Theory of the Growth of the Firm

by Edith Penrose

  The move to Johns Hopkins was an important one in Edith’s development as an economist. She began her master’s and doctoral studies, which she completed in 1951.5 She then became Lecturer and Research Associate at Johns Hopkins where she and Pen stayed until 1959, with extensive stays out of the country.

  At Hopkins Edith’s supervisor was Fritz Machlup, who co-directed with G. H. Evans Jnr a research project on the growth of firms. Her description of how she became involved in the project is given in an illuminating interview with David King in the British edition of Parkin and King’s economic textbook:6

  I had no special interest in firms, but a Professor there [Johns Hopkins] had a large grant to do studies of the growth of firms, and he asked a group of us to participate. I didn’t mind what I specialised in, but I had to earn some money and the growth of firms seemed interesting. So I elected to work on the theory of the growth of the firm and it took me nine months of reading and especially thinking before I realised that the traditional theory of the firm, in which I, like other economists had been trained, was not relevant to the problem of the growth of firms.

  For her fieldwork Edith was attached to the Hercules Powder Company as a Fellow under the College–Business Exchange Program, and this was the beginning of research which eventually led to TGF. Machlup remained a lifelong friend and mentor.7 Indeed, Edith’s intellectual development and the rigour of her thought were very much a product of her association with first, Pen, and second, Fritz Machlup, both of whom were demanding in their requirement of clear and uncluttered analysis. But Pen was also very wise in the way institutions worked, and mistrusted the increasingly specialized trends in economics. Although her conclusions were sharply at odds with textbook theories, she never sought confrontation: ‘Would anyone. . . try to reconcile a football game with a cricket match just because they are both ball games?’

  Pen became increasingly disillusioned with the United States during the 1950s. The Committee for UnAmerican Activities chaired by Senator McCarthy had targeted academic institutions, and Johns Hopkins was caught up in the net as Owen Lattimore, the eminent sinologist and Mongolia specialist, was accused ‘of losing China’ by McCarthy. Edith and Pen played central roles in his defence. Although the University was generally supportive, the experience prompted Pen to take sabbatical leave until retirement, first in the Australian National University in Canberra (1955), where Edith continued work on TGF, and then in the University College of Arts and Sciences in Baghdad (now the University of Baghdad) (1957–9), from which sprang a lifelong interest in the Arab world. After Pen’s retirement in 1960, they made many return trips to Iraq until they were expelled from the country in the mid-1960s. Later they jointly wrote Iraq: International Relations and National Development (1978), and were an important influence on a generation of Iraqi economists in particular and Arab economists in general. Pen and Edith travelled extensively in the Middle East, teaching in the American University of Beirut, and in the universities in Cairo and in Khartoum.

  A natural development of Edith’s work on the growth of the firm was that she became interested in the international firm and the oil industry. Edith’s economic preoccupations were frequently a response to the situations in which she found herself. Although in one sense this characteristic meant that she did not follow a given path over time, in another sense it contributed to the way she approached theory, from observing the real world and trying to make sense of it. ‘When I went to Baghdad in the late 1950s . .. I found that no economist had published any analysis of the international oil companies in spite of the fact that the oil industry was a very large and vitally important industry, accounting for a large proportion of international trade and run by some of the largest companies in the world. I happily took advantage of this splendid opportunity for empirical research.’ Her interest in developing countries dates from this period, in particular the role that international firms have as investors in developing countries, and, by extension, problems of development in a wider sense. Again, her theoretical concerns arose from observation of the real world: ‘essentially this is all common sense, which is especially important when you deal with theory, for it is not always easy for beginning students to understand the relation of the “theory” they study to what they see as the “real world”.

  The path to Johns Hopkins was a fortuitous one; so was the path to London. In 1959 Edith and Pen drove across the Syrian Desert, through Turkey, and on to England in an old Hillman estate car so that she could attend an interview at Cambridge. TGF had not been published but was circulating in manuscript. She failed to be appointed, but successfully applied for a joint Readership in Economics with Reference to the Middle East in the London School of Economics and the School of Oriental and African Studies (SOAS).

  In 1964 she took the first Chair of Economics with Special Reference to Asia in SOAS which she held until 1978. During this period her research preoccupation was very much with oil and the multinationals. She was also a remarkable teacher. In addition, she visited many parts of the world, notably the Middle East (Baghdad, American University of Beirut, Cairo, Khartoum, Amman), but also Delhi, Tanzania (where she provided advice on the government’s treatment of foreign companies which was not well received8), Indonesia, and other countries.

  In 1978 she was asked by INSEAD in Fontainebleau whether she could recommend anyone for a political economy position, and to their surprise she recommended herself. She retired from SOAS and took up a position as Professor of Political Economy in INSEAD, where she was also Associate Dean for Research and Development. She had been one of the very few female full professors in London, and INSEAD was also largely a male preserve, but that had never bothered her. Pen died in 1984. Edith and Pen had had a long and fulfilling marriage, and had been entirely self-sufficient in each other’s company. His death, though not unexpected, was a serious blow, as each had provided for the other the centre of their existence: geographical location did not matter. On his death she retired from INSEAD and moved to Waterbeach, near Cambridge, to live near her sons.

  In her years of retirement she led a very active life. She was on several governing bodies, including the council of the Overseas Development Institute, and the board of the Commonwealth Development Corporation. She sat on the Pharmaceuticals Committee for many years, having in the early 1970s provided advice to the Labour government on pharmaceutical industrial policy. She also undertook consultancy work, including advisory work for the Iranian government on compensation claims resulting from the nationalization of the oil industry.9

  In the period after her retirement the pace of recognition of her early work gained momentum—she had never formally taught the theory of the firm in INSEAD, but her approach to economic analysis influenced a generation of MBA students who came into contact with her. She received honours from American, British, and other European universities, and a steady stream of visitors arrived at Waterbeach. She had always been modest about her work, and gained much pleasure from the belated recognition accorded to it. The stimulus of the renewed interest in her work set her thinking again about theories of the firm, both in terms of business and management, and in terms of the poverty of the neoclassical model. She became interested in how firms were changing, having toyed with the idea of a theory of the death of the firm, the idea metamorphosing into the metamorphosis of the firm (see Penrose 2008).

  Edith used to quote advice given to her by John Winant: ‘the important thing is to lose your illusions and not become disillusioned’. She did not become disillusioned. She was one of the most original economic thinkers of the century, but it seemed as though she was unaware of her achievement. She was not ambitious for herself and had had little interest in academic politics.

  She believed in the goodness of people, as Pen had done, and retained a vigorous interest in other people’s business, as all those who sought her advice (as well as many who did not seek it) will remember.

  She had a slight stroke in 1994, after which her
thought processes slowed, but she lost none of her acuity or interest in life. She continued to enjoy robust conversations with her visitors, and enjoyed her evening drink. She died from heart failure in her sleep on 11 October 1996, shortly before her 82nd birthday.

  III. Penrose’s Contribution

  As the short account of her life shows, Penrose’s contribution to economics was wide ranging: from ‘food control’ through the patent system, to the theory of the (growth of the) firm, the multinational enterprise, the theory of industry organization, the international oil industry, the economics of Arab countries, international economic relations, and more. Within this context, she proposed theories of competition, innovation, mergers and acquisitions, small firms and networking, and anti-trust and industrial policy. In her early work, for example on the economics of the International Patent System (1951),10 Penrose questioned the alleged positive benefits of the international extension of the patent system to social welfare, in particular of developing countries. That work was described as ‘novel and controversial… several dogmas which legal experts have held in great respect are exposed to the bright searchlight of a skilled economic analyst and are shown to be untenable’ (Machlup 1951, p. viii).

  Despite such praise, Penrose’s early work has not been particularly noticed. However, it helps expose some of her early interests in ‘monopoly’, ‘innovation’ and social welfare, which were to later assume a dominant position in her thinking.

  Penrose’s major claim to be remembered as an economist is undoubtedly The Theory of the Growth of the Firm, first published in 1959. The result of her work with the Hercules Powder Company, ‘The Growth of the Firm, A Case Study: The Hercules Powder Company’ was completed in 1956, and published in 1960. It ‘was originally intended for inclusion in [the] Theory of the Growth of the Firm, but omitted to keep down the size of the book’ (1960, p. 1). Given this, it is safe to consider the two pieces as part of an integrated whole and consider its main arguments.

  On various occasions, Penrose (1959, 1985, 1995) describes her experiences with seeking guidance from existing economic theory to address the issue of her concern, the growth of a real life firm. She found very little. In brief, the economic theory of the firm had no firms in it. For mainstream economic theorists ‘the “firm” was primarily a set of supply and demand functions’ (Penrose 1985, p. 6a),

  part of the wider theory of value, indeed one of its supporting pillars, and its vitality is directed almost exclusively from its connection with this. . . general system for the economic analysis of the problem of price determination and resource allocation… the ‘equilibrium of the firm’ is, in essence, the ‘equilibrium output’ for a given product (or given group of products) from the viewpoint of the firm. It does not pretend to be an ‘equilibrium’ of the firm if the firm is represented in any other way, or if any other considerations affect it than those permitted in the theory of price and output. Hence if we become interested in other aspects of the firm we ask questions that the ‘theory of the firm’ is not designed to answer. In that theory the ‘growth’ of the firm is nothing more than an increase in the output of given products, and the ‘optimum size’ of the firm is the lowest point of the average cost curve for its given product (1959/2009, p. 10; all references to TGF in this introduction are to this 2009 edition).11

  She went on to suggest that the adequacy of traditional explanations of limits to growth (limitations to management, the market, and/or uncertainty) do not stand up to scrutiny and concluded that such a theory of the firm cannot be easily adapted to ‘the analysis of the expansion of the innovating, multi-product, “‘flesh and blood” organisation that businessmen call firms’ (p. 12).

  III.a. The Penrosean Firm and the Market

  The firm in TGF is a collection of productive resources (human and non-human) under administrative coordination and authoritative communication that produces goods and services for sale in the market for a profit (Penrose 1959, 1985, 1995). Administrative coordination and ‘authoritative communication’ define the boundaries of the firm. Very much like Coase (1937), but without having at the time been influenced by his classic article, Penrose maintained the distinction between the firm and the market.

  The essential difference between economic activity inside the firm and economic activity in the ‘market’ is that the former is carried on within an administrative organization, while the latter is not (1995, p. 15).12

  The boundary of the firm is what distinguishes it from the market and therefore must ‘exist’ whether or not it is ‘real’… (p. xvi).13

  From of the resources within the firm, human resources, and in particular managerial resources, are most important. One reason is that any expansion requires ‘planning’, which can only be done by the firm’s own management, which itself is firm-specific and not available in the open market.

  There are two major categories of ‘causes’ of growth; those external to the firm and those internal. Penrose suggests that external causes, for example raising capital, demand conditions, etc., while of interest, ‘cannot be fully understood without an examination of the nature of the firm itself’ (1955, p. 532). The problem as she saw it was ‘the internal incentives to and limits on growth—a theory of the growth of the firm that does not relate to fortuitous externals events’ (p. 532).

  There are two basic reasons why there are incentives for growth endogenous to the firm which moreover are self-reinforcing, leading to opportunities for further expansion. First is the claim that the execution of any plan requires resources which are in excess of those strictly necessary for this execution. Second, upon completion of a plan, managerial resources will be released. Crucially, moreover, ‘the services that the firm’s management is capable of rendering will tend to increase between the time when the plan is made and the time when the execution is completed’ (1955, p. 533).

  Penrose attributed the ubiquitous presence of unused resources to arguments by Charles Babbage, Austin Robinson, and Sargent Florence such as the ‘balance of processes’ or ‘the principle of multiples’, which suggest that

  if a collection of invisible productive resources is to be fully used, the minimum level of output at which the firm must produce must correspond to the least common multiple of the various outputs obtainable from the smallest units in which each type of resource can be acquired.. . . This output will tend to be greater the larger the variety of resources and the more diverse the units in which they come (1955, p. 533).

  Accordingly ‘a firm would have to produce on a vast scale if it were to use fully the services of all the resources required for much smaller levels of output’ (1955, p. 533). In addition,

  most productive services. .. are capable of being used in many different ways and for many different purposes. Hence a firm in acquiring resources for particular purposes—to render particular services, also acquires a range of potential productive services, most of which will remain unused (p. 534).

  Managerial services are of particular importance in this context, also because they are available to the firm only in limited amounts: ‘executives with experience within any given firm can only be found within that firm . .. The production of these services requires time and this limits the scope of a firm’s expansion plans at any given time, but permits continuous extension of these plans through time’ (1955, pp. 534–5).

  However, the completion of expansion plans creates and releases resources. It creates resources because ‘all personnel in the firm will gain additional experience as time passes’ (1955, p. 538). It releases resources because ‘not only is there likely to be a generalized improvement in skill and efficiency but also the development of new and specialized services’ (p. 538).14

  This increase in knowledge not only causes the productive opportunity of the firm to change in ways not directly related to changes in the environment, but also contributes to the ‘uniqueness’ of the opportunity of such individual firms (1959/2009, p. 48). This is particularly true given
that not all knowledge is ‘objective’ (transmittable); some takes the form of ‘experience’, which is hard to transmit.

  In TGF, unused productive services are, for the enterprising firm, at the same time a challenge to innovate, an incentive to expand, and a source of competitive advantage. They facilitate the introduction of combination of resources—innovation—within the firm. In addition, they are ‘a selective force in determining the direction of expansion’ (1959/2009, p. 77).

  Once it is recognized that firms are not to be defined in terms of products, but instead of resources, and given the potential versatility of the latter, demand conditions cannot limit a firm’s expansion. In this sense, and in the absence of traditional managerial diseconomies, the existence of which Penrose questions,15 there is no limit to the size of the firm, but only to its rate of growth.

  Whilst focusing on the internal environment and in contrast to the critique by Andrews (1961), Penrose does not ignore the external one. In her introduction (abstract) to the Hercules Powder Company case, she claims that

  growth is governed by a creative and dynamic interaction between a firm’s productive resources and its market opportunities. Available resources limit expansion; unused resources (including technological and entrepreneurial) stimulate and largely determine the direction of expansion. While product demand may exert a predominant short-term influence, over the long term any distinction between ‘supply’ and demand’ determinants of growth becomes arbitrary (1960, p. 1).

  It is not an easy task to summarize all of Penrose’s major ideas. The following points, however, may help to recapitulate and complement the above account.

  • Firms are bundles of resources, under internal direction, for production of goods and services, sold in markets for a profit. Their boundaries are defined by the area of coordination and ‘authoritative communication’.