Theory of the Growth of the Firm

by Edith Penrose

  From our point of view, the significance of indivisibility does not lie so much in the fact that large units of equipment or large-scale processes may be most efficient in certain types of production—the traditional examples being railways, public utilities, mass production industries, etc. It lies rather in the fact that a large number and variety of indivisible resources are used. None of these need be very large, but if each is capable of rendering not only different amounts, but also different kinds of services, a combination that achieves the full utilization of all of them may perforce call for an output much larger and more varied than can be organized by a firm in any given period of time.

  We have seen that there is a limit on the amount of expansion a firm can undertake at a given time. Obviously the output that will fully use the productive services available from every one of the firm’s resources can be reached only if there is no limit short of this output on the availability of any of the productive services required to produce that output. If we take into account all of the resources used by a firm, the limit on the amount of expansion it can plan may well force it to forgo the use of many of the services available to it. In other words, in putting together the jig-saw puzzle of resources required in an expansion programme, the firm may find that a number of awkward corners persist in sticking out.68

  On the other hand, we have also seen that the limit on expansion is a receding one; in the next period the firm can undertake still more. But in the process of expansion the firm will acquire still further resources, and the individual units of many of these will vary in the amount and type of service they can provide. Thus the ‘multiple’ will again be changed, and further expansion may be called for; the firm may be aware that this will be the case even before it undertakes the expansion, but be unable to do anything about it; the firm needs the resources it acquires, but at the same time it cannot plan a programme large enough to use all of them fully.

  The jigsaw puzzle becomes more complicated when we consider imperfections of the market, whether they arise from transport costs, monopoly positions, competitive differentiation of products, or the necessity of incurring selling costs. The full use of important resources in the process of production may, under such conditions, require some diversification of output because further expansion of some existing product lines may not be warranted by market conditions at the time, even though further growth in demand for these products may be expected in time.

  When, however, a firm embarks on a programme of diversification, new types of resources rendering services quite different from those required to produce its older products will be added to the firm’s collection of resources, and the problem of ‘balancing processes’ may carry the firm off in entirely new directions.69 Examples of this process will be given in Chapter VII, which deals with the economics of diversification.

  Since attempts to achieve a ‘balance’ in the utilization of resources can never reach the continually receding goal, some resources will always be only partly used and some will be used less efficiently than they would have been in the absence of the restriction on the firm’s expansion. ‘Idle’ services range from those available from resources which could be by-products but which are in fact treated as waste-products and thrown away or dumped (because the firm cannot organize the profitable exploitation of them and is unable to sell them) to idle man- or machine-hours at various points in the production process and in the managerial staff.70 By-products and certain other types of potential joint-products have in fact provided an important basis for expansion for some firms, once the energies of management could be released from the task of expanding the firm’s primary lines.

  The Specialized Use of Resources

  The avoidance of ‘idleness’ in resources is only one aspect of the problem posed by the indivisibility of resources and by the logical implications of the ‘principle of multiples’ for the planning of the most efficient scale of a firm’s operations. A firm has an incentive not only to engage in operations large enough to eliminate pools of idle services, but also to use the most valuable specialized services of its resources as fully as possible. A small firm may employ a chemist to test products in the process of production even though his services as a chemist are required only a few hours a day. The rest of his time may be used in checking inventories or in sending out accounts; he is not ‘idle’, but neither are his most valuable services fully used because the firm’s output is too small to permit their use. In general, the extent to which a firm can employ the most advantageous division of labour depends on the scale of its operations; the smaller its output the less can resources be used in a specialized manner.

  That increasing division of labour is promoted by large markets, and that division of labour makes possible a more efficient use of resources, are among the most firmly accepted of the principles of economics. An increase of efficiency in the use of resources through the specialization of firms on narrowly defined products or processes was early seen to be a characteristic of the ‘industrial revolution’.71 But just as the division of labour in the economy as a whole is limited by the demand for goods and services, so within a firm the division of labour, or the specialization of resources, is limited by the total output of the firm, for the firm’s output controls its ‘demand’ for productive services. If the chemist in our example were used only as a chemist, then other workers would have to be employed to check inventories and to send out accounts, but the employment of these new personnel becomes profitable only if the scale of operations is enlarged.72

  Thus specialization can take place within a firm only to the extent that the output of the firm is large enough to justify it. In other words, increasing advantages from further division of labour within a firm are available to the firm only if it can grow. By the same token, to expand efficiently, a firm must effect a division of labour appropriate to the size of the expansion it wants to undertake.

  An extreme illustration of this was given earlier in another connection where it was pointed out that if the manager of a small firm is unwilling to relinquish any of his functions to others he creates a bottleneck which will effectively restrict further growth. In general, it can be said that when the demand for specialized services is sufficient to justify the specialization of resources, a failure on the part of a firm to effect at least a minimum degree of specialization will lead to such inefficiency that even firms in highly protected positions will run into serious administrative or technical trouble with a consequent severe increase in costs. A firm with only half a dozen administrative personnel would hardly consider a type of organization where there was no division of labour at all between the administrators, each doing a bit of everything in turn.

  As a firm grows in size, therefore, it will reorganize its resources to take advantage of the more obvious opportunities for specialization. As a result, a higher level of output will be required if full use is to be made of resources. In consequence, the process of growth which itself necessitates, at least up to a point, increasing specialization, gives rise at the same time to higher and higher ‘lowest common multiples’ with respect to the output which will fully use the specialized services of the resources acquired. This has been called the ‘virtuous circle’ in which ‘specialization leads to higher common multiplies, higher common multiples to greater specialization’.73

  The mere fact, however, that a higher level of output is called for does not mean that a firm can plan the amount of expansion necessary to produce it. To the extent that the problem is primarily one of attaining the lowest-cost scale of production for a given product, it seems probable that a point will be reached where no further gains are to be obtained from specialization. But the process is a good deal more than this, for the advantages of using the specialized services of resources may themselves lead a firm to diversify its final output. It often happens, for example, that there are ‘stages’ in the processes of production in which significant economies can be obtained if sufficient use can be made
of specialized resources. This may promote diversification of final output by encouraging a firm to produce a group of products which require the same productive services at some stage, for example, products that use raw materials processed in common, or products that are sold through the same channels of distribution. In other words, if a group of products have costs in common, specialization at the point of common cost may reduce the cost of production of any one of them. And once new products are added, new types of specialized resources may be required at other stages of production or distribution, and a new series of advantages from further specialization in still different directions may become obtainable.

  The new resources required are, of course, not only managerial, but include other types of personnel, such as engineers and salesmen, as well as physical resources, such as plant and equipment. Moreover, with larger outputs it becomes profitable to use different kinds of resources and processes. In particular, it becomes profitable to employ expensive capital equipment instead of, or in addition to, specialized labour resources, and to undertake activities unprofitable at smaller scales of operation, such as extensive advertising, market analysis or other research. The total of the productive services available to the firm is again enlarged, and the ‘jigsaw’ puzzle changes in size. But there is every reason to assume that the problem of fully using all resources will never be solved, partly for the reasons discussed above, but partly also because new services will become available from existing resources—services which were not anticipated when the expansion was originally planned. Why new services from managerial resources will be created has already been demonstrated; but the change in the services of managerial resources also changes the nature of the productive services available from other resources, as well as the significance to the firm’s management of existing services. Let us see how.

  The Heterogeneity of Resources

  Productive services are not ‘man-hours’, or ‘machine-hours’ or ‘bales of cotton’, or ‘tons of coal’, but the actual services rendered by the men, machines, cotton, or coal in the productive process. Although it is manifestly services in this sense that are the actual (physical) ‘inputs’ in production, a less specific or more indirect definition is usually required when services must be expressed as measurable homogeneous quantities, for example, if it is desired to measure the cost of certain productive services or to construct technological production functions for certain outputs. In the theory of production, therefore, manhours, machine-hours, acre-years, or the units in which a resource is acquired, are themselves often treated as the productive services of the resource.74 Such generalized definitions of services are sufficient where it is the homogeneity of the services per unit of any given resource that is relevant for the analysis; they are not useful where the heterogeneity of the services contained in resources makes a fundamental difference.

  For many purposes it is possible to deal with rather broad categories of resources, overlooking the lack of homogeneity in the members of the category. Economists usually recognize this, stating that for convenience alone resources are grouped under a few heads—for example, land, labour and capital—but pointing out that the sub-division of resources may proceed as far as is useful, and according to whatever principles are most applicable for the problem in hand.75 There are many resources of which each unit is so much like every other unit that a homogeneous category can be established which includes a large number of units. This is true of many materials. With respect to other resources, however, each unit may be so unique that any classification, except one that makes each unit a separate resource, must disregard some heterogeneity; this is the case for human beings, land, and certain other types of resources.

  The lack of homogeneity within any classification of resources does not much matter if we are concerned only with the analysis of the supply of particular services (as is true for the most part in the theory of production) and if there is a reasonable relation between the amount of service supplied and the measure of the service in terms of the resource. For some productive services even this is lacking: entrepreneurial services are the classic example and many economists have refused to include entrepreneurs among the ‘factors of production’ since the heterogeneous nature of entrepreneurial services is such that no ‘unit’ of input can be devised. The number of entrepreneurial man-hours has surely very little relation to the ‘amount’ of service rendered. This is equally true of research personnel, of the higher grades of managerial personnel, and similar types of human services. In all these cases, not only is each resource unique, but many of its services are unique in the sense that the same service is not repeatable. An idea produced, a decision made, an important employee grievance settled, are each a unique operation of value in the organization of production—services performed which cannot be repeated. There is no supply curve or production function into which such services can be fitted, but they are nevertheless inputs in production.

  The fact that most resources can provide a variety of different services is of great importance for the productive opportunity of a firm. It is the heterogeneity, and not the homogeneity, of the productive services available or potentially available from its resources that gives each firm its unique character. Not only can the personnel of a firm render a heterogeneous variety of unique services, but also the material resources of the firm can be used in different ways, which means that they can provide different kinds of services. This kind of heterogeneity in the services available from the material resources with which a firm works permits the same resources to be used in different ways and for different purposes if the people who work with them get different ideas about how they can be used. In other words there is an interaction between the two kinds of resources of a firm—its personnel and material resources—which affects the productive services available from each.

  Interaction between Material and Human Resources

  For physical resources the range of services inherent in any given resource depends on the physical characteristics of the resource, and it is probably safe to assume that at any given time the known productive services inherent in a resource do not exhaust the full potential of the resource. In other words, it is likely that increases in knowledge can always increase the range or amount of services available from any resource. Of the services available, only a few can be profitably used by a given firm at a given time. Some of the services may be alternative uses of the resource—if used for one purpose the resource cannot be used for another; some of them may be suitable only for products which the firm, because of cost and demand conditions, cannot profitably produce under the circumstances; some of them may be useful only in combination with other types of services which the firm cannot obtain at the time.

  The possibilities of using services change with changes in knowledge. More services become available, previously unused services become employed and employed services become unused as knowledge increases about the physical characteristics of resources, about ways of using them, or about products it would be profitable to use them for. Consequently, there is a close connection between the type of knowledge possessed by the personnel of the firm and the services obtainable from its material resources.

  That the knowledge possessed by a firm’s personnel tends to increase automatically with experience means, therefore, that the available productive services from a firm’s resources will also tend to change. In addition, there is likely to be an increase in what, for want of a better term, I have in Chapter IV called ‘objective’ (or transmissible) knowledge. ‘Objective’ knowledge does not automatically increase in the same sense that the experience of a firm’s personnel will automatically accumulate as the firm operates. The search for ‘objective’ knowledge is, in a way, deliberate and voluntary, but at the same time it is so much a part of the normal operations and thinking of businessmen that it cannot safely be left outside our system of explanation. Economists have, of course, always recognized the dominant role that increasing knowle
dge plays in economic processes but have, for the most part, found the whole subject of knowledge too slippery to handle with even a moderate degree of precision, and have made little attempt to analyze the effect of changes in the traditional economic variables upon changes in knowledge76. We cannot afford to avoid such an analysis here because not only are the significance of resources to a firm and the productive services they can yield functions of knowledge, but—and this is the crucial fact—entrepreneurs are fully aware of this. Surely extensive questionnaires are not required to convince us that able businessmen are well aware that the more they can learn about the resources with which they are working and about their business the greater will be their prospects of successful action.

  A firm is basically a collection of resources. Consequently, if we can assume that businessmen believe there is more to know about the resources they are working with than they do know at any given time, and that more knowledge would be likely to improve the efficiency and profitability of their firm, then unknown and unused productive services immediately become of considerable importance, not only because the belief that they exist acts as an incentive to acquire new knowledge, but also because they shape the scope and direction of the search for knowledge. If there are circumstances in which a businessman acquainted with the properties of the resources at his disposal (including his own abilities) says to himself regarding a particular resource, ‘there ought to be some way in which I can use that’, and subsequently proceeds to explore the possibilities of using it, then we can fairly conclude that he believes there are productive services inherent in that resource about which as yet he knows little or nothing. The effort to discover more about the productive services of a resource may take the form of research into its characteristics or of research into ways of combining its known characteristics with those of other resources.