Theory of the Growth of the Firm

by Edith Penrose

  26 This is not only true in a country like the United States where firms have reached a very large absolute size, but also in some smaller countries as well. In the sample of large industrial firms that I studied in Australia, for example, not one was effectively owner-controlled in spite of the fact that no firm in Australia would be considered large in comparison with United States firms. The only exceptions were some of the wholly-owned subsidiaries of foreign corporations, and even here the influence of management was often very strong in all policy decisions.

  27 This does not mean that executives will keep their own salaries small in order to leave more for profits. On the contrary, the salaries of top executives will tend to get as high as the community will condone or as the conscience of the executives themselves will permit (and sometimes higher if the size of the remuneration can be concealed or ‘justified’ by devices such as stock purchase options or other bonuses). The total remuneration of ‘top’ executives in a large corporation will be such a small proportion of total profits that its effect on net profits has little practical significance, and the executives know this.

  28 It has been argued, for example, that an enterprise attempts to maximize net income to its owners, but that this is equivalent to maximizing the present worth of its assets, ‘for the significance of the assets to the firm is their ability to contribute to the realization of the desired stream of dividends’, that is, ‘the stream of cash payments (dividends) to owners (shareholders) having the greatest present worth’. N. S. Buchanan, The Economics of Corporate Enterprise (New York: Holt, 1940), p. 209.

  I am saying, on the other hand, that the enterprise must be considered separately from its owners from this point of view. In the calculation of the present value to owners of a dividend stream, dividend payments in the near future should be given more weight than dividend payments in the distant future. For the firm, however, dividend payments in the present may reduce funds available for investment and therefore reduce net earnings in the future, and there is no evidence at all that firms consider that the greater value of present cash payments to owners offsets in any degree the value to be attached to the prospect of higher earnings for the enterprise in the future. Furthermore, the ‘significance of assets to the firm’ may just as well be considered to lie in their ‘ability to contribute’ to meeting a ‘desired’ payroll, a ‘desired’ managerial bonus payment, or any other ‘desired’ cost. Only if higher dividends in the present are expected to maintain or increase the availability of capital funds in the future will the firm have an incentive to make them.

  29 Of course, no assumption about motivation will fit all firms. Indeed, there are many examples of firms that have been ‘milked’ by those in a position to do so, and the firm destroyed because individuals in control were more interested in protecting their own interests than those of the firm or even of its owners. See, for example, the story of the destruction of the Amoskeag Manufacturing Company by a group of somewhat unscrupulous trustees. Alan Sweezy, ‘The Amoskeag Manufacturing Company’, Quarterly Journal of Economics, Vol. LII (May 1938), pp. 473–512.

  30 It should be noted that this in no way gets around the ambiguities inherent in the notion of a ‘most profitable’ course of action in an uncertain world where businessmen possess different degrees of optimism and different attitudes toward risk and uncertainty. These questions are discussed in the next chapter.

  31 Compare, for example, the views of one of the more ‘popular’ writers on business matters. Speaking of large corporations Herrymon Maurer remarks, ‘Such an enterprise is too big for any one owner or group of owners to control. It is run, therefore, not primarily for the stockholders, who have generally become used to a socially approved return on their investment, but for the enterprise itself. The aim of the enterprise is not immediate or even future maximum profits, once thought to be the goal of all enterprise, but healthy future existence, to which the size of profits is an important but secondary consideration’. Herrymon Maurer, Great Enterprise: Growth and Behavior of the Big Corporation (New York: Macmillan, 1955), p. 186.

  32 ‘Payout, under an ideal dividend policy in a growth situation, should not exceed the minimum amount necessary to maintain the market position and integrity of existing debt and equity issues and of issues contemplated in the near future’. Harold Quinton, ‘Financing Growth Industries in an Inflated Economy: Standards, Theory and, Practice’, in Long-Range Planning in an Expanding Economy (American Management Association, General Management Series, No. 179), p. 29.

  33 The term ‘entrepreneur’ throughout this study is used in a functional sense to refer to individuals or groups within the firm providing entrepreneurial services, whatever their position or occupational classification may be. Entrepreneurial services are those contributions to the operations of a firm which relate to the introduction and acceptance on behalf of the firm of new ideas, particularly with respect to products, location, and significant changes in technology, to the acquisition of new managerial personnel, to fundamental changes in the administrative organization of the firm, to the raising of capital, and to the making of plans for expansion, including the choice of method of expansion. Entrepreneurial services are contrasted with managerial services, which relate to the execution of entrepreneurial ideas and proposals and to the supervision of existing operations. The same individuals may, and more often than not probably do, provide both types of service to the firm. The ‘management’ of a firm includes individuals supplying entrepreneurial services as well as those supplying managerial services, but the ‘competence of management’ refers to the way in which the managerial function is carried out while the ‘enterprise of management’ refers to the entrepreneurial function. The nature of the organization of a firm and the relationships between the individuals within it have often as important an influence on the competence and enterprise of management and on the kinds of decisions taken as do the inherent characteristics of the individuals themselves. The influence of ‘organizational structure’ has been particularly stressed by the ‘organization theorists’. See, for example R. M. Cyert and J. G. March, ‘Organization Structure and Pricing Behavior in an Oligopolistic Market’, American Economic Review, Vol. XLV, No. 1 (Mar. 1955), pp. 129–39.

  34 As Kenneth Boulding has suggested in ‘Implications for General Economics of More Realistic Theories of the Firm’, American Economic Review (Papers and Proceedings), Vol. XLII, No. 2 (May 1952), p. 40.

  35 Entrepreneurial services are probably required in some degree in most firms, for only if all the activities of a firm are carried out in a well-defined traditional way can one say strictly that no entrepreneurial function is being performed. It is, I think, important to recognize that there are varying degrees and qualities of ‘enterprise’. The Schumpeterian ‘entrepreneur’, though more colourful and identifiable, is too dramatic a person for our purposes. Schumpeter was interested in economic development and his entrepreneur was an innovator from the point of view of the economy as a whole; we are interested in the growth of firms, and here the entrepreneur is an innovator from the point of view of the firm, not necessarily from the point of view of the economy as a whole.

  36 The history of the Farr Alpaca Company provides an instructive example not only of the effect of enterprising leadership on a small firm’s ability to raise capital, create markets, alter its product lines as conditions change, and grow large and powerful, but also of the effect on a successfully established firm of the advent of unenterprising and short-sighted leadership when its original ‘productive opportunity’ declines. Frances G. Hutner, The Farr Alpaca Company: A Case Study in Business History (Northampton, Mass.: Dept. of History, Smith College, 1951).

  37 Such, for example, was the ability of W. R. Morris (later Lord Nuffield), the well-known British automobile industrialist, to inspire confidence, that once when he asked for credit from a bank and was turned down, one of the directors of the bank threatened to sell his shares in the bank and finance Morris per
sonally. Morris got the money, for, as Andrews reports, ‘ . . . in the last resort, what really interests a bank is just this sort of judgment of personalities [and] it was prepared to give way. . . ’. P. W. S. Andrews and Elizabeth Brunner, The Life of Lord Nuffield (Oxford: Basil Blackwell, 1955), pp. 105–6.

  38 A prominent management consulting firm has stressed the same point: ‘Among the resources which are scarce in the economic sense are certain psychological aptitudes including the spirit of enterprise and the ability to organize and run a new firm. There is reason to believe that only a small fraction of the working population possess these talents to an extent which is adequate for success.. . . The allocation of entrepreneurial skills is a controlling factor in the allocation of other scarce resources. A primary function of the entrepreneur is to persuade investors to put up their money.. . . If he does not posses adequate personal funds to launch the business he must then convince others that a differential advantage exists and can be exploited effectively at the proposed level of capitalization. Thus the size of the capital requirement is not in itself a barrier if a genuine opportunity exists. The larger the amount required, however, the smaller may be the number of prospective entrants who will be able to gain the confidence of investors either because of their persuasive powers or because of a personal record of success.’ Alderson and Sessions, Cost and Profit Outlook, Vol. VII, No. 11 (Nov. 1954), p. 2. (Italics added).

  39 For a discussion of the special problems of small firms see Chapter X below.

  40 From one point of view, perhaps, these two types of entrepreneur are analogous to the ‘Stickers’ and ‘Snatchers’ that Hicks has described with respect to pricing policy. The former are concerned with building up a steady business, the latter with quick profits. See J. R. Hicks, ‘The Process of Imperfect Competition’, Oxford Economic Papers, New Series, Vol. VI, No. 1, (Feb. 1954), pp. 41–54.

  41 See my article ‘Biological Analogies in the Theory of the Firm’, American Economic Review, Vol. XLII, No. 5 (Dec. 1952), pp. 814–15, and the subsequent Rejoinder to the Reply of A. A. Alchian, ibid. (Vol. XLII, No. 4 (Sept. 1953), pp. 600–9.

  42 In spite of the fact that acquisition is one of the most significant and powerful methods by which firms do in fact grow, it is useful for analytical purposes to discuss growth by merger separately. In the first place, the factors limiting expansion by merger are much the same as those limiting ‘internal’ growth but they operate somewhat differently. Secondly, the process of expansion by merger raises difficult problems regarding the nature and function of the firm, and this in turn requires that the consequences of growth by merger be appraised somewhat differently from the consequences of growth by internal expansion.

  43 The judgment regarding which of several alternative possibilities is ‘best’ will, of course, for any given firm be influenced by the attitude of the firm’s entrepreneurs towards risk and by their ideas about the kind of action appropriate to their firm. We need not inquire into these things for the present but merely assume that they remain unchanged from one planning period to the next.

  44 The emphasis I am placing on managerial experience within a firm does not imply that ‘outside’ experience is not also very valuable, especially for the ‘chief executive’ of a large corporation. It should be remembered that the ‘management group’ that we are discussing includes the entire managerial organization, subordinates as well as ‘chiefs’. Herrymon Maurer, in his breezy and journalistic, but frequently shrewd discussion of the ‘big corporation’, points out that decisions in the modern corporation are ‘group’ decisions in which the president, or chief executive, of the corporation may take little direct part; his role being that of providing relatively unobtrusive guidance, lubrication, and conciliation. It is incidentally for this reason that, while the management group as a whole must be experienced in working together, a new ‘leader’ from outside with the required personal qualifications and general experience, may very effectively preside over and ‘lead’ the ‘team’. See Herrymon Maurer, Great Enterprise: Growth and Behavior of the Big Corporation. (New York: Macmillan, 1955). Mabel Newcomer also stresses the contribution of outside experience to the successful functioning of the chief executives of large corporations. Her study dealt only with Presidents and Board Chairmen, but from the point of view of the problems of expanding an administrative organization these officials may be of less importance than their subordinates. See Mabel Newcomer, The Big Business Executive (New York: Columbia University Press, 1955).

  45 For example, in a report of the National Science Foundation it was noted that one chemical company in their survey ‘has developed an optimum rate-of-growth factor expressed in terms of an annual percentage increase in personnel. The percentage is based upon the number of new employees the company believes can be successfully assimilated each year. This percentage is applied to the company’s research staff, as well as to the other parts of the firm, but with modifications depending on the amount and kind of research considered necessary to assure overall company growth at the established rate.’ National Science Foundation, Science and Engineering in American Industry: Final Report on a 1953–1954 Survery (Washington D.C.: U.S. Government Printing Office, 1956), p. 48.

  46 The former director of the Tennessee Valley Authority, in discussing the problem of developing atomic energy quickly during the war and of putting production on an industrial basis, mentioned the various types of skills that were needed, and added ‘most important of all, these three capabilities of research, industrial techniques and operation had to be combined in the same team, with experience in working together as a unit. To go out and create such an organization was out of the question. There was not time.’ This was why it was necessary, he says, to turn to already established organizations, such as the Bell telephone system. David Lilienthal, Big Business: A New Era (New York: Harper, 1953), p. 102.

  47 One student of industrial organization has noted that ‘. . . business enterprise today (as we must not cease to observe) is a corporate manifestation and its capacity to cope with larger outputs is not fixed but expands with its structure—and depends on the relation. . . between the governing members of the corporation.. . . Some firms will fail with size because of management, if the immediate jump in size which they attempt is too great; or if the management is incapable of adapting its structure. . .’. P. Sargant Florence, The Logic of British and American Industry (London: Routledge and Kegan Paul, 1953), p. 64.

  48 The problem is more often mentioned in the literature of industrial organization than in ‘theoretical’ economics, but even the latter has not ignored it. R. F. Harrod, for example, found the ‘preponderating answer to the question why an entrepreneur does not move forward along his increasing returns curve’ to be in the fact that his ‘enterprise is a delicate organism with complicated labour relations and managerial relations. There is an optimum rate at which labour can be diluted and management formalized in the way required for larger scale; to accelerate beyond this rate would not yield increasing returns’. R. F. Harrod, Economic Essays (London: Macmillan, 1952), pp. 184–5.

  49 It should be noted that this analysis applies only to the scale of organization of the firm, not necessarily to the scale of its production measured in terms of capital investment. As we shall see, in Chapter IX, for a given capital expenditure, the organizational problem may be reduced by the use of large-scale equipment and technical processes.

  50 See for example, C. Roland Christensen, Management Succession in Small and Growing Enterprises (Harvard: Harvard University Press, 1953) for a good discussion of the managerial limits on the expansion of small firms. He stresses the time it takes to develop a good manager, the lack of experienced personnel in the small firm, and the relation between existing managerial abilities and the development of new men to take on managerial functions.

  51 Even when it has been recognized that the existing staff of a firm limits the amount of expansion it can undertake, the relation between the exi
sting staff and the firm’s past activities has not always been perceived. Robert Dorfman recognized, for example that ‘Within a short time-period [the permanent and integrated staff of the establishment] limit absolutely the opportunities available to the firm, and in a dynamic context they limit the firm’s rate of growth’; yet four pages later he commented, ‘Dynamic models are particularly adapted to the study of self-contained organizations whose current activities are to a significant extent dependent on their own recent past. They do not appear to be readily applicable to the study of individual firms or industries which can procure necessary equipment from outside and can finance such procurement by recourse to external sources of credit.’ Robert Dorfman, Application of Linear Programming to the Theory of the Firm (Berkeley: University of California Press, 1951), pp. 86 and 90.