Theory of the Growth of the Firm

by Edith Penrose

  Changes in the Rate of Growth with Increasing Size

  The import of the above considerations is clear and can be easily summarized. There is a maximum rate at which each individual firm can grow under given circumstances. If we consider only firms for which these circumstances are extremely favourable, we should expect the rate of growth of the medium-sized and moderately large firms to be higher than that of the very new and very small firms and higher also than that of the very large firms. The pattern sketched need fit no individual firm; firms of the same size will not necessarily grow at the same rate, and the point at which the rate of growth starts its real decline will be different for different firms. Furthermore, this point may be extremely hard to locate statistically, for in practice growth takes place in spurts, and periods of relative decline may well be followed by periods of accelerated growth.

  The ‘Growth Curve’

  The testing of the theory set forth here is difficult indeed; all sorts of factors other than those controlling its ‘maximum’ rate of growth will affect the actual rate of growth of an individual firm in specific circumstances at a particular time, and the pitfalls of interpreting a growth curve’ when the end is not in sight are well known.216 Indeed, it could be argued that the discussion has been in a sense trivial and the conclusion obvious, for perhaps the central point is that firms, in common with most other things, cannot be expected to grow indefinitely at a compound rate. Nevertheless, what we have set forth is an explanation of the ‘typical’ pattern of growth (or growth curve’) that is widely believed to characterize the successful business firm, an explanation couched in terms of the mechanism of growth and related to the problems of growing bigger and not merely to the complexities of absolute size.217

  When a firm reaches a point at which its rate of growth tends to diminish, its absolute size is continuing to increase, and there is no reason to believe that some increase in the size of even the largest firms imaginable will ever become impossible. The limit to size, as demonstrated in Chapter II, lies not in the process of growth but rather is set by the administrative criteria that we choose to apply in deciding whether or not a given collection of economic activities constitutes a business firm instead of an investment holding company or financial ‘community of interest’.

  The decline in the rate of growth of the firm (as we have defined it) may be very slight and may show up primarily in a shift of the investment expenditures of the firm from activities within the firm, which we assume to be the preferred investment, to investment outside the firm, that is to say in other companies; there is nothing in this analysis which would lead to the conclusion that a firm’s power to grow financially necessarily declines at any point. Under such circumstances if one firm acquires a controlling stock interest in another, the application of a rule of thumb which automatically lumps the two firms together as one, regardless of the administrative arrangements for actual control, can be very misleading.

  This analysis of the expansion of an individual firm can in no sense, I must repeat, be taken as a model of the expansion of a ‘typical’ firm, whatever that may mean. We assumed a ‘special opportunity’ for the small or new firm which enabled it to grow until it reached the position of a large firm and faced the environment of ‘big business’ competition. Thus we evaded what is widely held to be the characteristic position of the small firm in a developed industrial economy—an inability to compete with large firms, an inability which precludes its growth into those areas particularly suitable for the operations of larger firms. If this were the characteristic position of small firms, it would be idle to discuss the prospects for their continued growth with reference to the quality of their entrepreneurs and the nature of their resources. The ‘environment’ in the shape of competition from large firms would determine their opportunities and would either confine them to certain activities in which large firms could not effectively operate or abruptly shut off their growth in other fields where large firms could operate. In other words, environmental conditions would limit the growth of small firms regardless of their resources or entrepreneurial ability.

  That a particular firm may not possess the productive services which would enable it to take advantage of opportunities in the economy for expansion is evident, and of no consequence for our analysis. But if whole groups of firms are in such a position because of their size alone, then the problem is more general and becomes of considerable significance for the theory of the growth of firms. We must now investigate this possibility and analyze the position of small firms in a growing economy.

  X

  The Position of Large and Small Firms in a Growing Economy

  The special position of small firms. Competitive handicaps, especially finance. The continued existence of small firms. Opportunities for growth. ‘Interstices’ in a growing economy. The principle of comparative advantage.

  THERE is considerable evidence that small firms, because of their size alone, are restricted by their environment to certain types of opportunity where the prospects of continued expansion are extremely limited. Aware of the possibility that the growth of this large group of firms may be more controlled by the environment than by the quality of resources or the enterprise and ingenuity of entrepreneurs, many readers have probably been uncomfortable with the way in which external conditions have so far been handled in this study. The environment has been treated not as an objective ‘fact’ but rather as an image’ in the entrepreneur’s mind; the justification for this procedure is the assumption that it is not the environment ‘as such’, but rather the environment as the entrepreneur sees it, that is relevant for his actions. While this assumption may be valid enough, it does not justify us in ignoring the effect of external conditions where there is reason to believe that they are sufficiently general and identifiable to enable us to predict, with reasonable assurance, how they will affect an entrepreneur’s actions.

  We have found that what an entrepreneur sees in his environment, and his ability to take advantage of what he sees, are conditioned by the types and amounts of productive services existing in the firm and with which it is accustomed to operate. For a general theory of the growth of firms this procedure is legitimate if we can assume that opportunities for expansion do ‘exist’ in some sense, and that some firms will always see them reasonably correctly and take advantage of them. In effect, then, we ask the questions what, under such circumstances, are the general conditions required for the continuous growth of an individual firm; what determines the direction and method of growth; and what are the fundamental limits to the rate of growth and the ultimate size of the firm. In other words, assuming that ‘real’ opportunities for profitable investment are to be found in the economy, what determines who will see them, who will be able to take advantage of them, and to what extent.

  In this way we brought to the centre of the analysis the significance of the types of resources of individual firms and the relationship, not only between ‘the inherited’ resources of a firm and the ability of the firm to take advantage of the opportunities perceived by its entrepreneurs, but also between these resources and the perceptions of the entrepreneurs. We thereupon examined the process of expansion, leaving by the wayside those firms lacking at any point the ability to grow. We dealt only with the restrictions on growth and size inherent in the nature of the firm, and only with the nature and characteristics of successful growth under specified conditions. The central analysis has not been concerned with the prospects of growth of particular firms, but only with an exploration of the characteristics of firms that can grow successfully, and of the factors shaping and limiting their growth. For this purpose it is appropriate to take the existence of a spectrum of opportunities as given, and to look to the productive services available to firms for the source of their ability to grow and for the determinants of their pattern of growth.

  Nevertheless, it remains true that the maximum possible expansion for all firms taken together is determined by the availabilit
y of resources (including labour, current output, existing assets, and new resources) for investment purposes, even though the actual amount of expansion attempted is controlled by the expectations of entrepreneurs about the profitability of using their own resources. The relative scarcity of the different kinds of resources in the economy as a whole affects the individual firm through the prices at which resources and finance can be obtained on the market; the expected profitability of expansion is controlled by the ability of the firm to see opportunities for the use of its own resources, and is a function not only of the cost of other resources with which they must be combined in production but also of the external opportunities themselves.

  Now none but the most philosophically sophisticated businessman will accept the proposition that the opportunities for the expansion of his firm are simply his ideas about what his firm can do; he will insist that the opportunities he sees reflect the ‘facts’ of the world, facts that may be known only with indifferent accuracy to be sure, but facts none the less—the prices of the factors of production, market conditions as determined by the actions of competitors and by the tastes, or at least the psychology, of consumers, the line of credit his bank will give him, etc. And of course the businessman is correct, for in the last analysis these are the facts’ with which he must deal and he is right in insisting that unless he has interpreted his environment correctly he is likely to fail in his efforts.

  There can be no question that for any particular firm the environment ‘determines’ its opportunities, for it must take its resources as given (in the sense that it must recognize the limitations on what it can acquire with what it has) and must look to the opportunities it can find for using them for the source of its power to grow. Whether or not we should treat the resources of the firm or its environment’ as the more important factor explaining growth depends on the question we ask: if we want to explain why different firms see the same environment differently, why some grow and some do not, or, to put it differently, why the environment is different for every firm, we must take the ‘resources approach’; if we want to explain why a particular firm or group of firms, with specified resources grows in the way it does we must examine the opportunities for the use of those resources.

  Clearly no general theory of growth can take into account all of the particular circumstances of particular firms that will determine their ability to grow; but if there are environmental circumstances which affect in a systematic manner whole groups of firms the resources of which have some significant characteristics in common, then it is appropriate to analyze the prospects of growth for firms in such groups. In doing this we go further than we have gone so far in examining a relationship between certain specific characteristics of the resource-base of a firm and the firm’s opportunities for expansion.

  The Special Position of Small Firms

  There is good reason to believe that the amount of resources administered by a firm has in itself a significant influence on the opportunities for expansion open to the firm, that is, that smaller firms as a group are in a different position vis-à-vis the external world from that of large firms as a group. We have already noted this in several places, in particular in the preceding discussion of changes in the rate of growth of firms with increasing size, but there, as well as in other places, we were concerned only with the amount and nature of the productive services required for expansion; we did not consider the possibility that the position of the firm might be such that the opportunities open to it were severely limited, not by the quality of its resources, but by impassable barriers existing in the environment. We ignored this possibility because we wanted to examine the processes of growth of only those firms for which no such barriers existed. Now, however, I want to take up the question of the restrictions on the opportunities for growth that are imposed on small firms by external conditions, in particular, by the superior competitive power of large firms.

  Competitive Handicaps, Especially Finance

  In point of fact, firms that are both larger and older in any economy or industry do tend to have many competitive advantages over smaller or newer firms, no matter how able the management of the latter may be. Their market connections tend to be more extensive, their standing in the capital market better, their internal funds larger—a successful past record is alone an enormous aid to further advance. They have accumulated valuable experience and, by virtue of their size, they can take advantage of many technological and organizational economies not possible at smaller scales of operation. These are not ‘monopolistic’ advantages in a restrictive sense, nor are they easily removable—they are corollaries of size, experience, and a successful past. We have already analysed in some detail the economies of size, and if we add the possibility of ‘unfair’ competitive practices stemming from the monopolistic power of large firms, the position of the smaller firms is even more unfavorable; but we need not do so in order to establish the point.

  The cause and consequence of most of these competitive disadvantages are evident enough, but a few words should perhaps be said about the problem of access to capital, one of the most serious of the competitive handicaps of the small firm. Here we deal with two questions: the relatively higher rate of interest that small firms must pay, and the absolute limit to the amount of capital they can obtain at any rate, both of which are the result of the inescapable fact that on the average the risk of lending to small firms is greater than to large ones. The former, though leaving the small firms at a cost disadvantage vis-à-vis larger firms, does not necessarily restrict the expansion plans of those small firms that believe their opportunities are likely to prove sufficiently profitable to justify the payment of a high rate of interest. For small firms as a group the relatively higher interest rate merely means that they must have more profitable opportunities than larger firms before they can obtain the capital for expansion, and that they may be unable to compete in the same field with the large firms.

  Restrictions on the amount of credit a small firm can obtain have a more far-reaching effect. Regardless of how bright may be its prospects, its expansion may be limited by an inability to obtain capital on any terms, and it may never get a chance to put its plans to the test. Its prospects are prejudged by outsiders, and the judgment is not based solely on the brightness of the opportunity but also on the fact that failure of the particular venture may involve the loss of the money advanced—the small firm is itself a greater risk. The larger firm, on the other hand, faced with the same risk of failure of a particular venture may nevertheless be able to raise capital because the total ‘security’ for the funds is so much better.

  It is, incidentally, because rationing is such an important means of restricting credit that anti-inflationary monetary policies can be expected to work to the disadvantage of small firms. If the monetary authorities raise interest rates and restrict the availability of bank credit during periods of high employment when ‘easy money’ would result in an inflationary rise of prices, the position of the small firms in the economy is likely to be more prejudiced by the pressure on the reserves of the banks and by the consequent credit rationing than it would have been by rising prices. In general, rising interest rates and restrictions on bank credit are designed merely to reflect the scarcity of real resources for further investment; if credit were cheap and easy to obtain, prices of resources would be bid up, the cost of expansion would rise and, even apart from any subsequent depression brought on by an inflation, no net gain would be obtained by industry as a whole from the ‘artificially’ low cost of finance capital.

  But when prices of resources other than capital rise, the relative competitive ability of the small firms to obtain resources is not necessarily worsened (though it may be), whereas it is necessarily worsened when credit is tightened and the tightening involves not only rises in interest rates but also increased credit rationing. If only interest rates rise, the small firms may be able to obtain the capital necessary to enable them to put their prospects to the
market test whenever they are willing to pay the price; if credit is denied them, they are not permitted to do so, and consequently even firms with opportunities they confidently believe would turn out to be genuinely profitable in spite of rising costs or high interest rates, are precluded from taking advantage of them and are not even given a chance to test them. The special ‘capital-raising’ ingenuity of entrepreneurs rises in importance for the small firm in relation to the other productive services available to the firm, but there is no presumption that such ingenuity has much relationship either to the firm’s productive efficiency or to its competitive ability in the market for its products. We have noted in earlier chapters that this peculiar type of entrepreneurial service may be an essential ingredient of the collection of productive services required for the successful expansion of the small firm.

  The Continued Existence of Small Firms

  The competitive disadvantages of small firms are so serious that economists have apparently felt some special explanation of the continued existence of small firms to be required. It would seem that at any given time a fair number of small firms would be in existence simply because they were young, and that at a later date the same firms would have developed into medium-size or large firms. This possibility, however, is rarely included among the explanations advanced for the existence of small firms, the analysis usually being presented in terms of the economies and diseconomies of size, using a kind of ‘static’ or cross-section approach.218 Thus, in effect, the various explanations place small firms in our class of ‘firms that do not grow’ or, at least, that do not grow very much.