Theory of the Growth of the Firm

by Edith Penrose

  The Firm as an Administrative Organization

  It is not the degree of abstraction involved in the ‘theory of the firm’ that makes it inappropriate as a starting point for an analysis of the growth of the firm, but rather the kind of abstraction. That is to say, the purpose of any study, ‘theoretical’ or ‘empirical’, must be defined, and only those aspects of ‘reality’ selected which are relevant. Irrelevant matters are rightly ignored, or ‘abstracted’ from. The object of the present study is to investigate the growth of the industrial (non-financial) firm as an economic entity in the broadest sense. But an economic analysis of the growth of firms has meaning only if there is some economic function or economic effect with respect to which the size and growth of firms is relevant. Consequently the definition of what constitutes a ‘whole firm’ for our purposes depends upon its essential function as an economic entity in the economy.

  The Function and Nature of the Industrial Firm

  Probably it would be generally agreed that the primary economic function of an industrial firm is to make use of productive resources for the purpose of supplying goods and services to the economy in accordance with plans developed and put into effect within the firm. 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. The growth in the ‘size’, however defined, of the industrial administrative unit is of importance because the larger this unit is, the smaller is the extent to which the allocation of productive resources to different uses and overtime is directly governed by market forces and the greater is the scope for conscious planning of economic activity. The chief controversies over the social desirability of large firms come either from disagreement over the question whether the increase in the scope for conscious planning in the organization of production and distribution has ‘good’ or ‘bad’ results, or from disagreement over the question whether extensive administrative organization of productive resources, if ‘good’, should be in private hands and conducted in response to opportunities for private profit.

  One important aspect of the definition of the firm for our purposes, then, involves its role as an autonomous administrative planning unit, the activities of which are interrelated and are co-ordinated by policies which are framed in the light of their effect on the enterprise as a whole.14

  All such units have some form of central managerial direction responsible for the general policies under which the firm’s administrative hierarchy operates. Let us call this ‘court of last resort’ in the firm ‘central management’. In practice it is made up of some combination of the board of directors or committees thereof, the president, and general managers of the firm. Just who is included in central management varies from firm to firm. Whatever the effective group, it must be accepted in practice as the highest authority within the administrative framework of the firm, and must be small enough to make more or less agreed decisions. In general, central management is responsible for establishing or altering the administrative structure of the firm, laying down general policies, and making decisions on those matters where no subordinate executive has been authorized to act or where no clear-cut principles have been set out in advance. In the last category are usually included at least the major financial and investment decisions of the firm, and the filling of the top managerial posts.

  In the ideal case, once an administrative framework has been created within which the ‘bureaucracy’ of the firm functions smoothly, and once policies are laid down which are accepted as guides for decisions by the administrative personnel of the firm, no further intervention by the central management is required so long as each decision that has to be made is of a type and scope envisaged in established policies. This does not mean that all decisions must be rigidly circumscribed in advance and no exercise of judgment allowed, but merely that there must be no confusion as to who makes any given decision, the principles that shall be considered in making it, and the scope of its effects.15

  It is evident that there will be great variations in the number, range, and nature of the tasks of the central management of different firms, depending on the structure of the firm, the preferences and ambitions of the top management group, and the extent to which the firm is faced with external changes which require action not provided for under existing arrangements. In an unchanging environment, for example, an established firm that had succeeded in creating optimum administrative procedures and framing an optimum set of policies could operate successfully without any overt acts of ‘central management’ at all; even new appointments could conceivably be made according to established regulations. Managerial and supervisory functions could be carried on by appropriate officials on different levels in the firm within the framework provided by the administrative organization and existing policy ‘directives’.16 In such circumstances, the administrative problem is ‘solved’ once an appropriate administrative structure has been established.

  Adaptation to change poses somewhat different problems. One type of problem is the adjustment to ‘short-run’ conditions—the day-to-day, month-to-month decisions required in operations—and another is the adjustment to ‘long-run’ changes and the making of ‘long-range’ policies. While undoubtedly no clear dividing line can be drawn between the two types of problem, the former certainly requires many decisions that cannot be individually ‘cleared’ with central management in the large firm; in consequence, organizational structures and procedures have been evolved which not only permit the making of such decisions on almost all administrative ‘levels’ in the firm but also ensure at the same time a high degree of consistency among decisions. Similarly, techniques and procedures have been created to enable central management to deal with the longer-run problems without excessive congestion at the top.

  Size and Administrative Co-Ordination

  The question has often been raised and is still debated, whether a firm can get ‘too big’ to enable both kinds of problem to be efficiently handled. At one time it was almost universally agreed that such a point would be reached as a firm grew in size, that management or ‘co-ordination’ was a ‘fixed factor’ which would necessarily give rise to diminishing returns and increasing costs of operation at some point. Behind this notion lay the common-sense deduction that consistency of behaviour requires ‘single-minded’ direction which is clearly limited in its possible scope simply because the capacity of any human being is finite. The conclusion that the limited capacity of the individual will limit the size of firms has not, however, been supported by events—at least not in any clearly discernible way. Now it seems likely that this ‘single-mindedness’ can be achieved through an appropriate form of organization inherited from the past and operated by people, also inherited from the past, who share a common tradition, who are accustomed to the organization and to each other, and who thus form an entity which works with sufficient consistency and efficiency in broad areas to make unnecessary any one individual having to comprehend and direct its detailed working. It is this capacity of the firm to alter its administrative structure in such a way that non-routine managerial decisions requiring real judgment can be made by large numbers of different people within the firm without destroying the firm’s essential unity, that makes it so difficult to say with confidence that there is a point where a firm is too big or too complex to be efficiently managed.

  At the present time at least it cannot be said that the large firms in the economy are unable effectively to compete with smaller firms nor that they tend to break up because of bureaucratic inefficiency and sheer inability of management to handle unwiedly size. On the contrary, the big firms appear extremely successful and there is no evidence at all that they are managed inefficiently when enough time has been given them to make the adjustments and adaptations of their administrative framework appropriate to increasing size. The techniques for decentralizing administrative organization have been developed to
a fine point, and the task of central management is apparently not one of attempting to comprehend and run the entire organization, but rather to intervene in a few crucial areas and to set the ‘tone’ of the organization. Operating control is effected largely through accounting devices which, to be sure, are highly centralized, but which place the task of ‘co-ordination’ in an entirely different framework, and incidentally permit the use of extensively mechanized techniques in carrying it out.

  Apparently what has happened as firms have grown larger is not that they have become inefficient, but that with increasing size both the managerial function and the basic administrative structure have undergone fundamental changes which profoundly affect the nature of the ‘organism’ itself. The differences in the administrative structure of the very small and the very large firms are so great that in many ways it is hard to see that the two species are of the same genus. We say they are because they both fulfil the same function, yet they certainly fulfil it differently, and it may be that in time the differences will become so great that we should consider in what sense they can both be called industrial ‘firms’. In other words, I think the question whether firms can get ‘too big’ for efficiency is the wrong question, for there is no reason to assume that as the large firms grow larger and larger they will become inefficient; it is much more likely that their organization will become so different that we must look on them differently; we cannot define a caterpillar and then use the same definition for a butterfly.

  Industrial Firms and Investment Trusts

  To be more specific, consider the difference commonly held to exist between an industrial operating firm and a financial investment trust. The one organizes production, the other holds financial instruments. But as an industrial firm becomes larger and larger, and its operations become progressively more decentralized with the lines of authority becoming more tenuous, permitting greater autonomy in the constituent parts, is it not possible that the firm will increasingly acquire the characteristics of a financial holding company, lose those of an industrial firm, and finally become virtually indistinguishable from an investment trust? And if this does happen, can we safely assume that the principles that govern the growth of an industrial firm are equally applicable when the organization is metamorphosed into an essentially financial firm?

  I do not think we can assume this; on the contrary, the techniques suitable for analysing the growth of firms engaged in the actual organization of production and distribution are probably very different from those required for the analysis of the growth of a purely financial organization. It follows, therefore, that if we define the industrial firm with reference to its administrative framework within which industrial activities are co-ordinated, we can be concerned with its growth only as such an organization. It is the ‘area of co-ordination’—the area of ‘authoritative communication’17—which must define the boundaries of the firm for our purposes, and, consequently, it is a firm’s ability to maintain sufficient administrative co-ordination to satisfy the definition of an industrial firm which sets the limit to its size as an industrial firm. Nevertheless, it cannot be presumed that if this limit is exceeded the organization has become ‘inefficient’; it may merely have become a different type of organization to which a different type of analysis must apply.

  ‘Authoritative communication’ can consist on the one extreme of the actual transmission of detailed instructions through a hierarchy of officials and, on the other, of the mere existence among a group of people of observed and accepted policies, goals, and administrative procedures established at some time in the past. Difficulties arise when we consider whether various kinds of ‘cross currents’ of ‘authoritative communication’, particularly those arising from outside the firm, weaken the applicability of this criterion of the limits of the firm.18 This is basically the problem of how the ‘area of administrative coordination’ can be discovered in practice, in other words, how we shall determine the size of any given firm at any given time.

  In earlier times, perhaps, before the predominance of the corporate form of enterprise, a firm was reasonably identifiable. The extensive and elusive lines of control in the modern business world, however, make it more difficult to decide what should be included within a given firm. The unincorporated individual proprietorship, the partnership, and the small corporation without subsidiaries create in general no trouble, but the large corporation with many subsidiaries over which it exercises some degree of control does.

  The concept of the firm developed above does not depend on the ramifications of stock ownership or the mere existence of the power to control, although extensive stock ownership may, and probably should, be one important consideration in any attempt to apply it. On the other hand, long-term contracts, leases, and patent license agreements may give an equally effective control, and yet cannot easily be treated in the same way. If a corporation is controlled by, or because of stock ownership is classed as a subsidiary of, a larger corporation, it is part of the larger firm only if there is evidence of an administrative co-ordination of the activities of the two corporations—for example, if its production programme or its expansion plans are co-ordinated with those of the larger firm or if its financial decisions are made by or jointly with those of the larger firm. It should not be classed as part of the larger firm if it appears to operate independently of the managerial plans and administrative arrangements of the larger firm, for in this case any influence the larger firm exerts should be viewed as an extension of economic power and not as an extension of the co-ordinated planning of productive activity. Thus, although many industrial firms are more or less loosely bound together by a common source of finance or a strong element of common ownership, the mere existence of such connections is not of itself sufficient evidence that administrative co-ordination is effective and adequate enough to justify calling such a grouping a firm.19

  Suppose, for example, one giant firm buys a strong minority interest in another giant sufficient to give it partial financial control, but makes no attempt to co-ordinate the productive activity of the other firm with its own. It may interfere at strategic points, but its power to do so may be no greater than that attaching to other relationships, for example, to the position of a powerful customer. Is the former firm bigger than it was before? The purchase may have been, from the point of view of the buyer, primarily a transformation of assets, say from cash to securities, and it is not even clear that the buyer has extended its area of control, for financial ‘size’ in terms of financial power over productive resources is not necessarily affected by such a transformation of assets.

  It is essential to distinguish between the extent of economic power and the size of the industrial firm proper. For an analysis of economic power there is no doubt that the industrial firm is not the most relevant unit; indeed, individual men as well as corporations may extend their economic power by extending their ownership interests, and an attempt to define the firm according to power groupings would produce too amorphous a concept to handle; the analysis of ‘growth’, of expansion and size would be of a very different kind. It is not clear in what economic sense a ‘financial group’ can be called a ‘firm’, or what reinvestment in such a ‘firm’ would mean. The extension of power of this sort is largely a matter of legal opportunities, legal institutions and legal limitations; yet in some sense a firm, in extending its financial power, is continuing to ‘grow’, but in another sense than ours; its growth still has economic significance, not so much for the organization of production as for the concentration of financial control and for the possibilities of using such control to manipulate the use of resources in the interest of the financial power of the controlling group. Public policy, or the hazards of financial speculation, and not conditions relating to the organization and administration of production, set the limits to this kind of growth.

  Continuity in the ‘History’ of a Firm

  Not only is it sometimes difficult to determine the boundaries of a pa
rticular firm at any given time; it is also sometimes difficult, in tracing the growth of a firm, to determine when a succession of legally different firms should be treated as events in the history of a single firm.

  In practice the name of a firm may change, its managing personnel and its owners may change, the products it produces may change, its geographical location may change, its legal form may change, and still in the ordinary course of events we would consider it to be the same firm and could write the story of its ‘life’. Whether the continuity was maintained by bankers in times of crisis or by the ingenuity of a clever promoter is irrelevant, provided that the firm neither suffered such complete disruption that it lost the ‘hard core’ of its operating personnel, nor lost its identity in that of another firm. There may have been reorganizations, but a reorganization in itself generally requires a continuing group of at least the subordinate administrators to effect it. Just as in political life the state ‘survives’ many changes of government and many reorganizations of its administrative organs, but not partition nor complete annexation by other states, so the identity of the firm can be maintained through many kinds of changes, but it cannot survive the dispersal of its assets and personnel nor complete absorption in an entirely different administrative framework.