Theory of the Growth of the Firm

by Edith Penrose

  The theory of growth is developed first as a theory of internal growth, that is, of growth without merger and acquisition. The significance of merger can best be appraised in the light of its effect on the process of and limits to internal growth. Some attention to merger is given in the discussion of diversification, but not until Chapter VIII does the full analysis of growth through merger appear, and with this the development of the theory of growth is completed. The emphasis of the analysis is then shifted from the internal resources of the firm to the impact of particular types of external conditions as firms grow larger and to the particular situation of small as compared with large firms in the economy. This permits the development of an analysis of changes in the rate of growth of firms as they grow, and finally leads to a discussion of the process of industrial concentration, which is, after all, primarily a question of the relative rates of growth of large and small firms in a changing economy.

  Economists are sometimes criticized for not making clear the historical or institutional environment to which their theories are supposed to be applicable. The present analysis is concerned only with the incorporated industrial firm operated for private profit and unregulated by the state (hence not to regulated public utilities, financial organizations, or even ‘trading’ firms) and is applicable only to an economy where the corporation is the dominant form of industrial organization; historically, therefore, only to the period since the last quarter of the 19th century. To be sure, the corporation was widely used in certain areas much earlier, but it did not dominate the field of manufacturing as it has since, at least in the western world.

  The adaptation of the corporation, or limited liability company, to private manufacturing business removed the most important limitation on the growth and ultimate size of the business firm when it destroyed the connection between the extent and nature of a firm’s operations and the personal financial position of the owners. So long as owners were personally liable for the actions of their agents as well as for the finance of their firms, there was in general a sharp limit to the risk attendant upon extensive financial commitments, in particular in illiquid industrial assets, that owners would be willing to assume, as well as a close limit on the delegation of authority in management that could safely be permitted. The business organization or bureaucracy could never become an entity in its own right, independent of the personal position of the firm’s owners, as it has increasingly tended to become today.

  The continued growth of a modern business firm can, I think, be most usefully viewed as the continual extension of the range and nature of the activities of an organization in which the role of the owners may or may not be relevant, and of which even ‘central management’ (or entrepreneur) is only a part, though a very important part. It is at the organization as a whole that we must look to discover the reasons for its growth. This stands in sharp contrast to the traditional economic analysis of the ‘firm’ in the economist’s ‘theory of the firm’, and much confusion has arisen because of a failure to distinguish the different meanings in economic analysis of the term ‘firm’; the economist’s firm in the ‘theory of the firm’ is not at all the economic institution that ordinary people would think of as a firm. It will be necessary to make the distinction clear at the very beginning in order to avoid compounding the confusion.

  Finally, a comment on an alleged ‘tautological problem’ which some have feared is inherent in a theory of the growth of firms concerned only with firms that can successfully grow. Many firms do not grow, and for a variety of reasons: unenterprising direction, inefficient management, insufficient capital-raising ability, lack of adaptability to changing circumstances, poor judgment leading to frequent and costly mistakes, or simply bad luck due to circumstances beyond their control. I am not concerned with such firms, for I am only concerned with the process of growth, and with the limits to the rate of growth, and therefore only with those firms that do grow. I am not attempting to present a theory which will enable an analyst to examine a particular firm and state in advance whether it will or will not successfully grow. One can easily state the necessary and sufficient conditions for successful growth, but how can one determine whether a given firm meets these conditions? In practice one cannot determine it in advance; one must wait to see whether or not the firm grows. Hence little is gained by posing the problem in this way—but one need not so pose it. I am not asking what determines whether a particular firm can grow, but rather the very different question: assuming that some firms can grow, what principles will then govern their growth, and how fast and how long can they grow? Or alternatively, assuming that there are opportunities for expansion in an economy, what determines the kind of firm that will take advantage of them and to what extent? For so long as there exist opportunities for profitable investment there are opportunities for the growth of firms.

  The problem is not unlike the problem of diagnosing the prospects for the growth of, say, a tree. Upon examination, one can say, for example, that the tree will not grow unless certain identifiable conditions are corrected and certain environmental conditions satisfied—but one can never certify in advance whether the tree will or will not survive all possible vicissitudes and how they will affect its growth—the next winter may be severe, the spring rains may fail, or blight may set in. For a firm, enterprising management is the one identifiable condition without which continued growth is precluded—this is one necessary (though not sufficient) condition for continued growth, as will be demonstrated. Although our analysis is concerned only with growing enterprising firms, it is not on that account circular.

  II

  The Firm in Theory

  Different ways of looking at firms—The firm in the theory of price and production. Limits to size. The ‘firm’ is not a firm—The firm as an administrative organization. The function and nature of an industrial firm. Size and administrative co-ordination. Industrial firms and investment trusts. Continuity in the ‘history’ of a firm—The firm as a collection of physical and human resources—The motivation of the firm. The profit motive. Long-run profits and growth.

  IN a private enterprise industrial economy the business firm is the basic unit for the organization of production. The greater part of economic activity is channelled through firms. The patterns of economic life, including the patterns of consumption as well as of production, are largely shaped by the multitude of individual decisions made by the businessmen who guide the actions of the business units we call firms. The very nature of the economy is to some extent defined in terms of the kind of firms that compose it, their size, the way in which they are established and grow, their methods of doing business, and the relationships between them. In consequence, the firm has always occupied a prominent place in economic analysis. It is a complex institution, impinging on economic and social life in many directions, comprising numerous and diverse activities, making a large variety of significant decisions, influenced by miscellaneous and unpredictable human whims, yet generally directed in the light of human reason.7

  In the literature of economics, the firm of the ‘real world’ has long lived in that uncomfortable no-man’s-land between the high and dry plateaus of ‘pure theory’ and the tangled forests of ‘empiric-realistic’ research. Border skirmishes between the natives of the two areas have been common, supplemented by formal jousts in the medieval manner between noble knights of the opposing allegiances, each warmly defending his faith. These encounters have one remarkable characteristic—it seems strangely difficult for any participant ever to discover precisely where his antagonist stands, with the result that an uncommon number of thrusts seem to be made in one direction but countered from an entirely different direction, broad swords and rapiers forcefully cutting the air, without really clashing. When such difficulties occur in the world of thought one is likely to find the source of them in the meaning of words, and indeed so it is with the present problem of the ‘firm’. A ‘firm’ is by no means an unambiguous clear-cut entity; it is not an o
bservable object physically separable from other objects, and it is difficult to define except with reference to what it does or what is done within it. Hence each analyst is free to choose any characteristics of firms that he is interested in, to define firms in terms of those characteristics, and to proceed thereafter to call the construction so defined a ‘firm’. Herein lies a potential source of confusion that it is essential to deal with at the very outset of this study.

  Because of its complexity and diversity, a firm can be approached with many different types of analysis—sociological, organizational, engineering, or economic—and from whatever point of view within each type of analysis seems appropriate to the problem in hand. Within economics itself there are several different approaches to the study of the firm, and one type—the so-called ‘theory of the firm’—continues to hold the field in spite of vigorous attacks; of all the approaches it is probably the most often misunderstood and misapplied by both its defenders and its attackers.

  Educated laymen as well as economists studying the vagaries of actual business behaviour often show an understandable impatience with the ‘theory of the firm’, for they see in it little that reflects the facts of life as they understand them. It is therefore worth a little trouble, perhaps, to discuss at the very beginning the nature of the ‘firm’ in the ‘theory of the firm’, to indicate why it provides an unsuitable framework for a theory of the growth of firms, but at the same time to make clear that we shall not be involved in any quarrel with the theory of the ‘firm’ as part of the theory of price and production, so long as it cultivates its own garden and we cultivate ours. Much confusion can arise from the careless assumption that when the term ‘firm’ is used in different contexts it always means the same thing.

  The ‘Firm’ in the Theory of Price and Production

  The ‘theory of the firm’—as it is called in the literature—was constructed for the purpose of assisting in the theoretical investigation of one of the central problems of economic analysis—the way in which prices and the allocation of resources among different uses are determined. It is but part of the wider theory of value, indeed one of its supporting pillars, and its vitality is derived almost exclusively from its connection with this highly developed, and still basically unchallenged general system for the economic analysis of the problem of price determination and resource allocation.8 In this context only those aspects of the behaviour of firms are considered that are relevant to the problems that the wider theory is designed to solve.

  Since the theory of value is concerned with the factors determining the prices of particular products or productive services, the appropriate model of the ‘firm’ is a model representing the forces determining the prices and quantities produced of particular products in the individual firm; 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.9 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 a firm is nothing more than an increase in the output of given products, and the ‘optimum size’ of the firm is the lowest point on the average cost curve for its given product; the question what limits the size of a firm is the question what limits the amount it will produce of the given product or products with respect to which the cost and revenue schedules apply that are used to represent the ‘firm’. The model is not designed for the analysis of a ‘firm’ free to vary the kind of products it produces as it grows.

  The Limits to ‘Size’

  The conditions of equilibrium analysis require that there be something to prevent the indefinite expansion of output of the individual ‘firm’ defined in the above manner. In the model of the firm in ‘pure’ competition, the limit to output is found only in the assumption that the cost of producing the individual product must rise after a point as additional quantities of it are produced; in the model of the firm in ‘monopolistic’ competition, the limit is partly found in falling revenue as additional quantities of the product are sold. Without some such limit to the output of a given product—which, in this context, means to the size of the firm—no determinate ‘equilibrium position’ can be posited in static theory.

  Thus, regardless of the specific framework of their particular theories, economists have looked to the limitations of management (causing increasing long-run costs of production) or of the market (causing decreasing revenue from sales), or to uncertainty about future prospects (causing both increasing cost of larger outputs and decreasing revenue from larger sales because of the necessity of making allowance for risk) to provide a limit to the size of firm.10

  The whole problem has been the source of much controversy, especially the question whether managerial diseconomies will cause long-run increasing costs; to establish such a result management must be treated as a ‘fixed factor’ and the nature of the ‘fixity’ must be identified with respect to the nature of the managerial task of ‘co-ordination’. This identification has never been satisfactorily accomplished and many theorists have given up the task, preferring to rely on other limits to size.11

  The notion that the market limits the size of firms follows from the assumption that a firm is tied to given products, that a specific group of markets governs its possibilities of expansion. If this assumption is dropped, however, one is dealing with a different concept of the ‘firm’ and a different type of analysis becomes more appropriate. With a different concept of the firm one can recognize that a ‘firm’, when appropriate resources are available, can produce anything for which a demand can be found or created, and it becomes a matter of taste or convenience whether one speaks of the ‘market’ or of the resources of the firm itself as the consideration limiting its expansion. The fact that demand curves for given products can be assumed to be tilted downward does not mean that the expected net revenue from additional units of investment need ever become negative. Net revenue may well be rising as investment—and therefore total production—increases. To say that the expansion of a firm which can produce unspecified new products is limited by ‘demand’, is to say that there are no products that the firm could produce profitably. This, of course, is not what is meant in the theory of the firm, simply because its ‘firm’ is not a firm.

  The introduction of ‘uncertainty’ or ‘risk’ as a limit to size merely underlines the fact that the expected cost and revenue calculations of firms reflect their expectations about the future course of events; these expectations are held with varying degrees of uncertainty which increase as output increases (thus increasing the risk of loss) and allowances must be made in a firm’s calculations for the possibilities of disappointment. It in no way alters the nature of the analysis.

  The ‘Firm’ is not a Firm

  When the ‘theory of the firm’ is kept in its proper habitat there is not much difficulty with any of the explanations of the ‘size’ of firms. Difficulties arise when an attempt is made to acclimatize the theory to an alien environment and, in particular, to adapt it to the analysis of the expansion of the innovating, multiproduct, ‘flesh-and-blood’ organizations that businessmen call firms. It makes little difference in the theory of the firm whether changes in the characteristics of the individual firm, for example its managerial ability, or changes in the expectations of the entrepreneur about the future course of events, are treated as causing changes in the size of a single firm or as causing the creation of a series of ‘new firms’.12 The theorist is free to adopt the technique most suited to his problem. But how such changes are treated makes a great deal of difference to the theorist concerned with the growth of the firm defined, say, as an administrative organization in the real world. For the latter purpose it becomes necessary to use a very different concept o
f the firm and little is gained by tortuously trying to force an adaptation of the theory of the firm merely because it has proved to be a valuable concept for a different purpose. To some extent the adaptation can be forced, as we shall see, but we shall be dealing with the firm as a growing organization, not as a ‘price-and-output decision maker’ for given products; for this purpose the ‘firm’ must be endowed with many more attributes than are possessed by the ‘firm’ in the theory of the firm, and the significance of these attributes is not conveniently represented by cost and revenue curves. Furthermore, not only is it inconvenient so to represent them, but it is also misleading, for it only compounds the confusion involved in a failure clearly to distinguish the ‘firm’ in price theory from the ‘firm’ as it is looked on by businessmen as well as by many economists dealing with the behaviour of firms—a confusion which has unnecessarily marred the reputation of the ‘theory of the firm’ and done its credit in this world much wrong.13