework which consists of a managerial administrativ
e ‘theory and policy’ acting as a sort of research programme, itself representing a kind of temporary evolutionary equilibrium of the firm having little to do with any equilibrium of the economy as a whole. In this respect he borrows from Frank Hahn’s definition of equilibrium noting (pp. 13–14) that:

  It may help us to judge the problems and possibilities if we make use of Frank Hahn’s proposal to shift the focus of equilibrium from prices and quantities to ideas and actions. It will not attempt to present Hahn’s arguments or his supporting definitions, but come straight to his proposition that ‘an economy is in equilibrium when it generates messages which do not cause agents to change the theories which they hold or the policies which they pursue’ (Hahn 1973; 1984, p. 59).

  If this analysis is carried further it raises the importance of appropriate government macro-economic policy since in practical terms we look at economic equilibrium not as a question of an impossible, and probably in a real sense, undesirable, neoclassical equilibrium, but merely as a reasonable stability.

  This is in part reminiscent of Schumpeter (1942) without his dramatic language and rushes of revolutionary creativity. His ‘creative destruction’ and ‘perennial gales’ are the result of a process that ‘incessantly revolutionises the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism…’ (p. 83) To this he adds a footnote which states that the ‘revolutions’ are not really incessant but occur in ‘discrete rushes’. This modification makes ‘creative destruction’ relevant to his analysis of business cycles. In his The New Competition (1990), Michael Best sees Schumpeter as dealing essentially with a capitalism in which the large firms are the engine of creative destruction—entrepreneurs with ‘the big idea’—contrasting this with the results produced by the collective interaction of a ‘Penrosian learning culture’. By applying Schumpeter’s process to successful firms generally Best brings in the concept of the strategic behaviour of firms as a means of ‘institutionalizing Schumpeterian organizational innovation’. In discussing Japanese firms he argues, for example, ‘that the successful Japanese firm has combined Schumpeter and Penrose, and thereby altered the notion of entrepreneurship from “big ideas by individuals” to a social process of learning within which individual contributions can come from the bottom up, as well as from specialist staff.’ (p. 138)

  Multinational Corporations

  Finally, a few words about the expansion of firms outside their national boundaries. Interest in the international growth of firms—once called foreign firms, then international firms, multinational corporations or enterprises, transnational corporations and now apparently referred to as global firms—has grown by leaps and bounds since the 1950s. Among the early articles devoted explicitly to this subject is my ‘Foreign Investment and the Growth of the Firm’ published in 1956 in the Economic Journal and reprinted in The Growth of Firms, Middle East Oil and Other Essays (Penrose 1971); all of my work on the international oil industry, primarily The Large International Firm in Developing Countries (1968), is a study of the large international firms in that industry and their impact on the world economy as well as on the economies in which they operate.

  The literature on the subject of multinational firms has burgeoned since the middle of the century, in line with the spread of such enterprises themselves in their several manifestations. Much of the analysis of the growth of firms as I have presented it seems by and large to apply equally well to expansion by direct foreign investment in its modern form—the processes of growth, the role of learning, the theory of expansion based on internal human and other resources, the role of administration, the diversification of production, the role of merger and acquisition are all relevant.

  There are, of course, substantial differences among countries, but if we assume that certain factors of production are not only highly mobile but tend to move in packages containing different proportions and types of capital, managerial services, technology, etc. bound together within the integrated framework of a firm, it is easy to envisage a process of expansion of international firms within the theoretical framework of the growth of firms as outlined in this book. It is only necessary to make some subsidiary ‘empirical’ assumptions to analyze the kind of opportunities for the profitable operations of foreign firms that are not available to firms confining their activities to one country as well as some of the special obstacles. Many, if not most, of these assumptions would apply equally to domestic firms expanding within the United States or other large and diverse countries and even some smaller ones. But with the advent of the very large global corporations of ‘firms’ there spread what became effectively an extremely sophisticated, though not entirely new, form of organization requiring a different analysis of the nature of the firm and the relation between the firm and the market.

  The Problem of Limits

  I have considered above the nature of the boundaries of the firm and have defined them in terms of the firm’s managerial and administrative activities; if defined in this way, the firm is a unit of planning and as it grows its boundaries expand as do its administrative responsibilities. That a firm has boundaries follows from the nature of the categories we think in, however, not because we can clearly ‘observe’ them in reality. The boundary of the firm is what distinguishes it from the market and therefore must ‘exist’, whether or not it is ‘real’ since the firm/market dichotomy has been perhaps the major building block of an economist’s analytical thinking.

  In an extremely perceptive and prescient article, G. B. Richardson as early as 1972 has shown how very inadequate is this foundation for the analysis of economic organization. He challenges the whole notion of a firm/market dichotomy, pointing out that there are three means of coordination: direction, co-operation, and market co-ordination and that interfirm networking blurs the boundaries of firms; that the firm in reality is not an island in a sea of market transactions, but itself part of a network consisting of rivals in direct competition, of suppliers of goods and services in special relationship as well as of consumers, be they individuals, organizations, other firms or even governments also in special relationship generally, or for specified purposes. He gives an excellent account of the possibilities and rhetorically asks ‘. . . how are we to distinguish between co-operation on the one hand and market transactions on the other?’ (p. 886).

  An argument can be made that when a firm is first organized it has advantages over market organization because transaction costs are less in the organized context on a relatively small scale. The reverse may tend to develop over time as scale increases, dissimilarities develop in the types of activity engaged in and expand so that higher transaction costs may induce a fundamental transformation in the nature of the very largest firms as we know them. If so, how will this come about? The innovation process, growth of knowledge and pressures from ambitious businessmen are cumulative and will continue, but with what result?

  It follows from the argument developed in The Theory of the Growth of the Firm that a firm’s rate of growth is limited by the growth of knowledge within it, but a firm’s size by the extent to which administrative effectiveness can continue to reach its expanding boundaries. Because the firm is not treated as an organization in neoclassical economic theory, the limit to the size of firm could only be found in the last analysis in an upward sloping cost curve or a downward sloping demand curve for existing products. If demand is not found to be necessarily restrictive of growth in view of the possibility of expansion through continuous diversification, the former remains as the only limit to size. Again, in order to focus on the internal dynamics of the firm, I assumed constant returns to scale and scope, implying that any size of firm is as efficient as any other size. In this respect I argued then, without developing the supporting evidence, that as firms grew larger they apparently did not necessarily become less efficient (at least at the time of writing there was no indication of this).
With increasing size both the managerial function and the basic administrative structure of firms seemed to undergo an administrative reorganization to enable them to deal with the increasing growth.

  In this respect, studies of administrative structure and managerial operations have especial relevance and the work of Williamson (1971) has received particular attention. Among other things he described the evolution and growth of the multi-divisional or ‘M-form’ of organization, in which strategic decisions were concentrated in a general office at the top of a large enterprise, served by an ‘elite’ staff whose function was to examine strategic options and exercise a general supervision over operating subsidiaries (called ‘quasi firms’). His analysis rested on the appraisal of transaction costs and he demonstrated the way in which firms could expand their managerial capacity and the type of organization required to effect it.

  Another approach has been recently advanced centering on the ‘culture’ of a firm to bind together the self-interest of the members of the firm’s community, from workers to top management. This is put forward as a relatively non-hierarchical form of administrative organization which is referred to as ‘the new organizational context’. With a philosophical approach very different from opportunism, much emphasis is placed on the possibilities of enhancing trust and co-operation in the administration of the firm as an alternative to contractual ways of guarding against opportunism. It draws heavily on sociology and organization theory, and on the role of confidence building and responsibility in the social philosophy of the firm. Many, if not most large firms develop a strong social and psychological culture on which heavy reliance is placed for effective internal management. This alternative approach sees an imaginative development of mutual trust, commitment and shared responsibility as a more effective instrument than financial control or even contracts as a means of ensuring that the managers of the firm sing in tune.