Theory of the Growth of the Firm

by Edith Penrose

  The other major (and related) difference between the classical and the neoclassical tradition concerns growth versus coordination. As Loasby (1999) and Richardson (1999) explain, the neoclassical focus is on coordination, while the classical focus is on growth. In Penrose’s ‘garden’ metaphor, neoclassical price theory does not deal with firm growth, which is Penrose’s ‘garden’.

  For Loasby (1999), Penrose’s work reinvented the classical resource-creation tradition. In addition, Richardson (1999) claimed that, in contrast to Penrose, one needs to deal with both coordination and growth, and that Penrose’s contribution arguably provides a tool that can help this come about. Indeed. Penrose’s endogenous knowledge perspective goes beyond Allyn Young in explaining why and how the size of the market is itself determined by specialization and the division of labour (as well as vice versa). It provides the requisite perspective and knowledge to approach the synthesis between dynamic innovation (equals) knowledge and (thus) productivity—growth perspective and dynamic coordination through the knowledge provided by firms’ own operations and the perceived equivalence (in part achieved through firms’ own conscious efforts) of supplies and demands. It helps bring together resource creation and efficient allocation as explained above, in that it is the internally generated knowledge within firms that is required to supply firms with the very tools to achieve (rather than assuming the know-how for) efficient resource allocation and innovation-growth. In this sense Penrose’s contribution is seminal. However, her inadvertent association with the ‘wrong camp’ and (thus) the ‘wrong issues’, alongside the difficulties we mentioned under the ‘Influence’ section, help explain why in the currently dominant neoclassical resource-allocation perspective, her views may be seen as peripheral or non-relevant. This is not the case for organization and management scholars whose focus instead is on resources, and firm growth, strategy, and entrepreneurship.

  Penrose’s ideas can arguably make a significant contribution to the issue of the ‘nature of the firm’, too, namely the question why firms exist (Coase 1937). Penrose took for granted that firms exist. Coase (1937) equated the ‘nature’ of the firm with the ‘employment relation’ and attributed this to the efficiency benefits derived from reductions in market transaction costs. Penrose’s approach has complementary implications for Coase’s ‘nature argument’. The ‘employment relation’ can be explained in terms of efficiency gains, effected through productivity enhancements, through endogenous innovation (equals) knowledge-growth (see Pitelis and Wahl 1998). To the extent that dynamic transaction costs can also be of relevance, it will be the overall dynamic transaction costs reductions cum knowledge-induced productivity benefits that might explain the Coasean firm. Importantly, the very perception of when and how to reduce transaction costs can only be afforded through intra-firm knowledge generation (see, among others, Fransman 1994, Pitelis and Pseiridis 1999). This Penrosean ‘insight’ leads us further afield. To explain firms from a situation of no firms at all, one requires an entrepreneurial idea to be attempted to be put in practice. Selling this idea in the open market may be hard at least for two reasons. First, being tacit, it may be hard to transmit. Second, if in addition (which is possible) this idea also has public goods characteristics, explaining it to anyone can lead to it being expropriated. The control afforded to entrepreneurs of their ideas in the cohesive shell of the firm can be an adequate initial reason for not selling the idea in the open market. This is prior to, and complements, the idea that firms may have productivity benefits vis-à-vis markets, which can also be an adequate non-transaction-costs-related explanation of the ‘nature’ of firms.

  Following the emergence and rise of the resource- capabilities/knowledge theory of the firm and the resource-based perspective in (business) strategy, Penrose’s work has now become a canonical reference—indeed she is arguably seen by some as the mother figure of this perspective (much as Michael Porter had become for the ‘positioning’/industry-centred view and Ronald Coase (1937) for transaction costs; see Kor and Mahoney 2000).

  Some early disputes focused on the extent to which Penrose’s book was influential in the early resource-based contributions, as well as on whether the resource-based view is tautological and/or possible to operationalize. In brief, as discussed in Foss (1999) and Rugman and Verbeke (2002) among others, at least a variant of modern resource-based theory is about rents in equilibrium, which is far from Penrose’s main theme. However, the last part of her book, which deals with the issue of firm size, artificial barriers to entry, etc., as well as her references to ‘impregnable bases’, can be interpreted in ‘rents in equilibrium’ terms (Pitelis 2004). This suggests that for Penrose, firms create value, but also try to appropriate value, both at (quasi-) equilibrium (monopoly) and at dis-equilibrium through building ‘relatively impregnable bases’. Despite the above, ‘rents in equilibrium’ was not Penrose’s main theme and interest.

  The other two criticisms of resource-based ideas come from two figures whose views currently inform two major ‘competing’ perspectives to Penrose’s on firm (strategy)—Michael Porter and Oliver Williamson. Both have dealt with resources and competences more recently in Porter (1999) and Williamson (1999). Porter is largely dismissive, the main reason being what he sees as vague concepts. Williamson has wider-ranging critiques, a major one being the apparently tautological nature of the perspective and the lack of operation-alizability and supporting evidence.26

  Penrose’s contribution has not been criticized as tautological. Indeed, the predictive and prescriptive aspects of her theory are both operationalizable and testable, and they have been operationalized and tested. For Kor and Mahoney (2000) the persistence of critiques on operationalization and evidence is just misinformed. They cite an extensive list of empirical studies that test and mostly support the Penrosean views (see also Mahoney 2005).

  Porter (1987) has written a classic article on conglomerate diversification, which in many respects is the best test of the Penrosean theory of diversification! The prescriptive implication of Penrose’s theory on this is to diversify where there is perceived evidence of the applicability of existing resources to the new venture. By transferring knowledge (thus skills and competences) there will be value added. Porter’s study provides empirical support to the claim that by transferring skills and by sharing activities, diversification can add value and succeed. The finding itself and even the terminology (skills, activities) are quite Penrosean. More recently, Mahoney (2005) summarized the significant and growing literature that tests Penrosean ideas. On balance these support Penrosean insights. The work of McGahan and Porter (1997) is of much relevance here. The authors find that intra-firm-level factors are more important than environmental factors in explaining firm performance, but the environment still matters. This supports Penrose’s ‘productive opportunity’ concept.

  V.b. Further Limitations and Generalizations

  It is arguable that Penrose’s contribution fails to fully address a number of important issues.

  The first has to do with the issue of knowledge-related intra-firm advantages. These are always taken by Penrose to lead to growth. This is not self-evident. The question is why not sell your (intangible) assets in the open market? One has to return to some sort of ‘market failure’ argument to address this, either natural (transaction costs- or tacit knowledge-related) or structural (fear of creating a competitor). Clearly, the argument can also be phrased in terms of differential capabilities; i.e. firms are better at making use of their own assets than other firms (i.e. the market!). One can read arguments by Buckley and Casson (1976), Teece (1977) and Kogut and Zander (1993), plus the importance of oligopolistic interaction, in this context. Penrose did not discuss transaction costs arguments in the book. While oligopolistic interaction is part and parcel of her story, it is not explicitly discussed in the context of ‘why not sell’.

  A second, related, limitation refers to the question why not shed excess resources, e.g. labour or even manageme
nt? Penrose deals with the issue by claiming that she focuses on growing firms in a growing economy. This is all very well, but even successful firms in a growing economy may choose to shed excess resources, rather than use them for further expansion. While excess resources may have zero marginal costs, the costs of thinking what to do about them could be large—as it is time by the management that has to do the thinking, see also Marris (1999). In this sense, the issue is not so straightforward as it may appear at first sight. Shedding excess resources (labour, middle-level management) is not only an option; it is one that was used extensively in the 1990s despite that being a period of unprecedented growth. Clearly this issue, too, needs further discussion.

  A third limitation has to do with a broad category of issues related to what is now called ‘agency’, ‘moral hazard’, ‘monitoring’, and the like. The literature on these issues is huge, notable contributions being Alchian and Demsetz (1972) and Jensen and Meckling (1976), and Grossman and Hart (1986), Hart (1988; 1995), and Hart and Moore (1990). In brief, the issue here is that whenever there exists a ‘principal-agent’ relationship, like for example employer– employee, or shareholder–manager, and when the interests of the two parties are not ex-ante fully aligned, agents may have discretion to pursue their own interests. When this is the case, it becomes important for principals to devise means for aligning the incentives of employees to their own. Besides Alchian and Demsetz, Jensen and Meckling, and the Grossman, Hart, and Moore (GHM) approach of incomplete contracting, managerial and behavioural theories of the firm are based on similar concerns (see Pitelis and Teece 2009). There is little of that in Penrose. Indeed there is no conflict of any kind within the production process. We believe her analysis could be usefully enhanced by allowing conflict to enter it (see below).

  Besides the aforementioned ‘limitations’, and building on (some of) them, we can propose some generalizations of Penrose. The first concerns excess resources. Building at the time on important insights by Charles Babbage, Sargent Florence, and others, Penrose considered it normal to expect excess resources to be present in all but very large scales of output, for reasons related to ‘balance of processes’, indivisibilities of resources, etc. All these are relevant but not strictly required. Penrose can be generalized even by starting from a hypothetical situation of no excess resources and just observing knowledge generation within firms. This suffices. Indeed the very observation that human beings (and some machines) have ever-present unrealized (brain) potential will do. In effect, organization aids potential, which (activates brainpower and) releases resources. All other arguments are sufficient but not necessary conditions for the Penrosean story to follow.

  The second issue we wish to explore by way of generalizing Penrose is that of intra-firm conflict. The conflict par excellence is that between employer and employee (Marx, Alchian and Demsetz, GHM). Recognizing this may help Penrose’s story in various ways. First, it provides an extra reason for thinking by entrepreneurs/management of how to address this—which is innovation—knowledge generation. Second, it helps explain/predict, at least partly, the direction of this thinking. Last, but not least, conflict can lead to creative tension, and thus be a source of new information, knowledge, and innovation but can also be destructive (Pitelis 2007a). The recognition of intra-firm conflict questions efficiency-only-based explanations of organizational change, including that of TGF. As for example argued by Hymer (1970) and Marglin (1974), conflict may lead to a choice of technology that favours sectional interests, not necessarily societal ones, for example labour-saving technology may serve as a labour-control device. Such choices by management may in turn help intensify conflict. This may render crucial the role of non-economic factors that help establish shared morals and vision through, for example, leadership, ideology, legitimization, shared views, culture, and enablement (Simon 1995, Boddewyn 2003).

  There is little of that in Penrose. In TGF, interest alignment appears to be in part always present, perhaps effected through managerial leadership and its ability to implant its vision to other groups within the organization. Whilst this may well be possible it is neither self-evident nor cost-free. For example, Cyert and March (1963) asserts the opposite—that conflict is simply always there and that firms can use ‘organizational slack’ (such as Penrose’s ‘excess resources’) to alleviate conflict. This points to the need to discuss in more detail leadership, ideology, legitimization, and the effectnation of shared values, beliefs, and common moralities in organizations.

  While organizational ‘slack’ can be used in principle by management to alleviate conflict, this requires knowledge. In TGF this is endogenously generated within firms. It also requires motivation and effectiveness. In TGF motivation is established through the possibility of putting ‘excess resources’ to use at zero marginal cost. While this is problematic in that it ignores the cost of managerial time itself, which can be high, and while the belief in TGF of the ability of management to implement change can be questioned (as it requires a degree of power asymmetry between intra-firm groups, and also a degree of managerial competence), both these are arguably plausible hypotheses to make (as well as being in line with, for example, Chandler’s (1962) views). In this context, we feel that the importation of the above TGF concepts/assumptions to the Cyert and March (1963) approach could be employed to suggest that through the relentless pursuit of (endogenous) innovation and growth, productivity and efficiency, emergent ‘organizational slack’ can be used by management to alleviate conflict and drive innovation, as well as to helping to establish shared vision, values, and moralities.

  Such a positive-sum approach to problem-conflict solution goes beyond economic theories (see, for example, Tirole 1988, Prendergast 1999) and is closer to management theories such as the stakeholder and institutional approaches. It points to enabling and motivating employees (by means other than simply the provision of control-based ‘incentives’) as a managerial strategy for long-term performance (Perrow 1986, Granovetter 1985, Powell and DiMaggio 1991, Clarkson 1998, Boddewyn 2003, Mahoney 2006). It looks at contract and conflict not as opposites but, rather, as related, both being shaped by, and in turn shaping, the relentless pursuit of productivity and innovation, which is itself driven by objective factors (‘excess resources’ and ‘organizational slack’ through knowledge generation) and subjective factors (the pursuit of maximum feasible profit, power, recognition and the love of the game), by firms’ management. Importantly, the very process of generating intra-firm knowledge can help management enhance its problem-solving capabilities. Managerial knowledge may serve as a means of a dialectical synthesis between ‘contract’ and conflict.

  The above possibilities are supported by scholars such as Selznick (1957) and Simon (1995) as well as by work on the psychology of obedience, e.g. Milgram (1963). For Simon, ‘agency’- and transaction-costs-based theories ignore key organizational mechanisms such as authority, identification, and coordination. These are crucial in explaining why employees so often exert themselves to satisfy organizational objectives, not what appears to be their own self-interest. In his ‘sociological interpretation’ of Leadership and Organization, Selznick observes that ‘this process of becoming infused with value is part of what is meant by institutionalization. As this occurs, organization management becomes institutionalized leadership’ (1957, p. 138, original emphasis). In Industrial Organization (IO) economics, Holmström (1999), too, points to the variety of methods used by ‘authority’ to influence employee behaviour. For Loasby (1999), authority provides not only such inducements, but also a framework for problem identification and attempted solution. Kogut and Zander (1993) see the provision of ‘identity’ as one of the major functions of firms. A substantial literature on ‘trust’ and ‘social capital’, both in economics and management, stresses the role of trust in the building of social capital as a means of effecting common beliefs, norms, and attitudes (see Organization Science (2003 special issue) for extensive discussion). In addition, th
e path-breaking work of Milgram (1963) and subsequent literature has emphasized the unexpected frequency of behaviour obedient to perceived legitimate authority, even when this behaviour involves breaking deeply held conducts such as inflicting harm on others (see also Gross (1990) for critical analysis).

  Crafting organizational, sociological, cognitive, and psychological elements on TGF may help explain why and how management, when seen as a legitimate authority, can effect conflict alleviation and leverage human resources to enhance firm performance. This in turn will tend to engender excess resources and slack, which can be used in part to alleviate conflict, in part to motivate and enable them to put it to profitable use through endogenous innovation and growth.

  An integration of behavioural and Penrose-inspired RBV would suggest that intra-firm knowledge generation can engender endogenous innovation and growth through the generation and leverage of ‘excess resources’ and ‘slack’. ‘Slack’ may not only serve as a means of conflict-alleviation alongside monitoring, incentives, and rewards, but also supply motivational and psychological reasons for obedient behaviour. Besides motivating endogenous growth and innovation, slack may also enable it, given resource availability. Intra-firm knowledge generation, moreover, can inform management as to why, whether, and how to leverage excess resources so as to alleviate conflict, breed success, and engender a virtuous cycle of endogenous growth and innovation.

  VI. Concluding Remarks

  By bringing in issues of endogenous knowledge, innovation and growth, human resources, the role of ‘image’ and ‘productive opportunity’, and the dynamic interaction between internal and external, agency and structure, Penrose went much further than existing economic theories to provide what we consider to be the first economics-based, yet interdisciplinary, organizational theory of the firm. Penrose’s view of firms as organizations, aiding the generation of knowledge, provides a new perspective on firms, and on organizations and institutions at large. Her theory serves as the glue that binds together economic and organizational theories of firms, organizations, institutions, and (business) strategy. Importantly, Penrose’s work has significant implications for managerial practice.