Theory of the Growth of the Firm

by Edith Penrose

  The Role of Enterprise and the Competence of Management

  There are probably many ways of defining enterprise, but for our purposes it can usefully be treated as a psychological predisposition on the part of individuals to take a chance in the hope of gain, and, in particular, to commit effort and resources to speculative activity. The decision on the part of a firm to investigate the prospective profitability of expansion is an enterprising decision, in the sense that whenever expansion is neither pressing nor particularly obvious, a firm has the choice of continuing in its existing course or of expending effort and committing resources to the investigation of whether there are further opportunities of which it is not yet aware. This is a decision which depends on the ‘enterprise’ of the firm and not on sober calculations as to whether the investigation is likely to turn up enticing opportunities, for it is, in effect, the decision to make some calculations. This is truly the ‘first’ decision, and it is here that the ‘spirit of enterprise’, or a general entrepreneurial bias in favour of ‘growth’ has perhaps its greatest significance.

  The assumption that firms are ‘in search’ of profits already implies some degree of enterprise, for it is only in the special case where the profitability of expansion in a given direction is obvious and the decision to expand almost automatic that no particular quality of enterprise is required. One sometimes does hear businessmen insist that their firms ‘just grew’, that there was no alternative—orders were coming in, demand was high and, pressed by circumstances, the firm simply ‘had to expand’. Such conditions do not last indefinitely and the unenterprising firm ceases to expand as this type of opportunity declines. The enterprising firm, if it is a large one, will permanently commit part of its resources to the task of investigating the possible avenues for profitable expansion, acting on the general presumption, supported perhaps by past experience, that there are always likely to be opportunities for profitable growth, or that expansion is necessary in a competitive world. Smaller firms may only periodically be able to consider in what directions expansion might be profitable. In any case, the decision to search for opportunities is an enterprising decision requiring entrepreneurial intuition and imagination and must precede the ‘economic’ decision to go ahead with the examination of opportunities for expansion.

  Entrepreneurial versus Managerial Competence

  ‘Enterprise’ is obviously closely related to ‘ambition’, but even if a firm is not very ambitious it may nevertheless be competently managed. This is particularly true of those smaller firms where there is a close relation between the ‘goals’ of owners and the ‘goals’ of firms. There are many businessmen, and very efficient ones too, who are not trying always to make more profits if to do so would involve them in increased effort, risk, or investment. In many industries and areas there are a considerable number of firms which have been operating successfully for several decades under competent and even imaginative management, but have refrained from taking full advantage of opportunities for expansion. Many of these are ‘family firms’ whose owners have been content with a comfortable profit and have been unwilling to exert themselves to make more money or to raise capital through procedures that would have reduced their control over their firms.

  It is not reasonable to expect all businessmen to devote their last ounce of energy to making money. In wage theory, it is well recognized that after a point higher wages may reduce, or at least fail to increase, the supply of labour. There is no reason to assume that businessmen and workers are fundamentally different in this respect. Hence we should not assume that the prospect of higher profits will always call forth the necessary effort from all firms in a position to earn them. Very good businessmen may well possess a personal scale of values in which an income greater than that necessary to provide a comfortable position in the community has a relatively low claim on time and effort.

  Such men may have a high degree of managerial skill and imagination; they may be hard and efficient workers, but the ambition that would drive other men in the same circumstances to expand their operations in an unending search for more profit, and perhaps greater prestige, may be lacking. There is no inconsistency here: a good businessman need not be a particularly ambitious one, and so long as a firm is dominated by men who are not ambitious always to make profits it is unlikely that the firm will grow very large. Entrepreneurial preferences of this sort provide exactly the same kind of restriction on a firm’s growth as does entrepreneurial inability to perceive or to act upon opportunities for profitable growth, for the most effective restriction on the quality of entrepreneurial services is that which stems from a lack of interest in experimenting with new and alien lines of activity, or in moving into new geographic areas. I say that this is the most effective restriction because mere specialization of managerial knowledge and ability is not of itself a serious bar to a firm’s branching out into new lines of activity if existing executives are sufficiently interested and imaginative to bring into the firm people possessing the relevant knowledge and ability. Thus, the managerial competence of a firm is to a large extent a function of the quality of the entrepreneurial services available to it.

  The Quality of Entrepreneurial Services

  ‘Enterprise’ is by no means a homogeneous characteristic, and the ‘quality’ of enterprise, that is to say, the particular types of entrepreneurial service available to a firm, is of strategic importance in determining its growth. Many of the most important services that a firm’s entrepreneurs can produce are not the result of ‘tempermental’ characteristics of the individual men but are shaped and conditioned by the firm itself; this point will be taken up in the following chapters, for the ‘production’ within the firm of an important class of entrepreneurial services is a significant aspect of its changing productive opportunity. Here I want merely to discuss some of the ‘temperamental’ aspects of the quality of entrepreneurial services which are not amenable to economic analysis, but which nevertheless cannot be ignored; all we can do is to note them here and at appropriate points consider their effect; we cannot explain them in economic terms.

  Entrepreneurial Versatility

  Entrepreneurial versatility is a somewhat different quality from managerial or technical versatility. The latter two qualities are primarily questions of administrative and technical competence; the former quality is a question of imagination and vision, which may or may not be ‘practical’. To the extent that entrepreneurial ideas are inherently impractical, they are of little use to a firm; but if they are commonplace and short-sighted they are equally useless, and firms whose entrepreneurs are ‘dull’ are by this fact alone restricted in their growth.35 It often happens that the horizon of a firm, particularly of a smaller firm, is extremely limited. Content with doing a good job in his own field, the less enterprising entrepreneur may never even consider the wider possibilities that would lie within his reach if only he raised his head to see them. If occasionally he gets a glimpse of them, he may lack the daring or the ambition to reach for them, although he may be an ambitious, efficient, and successful producer in his chosen field or chosen geographical location. ‘Specificity’ of entrepreneurial resources means that some of the productive services most essential for expansion will not be available to the firm even though all managerial services which are required for efficient operation in a particular field are fully available.

  There are many examples of firms with vigorous and creative management which have substantially altered their range of products, sometimes completely abandoning their original products and expanding their total output in spite of unfavourable demand conditions for the old products. But there are also many examples of other firms which have not been able to make the required adjustments. In such cases, failure to grow is often incorrectly attributed to demand conditions rather than to the limited nature of entrepreneurial resources.

  The relation between ‘demand’ and the growth of firms is discussed later (Chapter V). Plainly, however, to the exten
t that a firm is capable of producing only a given range of products, any limitations on the market for those products will restrict the firm’s opportunities for expansion. A versatile type of executive service is needed if expansion requires major efforts on the part of the firm to develop new markets or entails branching out into new lines of production. Here the imaginative effort, the sense of timing, the instinctive recognition of what will catch on or how to make it catch on become of overwhelming importance. These services are not likely to be equally available to all firms.36 For those that have them, however, a wider range of investment opportunities lies open than to firms with a less versatile type of enterprise, although the mere existence of ‘enterprise’ is not sufficient, as we shall see, to enable a firm to move indiscriminately into any kind of activity.

  It is not helpful to dismiss this lack of vision or of experimenting ambition as an example of a failure to attempt to ‘maximize profits’, for it is intimately connected with the nature of entrepreneurial ability itself and must be reckoned as a limitation on the supply of specific types of productive services.

  Fund-Raising Ingenuity

  Difficulties in obtaining capital are often given pride of place among the factors preventing the expansion of small firms, but this is legitimate in only a very limited sense. New, small, and unknown firms do not have the same facilities for raising capital as do established, large, and known firms. Of this there is little question. On the other hand, many small firms without adequate initial financial resources do succeed, do raise capital, do grow into large firms. And they do this, for the most part, by virtue of a special entrepreneurial ability. There are many examples testifying to the ingenuity of the superior businessman in obtaining the funds he needs, and only if the requisite entrepreneurial ability is lacking can one safely say that a firm cannot attract the required capital.37

  To be sure, the type of entrepreneurial service needed to raise capital may not be closely related to the type of services needed to run a firm efficiently, for successful raising of capital depends on an entrepreneur’s ability to create confidence. Thus small firms have often relied on a division of labour between an inventor or a skilled production manager, and a ‘businessman’ able to raise capital and buy on credit. The statement that ‘shortage of capital’ is the cause of failure of small firms often means merely that a very particular and possibly very rare sort of entrepreneurial ability is required to launch successfully a new firm on a shoestring or to keep up the rate of net new investment required to enable it to reach a size and position where its general credit standing is well established. On the other hand, even firms with substantial financial resources but indifferent managerial resources can escape trouble only if their entrepreneurs are sufficiently flexible and imaginative to know the kind of management needed by the firm and to attract it. Capital is a problem for the small and new firm in much the same sense that ‘demand’ is a problem—the same kind and quality of ‘enterprise’ that might be successful in a known and established firm, may not be successful in ‘selling’ a firm or its product to cautious and sceptical investors or consumers.38

  It is, of course, true that ‘capital-raising ingenuity’ is most easily recognized by its results, for it is difficult to say whether a given entrepreneur possesses the ability to raise capital if he has not yet demonstrated it by raising capital. Therefore it would not be very helpful, even if true, to say that small firms fail to raise capital because they do not have the ability to do so, and I do not mean to argue in this way. There is little doubt that the most ingenious and persuasive of entrepreneurs are at times unable to raise critically needed finance.39 I want merely to draw attention to the fact that there is a relation between entrepreneurial ability and the finance a firm can attract, and that difficulties attributed to lack of capital may often be just as well attributed to a lack of appropriate entrepreneurial services, in the sense that a different entrepreneur in the same circumstances might well achieve different results.

  Entrepreneurial Ambition

  The fact that businessmen, though interested in profits, have a variety of other ambitions as well, some of which seem to influence (or distort) their judgment about the ‘best’ way of making money, has often been discussed, particularly in connection with the controversial subject of ‘profit maximization’. From our point of view it will be useful to distinguish two broad types of entrepreneurial ambition, which are difficult to define with any precision, but which will be easily recognizable from a brief description of some of their characteristics.

  There are some entrepreneurs who seem to be primarily interested in the profitability and growth of their firm as an organization for the production and distribution of goods and services. These we might call ‘product-minded’ or ‘workmanship-minded’ entrepreneurs or ‘good-will builders’. Their interests are directed towards the improvement of the quality or their products, the reduction of costs, the development of better technology, the extension of markets through better service to consumers, and the introduction of new products in which they believe their firms have a productive or distributive advantage. They take pride in their organization, and from their point of view the ‘best’ way to make profits is through the improvement and extension of the activities of this organization.

  Another type of entrepreneur, whom we might call the ‘empirebuilder’ is of a different order. He is pushed by visions of creating a powerful industrial ‘empire’ extending over a wide area. Though he may be concerned with product-improvement and development as a means of maintaining the competitive position of his firm, these activities are delegated to others in the firm, for he is much more interested in the extension of the scope of his enterprise through acquisition or the elimination of competitors by means other than competition in the market. He may hold fairly closely to a particular industrial field with the notion of obtaining a dominant position in that field, or he may range widely in his ventures, taking up anything that appears profitable. The successful empire-building entrepreneur must have initiative and be aggressive and clever in the strategy required to bargain with and successfully outmanoeuvre other businessmen; he requires a keen instinct for purely financial manipulations and a shrewd judgment in assessing not only the value of other firms but also the minimum costs at which they can be acquired, for often whole firms may be bought and sold merely for the ‘quick profits’ to be obtained from them.40 Above all, the empire builder, as the name implies, is a business politician and strategist—upon ability of this type his success depends.

  The empire-builder will be of concern in this study only to the extent that he contributes to the process of growth of an industrial firm. Many empire-builders are, as individuals, nothing more than financial speculators, and the collection of firms they acquire never take on the characteristics of a single industrial firm as we have described it. We shall have occasion to examine the effects of ‘empire-building’ on the process of growth of a firm, but for the most part the entrepreneurial services that will be of interest to us are of the ‘product-’ or ‘workmanship-minded’ variety.

  Entrepreneurial Judgment

  Unlike ‘versatility’, ‘ingenuity’, and ‘ambition’, the quality of entrepreneurial judgment is only partly a question of the personal characteristics or temperament of the individual. So far as it does turn on the personal ability of the entrepreneur, we can only treat it as we have treated other types of individual ability, and content ourselves with the observation that firms whose entrepreneurs are not capable of reasonably ‘sound’ judgments do not come within the class of firms with which we are concerned. That there are firms who consistently make mistakes, over-estimate what they can do, guess wrongly the future course of events, no one can doubt, but they do not interest us here; no theory of growth will explain their actions—only a theory designed to explain ‘mistakes’ or failure.

  To a large extent, however, the problem of entrepreneurial judgment involves more than a combination of imagination
, ‘good sense’, self-confidence, and other personal qualities. It is closely related to the organization of information-gathering and consulting facilities within a firm, and it leads into the whole question of the effects of risk and uncertainty on, and of the role of expectations in the growth of firms. These aspects of the matter can be made an integral part of the analysis of the growth process, because the ‘expectations’ of a firm—the way in which it interprets its ‘environment’—are as much a function of the internal resources and operations of a firm as of the personal qualities of the entrepreneur. This relationship we take up in the following chapters, but first a word about the significance of expectations.

  The Role of Expectations in the Productive Opportunity of the Firm

  Although the ‘objective’ productive opportunity of a firm is limited by what the firm is able to accomplish, the ‘subjective’ productive opportunity is a question of what it thinks it can accomplish. ‘Expectations’ and not ‘objective facts’ are the immediate determinants of a firm’s behaviour, although there may be a relationship between expectations and ‘facts’—indeed there must be if action is to be successful, for the success of a firm’s plans depends only partly on the execution of them and partly on whether they are based on sound judgment about the possibilities for successful action. In the last analysis the ‘environment’ rejects or confirms the soundness of the judgments about it, but the relevant environment is not an objective fact discoverable before the event; economists cannot predict it unless they can predict the ways in which a firm’s actions will themselves ‘change’ the relevant environment in the future. In any event, what the economist sees may be very different from what an individual firm sees, and it is the latter, not the former, that is pertinent to an explanation of a firm’s behaviour. Firms not only alter the environmental conditions necessary for the success of their actions, but, even more important, they know that they can alter them and that the environment is not independent of their own activities.41 Therefore, except within very broad limits, one cannot adequately explain the behaviour of firms or predict the likelihood of success merely by examining the nature of environmental conditions.