Theory of the Growth of the Firm

by Edith Penrose

  150 Firms producing products the demand for which has been growing rapidly may be faced with difficulties in obtaining semi-manufactured items needed in their production process because of lags in the development of the supplying industries. This may be particularly important for mass-production firms in a relatively new industry which require large supplies of fairly specialized products, and is one of the reasons for some of the integration of the faster growing firms in the less industrialized countries. Or uneven growth at different levels of an industry may result from differences in technological developments and rates of investment. McLean and Haigh in their intensive study of integration in the oil industry, discovered that integration patterns were affected by the unequal growth of different sectors in the industry; for example differential technological developments between crude oil field and refinery, between refinery and marketing, and between wholesale and retail operations: ‘Technological developments often prompted alterations in integration patterns. . . the most dramatic example may be found in the technological development of the products pipe line’ after which a ‘broad movement toward integration into products transportation activities was launched’. See John G. McLean and Robert W. Haigh, The Growth of Integrated Oil Companies (Boston: Harvard, 1954), p. 513.

  151 In periods when supplies are exceptionally scarce relative to demand, individual firms are often unable to obtain all of their requirements without delay from their customary suppliers and they find that other suppliers are reluctant to disappoint their own regular customers for the sake of an occasional stranger. The importance attached by firms to the maintenance of their existing business relationships tends to modify their willingness to let prices be the sole, or even the primary, guide in their selection of customers, especially when periods of high prices are only temporary.

  152 McLean and Haigh found that ‘In nearly all cases, the shifts in the prime field of managerial competence were accompanied sooner or later by corresponding shifts in a company’s integration pattern.’ Op. cit., p. 512.

  153 Cf. the following appraisal of this aspect of integration in the oil industry: ‘It appears therefore that the managerial and operating gains permitted by vertical integration were rarely an important motivation for integration and were generally unanticipated at the time the moves were made. Ultimately, however, these gains may transcend in importance the specific forces and circumstances which have thus far prompted integration decisions.. . . The managerial and operating gains realized from vertical integration. .. have grown steadily in importance throughout the entire history of the industry, and there is considerable reason to believe that their full potentialities have by no means yet been realized.’ John G. McLean and Robert W. Haigh, op. cit., p. 302.

  154 The T.N.E.C. investigation of the product structure of 50 large manufacturing companies found that the ‘major portion of their total revenue tended in most cases to be derived from relatively few products’. Monograph No. 27, op. cit., p. 629. But for reasons pointed out above little can be concluded from the T.N.E.C. study. Not only is the sample small, but the ambiguity in the definition of ‘product’ and the fact that we do not know what kind of firms were included in the sample makes interpretation difficult.

  The Federal Trade Commission study of diversification does not give information about the revenue of firms, but does show that ‘a company’s 5 principal product classes constituted over 80 per cent of the total shipments in the case of every 1 of the 50 smallest firms among the 1,000 companies, in the case of 48 of the 50 median companies and in the case of 30 of the 50 largest companies’. And, furthermore, ‘that generally companies were much more dependent on a few industries than on an equal number of product classes’, op. cit., p. 39.

  155 The only usable published material is to be found in the annual reports of corporations which until the last ten to twenty years were remarkably uninformative. Such reports, together with discussions with businessmen, have provided much of the empirical material from which the analytical framework of this study sprang. No attempt was made, however, to collect and to analyze systematically the wealth of information available. The ‘testing’ in this manner of the propositions put forward here remains to be done.

  156 The Federal Trade Commission report to which we have referred above provides extensive statistical information by size-groups of firms for one year and is sufficient to establish the proposition that diversification is extremely widespread to-day. It also provides considerable information on the ‘extent’ of diversification so far as census product-classes and census industries are concerned.

  157 The remarks of C. W. Walton, General Manager, Adhesives and Coatings Division, Minnesota Mining and Manufacturing Company are typical: ‘Corporate growth possibilities can be unlimited for you if you will employ today’s modern methods of diversification research and new product commercialization in the conduct of your business.’ From ‘Corporate Growth Through Diversification Research and New Products Commercialization’, in Michigan Business Papers, No. 28. Conference on Sales Management, March 12, 1954. (Ann. Arbor: University of Michigan, 1954), p. 15.

  158 Some contemporary observers take the same view, however. See, for example, Kenneth Boulding, Reconstruction of Economics (New York: Wiley, 1950), p. 34.

  159 This point has also been stressed by George Stigler: ‘The only persuasive reason I have found for their [mergers] late occurrence is the development of the modern corporation and the modern capital market. In a regime of individual proprietorships and partnerships, the capital requirements were a major obstacle to buying up the firms in an industry, and unlimited liability was a major obstacle to the formation of partnerships.’ George J. Stigler, ‘Monopoly and Oligopoly by Merger’, American Economic Review, Vol. XL, No.2, Proceedings (May 1950), p. 28.

  160 Jesse Markham suggests that ‘mergers have been associated so closely with the monopoly problem’ largely because ‘the paths of economic theory and merger literature have rarely crossed.... Accordingly, the vast body of merger literature shows the lack of cohesive purpose that may have followed from empirical testings of merger theory’. Jesse W. Markham, ‘Survey of the Evidence and Findings on Mergers’ in Business Concentration and Price Policy (Princeton: Princeton University Press for National Bureau of Economic Research, 1955), p. 143.

  161 This statement is a simplified first approach. It ignores the problems raised by what I have called ‘empire-building’ desires of entrepreneurs. But it will do for the moment.

  162 One must be careful not to confuse the motives for expansion with motives for choosing the merger method of expansion. For example, among the motives for merger, one sometimes sees listed the desire to achieve economies of large-scale production, distribution or advertising economies, or the financial advantages of large size. These are motives for expansion but not necessarily for the merger method of expansion. Cf., however, J. Fred Weston, The Role of Mergers in the Growth of Large Firms (Berkeley: University of California Press, 1954), p. 86.

  163 This statement is misleading, though perhaps literally true, if the seller is under pressure from the buyer.

  164 The term ‘gross profits’ is used here for profits after taxes but before the deduction of depreciation and interest charges.

  165 The initial investment outlay includes, of course, all expenditures required to build up a market as well as to produce the product.

  166 In one survey of mergers, it was reported that ‘ ... there were about three and a half times as many instances in which the seller clearly took the initiative or was known to be “on the market” as instances in which the purchasing company took the initiative in bringing about a merger with a company not already “for sale” ...’ J. K. Butters, J. Lintner, and W. Cary, The Effect of Taxation on Corporate Merger (Harvard University 1951), p. 309. On the other hand, the Federal Trade Commission in its Report on Corporate Mergers and Acquisitions of May 1955 stated: ‘On the basis of available materials, it appears that by far the most im
portant type of promotion [of merger] is that which is carried on by the acquiring company’ (p. 73). But ‘Initial promotion by the acquired company appears to be a rather common procedure in merger or acquisition development’ (p. 75). The Commission gave illustrations but no statistics to support its contention that promotion by the seller is more important than initiation by the buyer.

  167 But it should be noted that a willingness, or even a desire to sell is not necessarily the same as a willingness to sell cheaply; it may merely indicate that the firm is willing to accept a reasonable offer—a willingness not always apparent among independent small businessmen. In one of the examples cited by Butters, Lintner, and Cary of an owner-manager desiring to sell because he thought his estate would thereby be left in a better condition, it is clear that the price of sale was based on capitalized future earnings, Op. cit., p. 91.

  168 Butters, Lintner, and Cary have an excellent description and discussion, based on their empirical investigations, of the ‘non-tax motivations for sale of business enterprises’, to which the reader is referred for further examples. See especially, pp. 213-22 of the book cited.

  169 Section 102 of the United States Revenue Act of 1950 imposes penalty taxes on retained earnings beyond the reasonable needs of business.

  170 The study by Butters, Lintner, and Cary cited above is almost the only systematic analysis and presentation of information regarding the effect of taxes on merger.

  171 Butters, Lintner, and Cary report: ‘One of the reasons for the acquisitions of other companies during the recent merger movement was the fact that the market prices of the stock of so many companies were substantially below their book values, and even more so below the replacement values of the underlying assets. It was therefore often much cheaper to acquire desired items—facilities, products, market outlets—by buying another company rather than by building or developing them directly.’ Op. cit., p. 312.

  172 For an excellent discussion of some of these problems see C. Roland Christensen, Management Succession in Small and Growing Enterprises (Cambridge: Harvard University Press, 1953), where the same point is made: ‘Top management’s job in the small but growing enterprise is a changing one ... growth calls for the development of new administrative and leadership skills ... at this stage the advantage shifts away from the manager who is able to do every job or watch over every detailed operation’ (p. 158).

  173 That some of the greatest managerial difficulties arise in the act of changing the managerial structure has often been stressed by theorists of management. See, for example, the various discussions in H. J. Kruisinga (ed.), The Balance Between Centralization and Decentralization in Managerial Central (Leiden: Stenfert Kroese, 1954), especially the papers by E. F. L. Brech and H. W. Ouweleen.

  174 The words of an owner-manager quoted by Butters, Lintner, and Cary, who sold out in order to ‘get out from under the terrific pressure and burden of running what was essentially a one-man business. ... ‘ He had competent technical assistance but he ‘had not been able to delegate responsibility for the top-management decisions in either the technical or general administrative phases of the enterprise’, op. cit., p. 75.

  175 For example, C. R. Christensen reported: ‘Finally, and most important, in small companies growth is severely restricted because management is incapable of building and using a supporting organization. Enterprises, like individuals, pass through various critical stages in their development. One such stage . . . occurs when the incumbent president steps down and a new manager is put in his place. Another takes place when the enterprise grows to a certain size, where effective performance and growth are impeded if the manager continues to run his firm on a one-man basis. If at that juncture the chief executive is able to bring along other men to take over some of his management responsibility, we have the beginnings of an executive organization and increased chances for growth and survival. In many small companies, however, management does not have the skills needed to develop an organization’. C. Roland Christensen, op. cit., p. 150.

  176 In a private letter to the author.

  177 Here again we meet the problem discussed in Chapter III, of the relation between entrepreneurial ability and the availability of capital. The two are so closely related that it is extremely difficult to isolate one or the other as the fundamental problem of the small firm.

  178 These outlays are of a kind that might result in what Joe S. Bain has called ‘shakedown losses’ for new entrants—losses that a new entrant to an industry may have to incur for a period while it is getting established. In his empirical study of barriers to new competition he found that ‘shake-down losses of entrants... in some cases may be large and prolonged’, and if the capital requirements of entry are taken into consideration, ‘there is probably some progression of the entrants’ disadvantage and the height of the resultant barrier to entry with the increase in capital requirements’. Joe S. Bain, Barriers to New Competition (Cambridge: Harvard University Press, 1956), pp. 156–65.

  179 Furthermore, since the foregone earnings on the capital funds tied up in an expansion programme must be counted as part of the cost of the expansion, the longer the time required for a given internal expansion, the greater the cost saving if acquisition of already going concerns can be effected, and the higher the price Alpha would find it worthwhile to pay for Beta.

  It has often been pointed out that entry into an industry where the optimum plant is very large may be impeded by the large investment outlays required. It follows from the above, however, that the entry of a new firm into such an industry through acquisition may actually be facilitated by this fact in those cases where the new firm has a significant competitive advantage, because of the effect of the threatened entry on the capital values of existing firms.

  180 If Alpha is in a strategic position vis-á-vis Beta by virtue of a monopolistic control over such things as raw materials and distribution channels, or is able to indulge in an ‘unfair’ competitive use of financial strength, this alone will force Beta to write down heavily its prospects of future income. The potential power of Alpha to compete so successfully with existing firms in the market that the latter’s profits will be substantially reduced should not, however, be treated as a similar form of pressure. But even if Alpha actually uses ‘unfair’ tactics, such as selling below cost to eliminate competitors or to force them to terms, it cannot be inferred that Alpha’s expansion would not have been profitable without such tactics. Their use may be merely one way of ensuring that an expansion considered profitable in any circumstances is effected as cheaply as possible. This, of course, does not justify social approval of ‘unfair’ competition, but if ‘fair’ competition can do the job, the fact that ‘unfair’ competition is used may not only reduce the cost of expansion for the large firms, but may also reduce the total losses of small firms in those cases where the large firms would enter and ‘out-compete’ them anyway. On the other hand, consumers may gain less than they would have from a prolonged depression of prices.

  181 This is the basis of much of the United States Federal Trade Commission’s opposition to extensive vertical integration. It is the common situation where large firms supply most, but not all, of their own requirements of certain parts or materials, relying on small independent producers for their marginal requirements. ‘This shifts to the independent parts manufacturer the risk of changes in volume of production which arise from changes in demand for products at the consumer level. Loss of a large contract by such an independent parts manufacturer may mean the difference between profitable and unprofitable operation or even may lead to bankruptcy. ... In case of loss of an important customer, the facilities of an independent parts manufacturer may become available for purchase in the open market. The result is that when either a raw material producer or a consumer goods manufacturer finds it desirable to expand his production of component parts, he frequently finds some facility already in operation available for purchase.’ Federal Trade Commission, Report on Corpo
rate Mergers and Acquisitions, 1955, op. cit., p. 116.

  182 Although I have assumed that firms are primarily interested in the profits they can make from their own operations rather than from outside investments, it does not follow from this that firms are in general unwilling to sell out entirely for a satisfactory price, even if they should use the funds to set up again in business. Furthermore, a distinction between the attitudes of owners and of managers is often significant. Where owners and management are the same, or where management reluctance has a significant influence on owners, the terms of sale often will include the provision of satisfactory positions in the acquiring firm for the managers of the acquired firm.