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The Theory of the Growth of the Firm – Edith Penrose (1959)

The discipline of social science research has traditionally been male dominated. Whether it be

economics, sociology, or psychology- the three building blocks of modern day management

studies, there have been very few female researchers. One of the most celebrated women

economists was Edith Penrose (1914-1966), who inked the landmark book- Theory of the

Growth of the Firm in 1959, and which led to the genesis of the Resource Based View of the

Firm as a dominant paradigm in today's strategic management research. Her contribution is so

legendary that one can't but talk about management, resources and strategy without borrowing

several of her ideas, and indeed she was ahead of her times, for it took almost 25 years before the

first paper on resource based view (Wernerfelt, 1984) came out, and ushered a whole new way of

thinking about firm's competitive advantage.

Here is an attempt to revisit some of the most significant contributions made by

Penrose and to put those in the context of the present day management thinking.

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Introduction

The purpose of the study was to identify the causes of growth of the firm, and the

factors that leads to limiting its rate of growth. The author studied for-profit corporate,

and those that had grown over the years, firms which are endowed with certain

resources, managed by the managers. She identified 'enterprising managers' as one

condition without which a firm's continued growth is precluded. Or more generally

speaking, a firm's existing human resources provide both an inducement to expand

and a limit to the rate of growth. From a knowledge perspective, a firm's rate of

growth is limited by the growth of knowledge within it, but a firm's size by the extent

to which administrative effectiveness can continue to reach its expanding boundaries.

The firm in theory

A theory of the firm answers questions around price determination and resource

allocation. Penrose defines a firm as a collection of (productive) physical and human

resources. It is 'an administrative planning unit, the activities of which are

interrelated and are coordinated by policies which are framed in the light of their

effect on the enterprise as a whole' (pp.15-16). This model of the firm has a central

managerial discretion responsible for general policies. The areas

of coordination and authoritative communication define the boundaries of the firm.

The firm is more than an administrative unit, and is 'a collection of productive

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resources the disposal of which between different users and over time is determined

by administrative decisions' (pp.24).

Penrose identifies two types of resources- physical and human. These resources are

themselves a bundle of potential services. Hence the size of the firm is the present

value of the total of its resources used for own productive purposes. Such a firm is

interested in profits in order to pay out dividends to its owners, which means that the

financial and investment decisions of firms are controlled by a desire to increase total

long-run profit.

The productive opportunity of the firm and the 'entrepreneur'

A business firms = administrative organization + collection of productive resources.

The productive activities of the firm are governed by the productive opportunities as

seen by the entrepreneur. The growth gets limited by the fact that the firm doesn't see

opportunities for expansion, is unwilling to act upon them, or is unable to respond to

them (p.32). For a firm, 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

(pp.34). Hence, the managerial competence of a firm is to a large extent a function of

the quality of the entrepreneurial services available to it (pp.35).

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The first of entrepreneurial services is entrepreneurial versatility, which comprises

of imagination and vision, manifested in terms of vigorous, experimentative and

creative managers. Another quality is fundraising ingenuity, which comes from the

ability of creating confidence, which often limit smaller firms. Yet another

is entrepreneurial ambition, which could be of two types- 1) product-minded or

workmanship-minded, and 2) empire-builder. Next quality is entrepreneurial

judgement, which stems from information gathering and consulting facilities built

within the firm.

The subjective opportunities stems from expectations, and not objective facts; and this

way the firm alters its external environment.

Expansion without merger: The receding managerial limit

The capacities of the existing managerial personnel of the firm necessarily set a limit

to the expansion of that firm at any given point in time, for it is evident that such

management cannot be hired in the market-place (p.46). The existing management not

only limits the amount of new management that can be hired, but also the rate at

which the new management can gain requisite experience; otherwise the efficiency of

the firm suffers.

Since the service from the inherited managerial resources control the amount of new

managerial resources that can be absorbed, they create a fundamental and

inescapable limit to the amount of expansion a firm can undertake at any time (pp.48).

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In small firms such a planning and execution function of expansion in sporadic, while

in large firms it is continuous. Any substantial expansion normally involves both

acquisition of new personnel and promotion and redistribution of the old. The

increasing experience of managers shows itself in two ways- changes in knowledge

acquired and changes in ability to use knowledge. Hence, the firm expands to exploit

it unused managerial services; the so called managerial limits to expansion. However,

firm's expansion plans are restricted by increasing risk and uncertainty, for as long as

the entrepreneur is assumed to be passive, which is seldom the case.

An entrepreneur can manage risk and uncertainty by deploying managerial

resources to gather more information, which in turn depends upon the competence

and temperament of the management. Risk and uncertainty can be reduced to the

extent that the firm can devote managerial resources, but can't be done away with

entirely. The managerial attitude towards risk limits growth of the firm, as the

resources have to be shared between operations, and planning (for containing risk and

resource acquisition).

Inherited resources and the direction of expansion

A firm's direction of expansion is determined by inducements and obstacles, both

internal and external. The external inducements include new markets, new

technological changes, and innovations, while obstacles could be in the form of

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competition, trade restrictions, monopolies, etc. Unless a firm's internal inducement

offers a competitive advantage, there is little reason to expand.

Internal inducements to expansion arise largely from the existence of pool of unused

productive services, resources, and special knowledge, all of which will always be

found within any firm (pp.66). So long as resources are not used fully in current

operations, there is an incentive for a firm to find a way of using them more fully.

However, an equilibrium state where a firm's all available services are fully used is

unlikely to reach, for many resources may be indivisible (least common multiple of a

resource set); can be put into new and different uses (specialization requires a

minimum scale); and new productive services are continually created (owing to

heterogeneity of managerial services).

The interaction between knowledge possessed by the personnel and services rendered

by the material resources can take different and creative shapes. The possibility of

using a service changes with change in knowledge, for with more knowledge

available previously unused services can now be used. Any entrepreneur hence

believes that there is productive services inherent is that resource about which as yet

he knows little or nothing (pp.77). There is an productive interplay between services

available with a resource, and the capabilities of men using those resources, who in

turn can create new services. Limits to growth of the firm is set by the perceived

demand by the entrepreneur, and as the firm grows in size its composition of product-

market mix changes accordingly.

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The availability of unused productive services, for the enterprising firm, is a challenge

to innovate, an incentive to expand, and a source of competitive advantage (pp.85).

The direction of planned expansion is shaped by the inherited resources, and the

resources the firm must acquire to carry out its production and expansion programs.

The economies of size and economies of growth

Penrose argues that the expansion of firms is largely based on opportunities to use

their existing productive resources more efficiently than they are currently being used

(pp.88). A large firms has technological and managerial economies. Technological

economies is determined by the cost of technology, cost of capital and raw material,

and will affect the size of the plant. Managerial economies, on the other hand include

marketing, financial and research economies of the managers employed by the firm;

and results into specialization of human resources. Such economies, and resulting cost

advantage of large firms, enable firms to expand in only certain directions.

The economies of growth depends upon the particular collection of productive

resources possessed by the particular firm, and the exploitation of opportunities

provided by these resources may be quite unrelated to the size of the firm (pp.100).

The economies of diversification

Diversification is defined here as 'increase in the variety of final products produced,

increase in vertical integration, and increases in the number of 'basic areas' of

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production in which a firm operates' (pp.109). Diversification can take place in a

firm's present area of specialization or outside of it. The opportunities to produce new

products arise from changes in the productive services and knowledge available in the

firm, and from external supply and market conditions perceived by the firm.

Some of the most important general sources of new opportunities for diversification

are: 1) new technologies coming out of industrial research; 2) selling or demand-

creating efforts of the large firm; and 3) technological competence. Often acquisition

can be a means of obtaining productive services and managerial knowledge, but the

limits of rate of growth is still set by the existing resources, apart from the problems

of regulating the new entity. Existing resources not only shape the limits to

acquisition, but also determine the direction of expansion. Hence, there is limit to

unrelated diversification that a firm can achieve through acquisition, for it need to

build on its existing unused services and knowledge.

The competitive forces necessitates that a firm devotes it scarce resources to specific

fields and participate in product innovation in that field, instead of competing across

multiple product-market sets across multiple competitors. It can't continue to make

new investments in several different fields, and yet remain profitable. Even for a firm

with a leadership position in a certain product-market set, marginal returns on

investment may be more in a new area than in the existing area, another reason for

diversification. Most successful large firms have invested significant lot in securing

certain strong positions, which they relatedly diversify upon.

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Some of the benefits of diversification include ability to absorb temporary fluctuations

in demand; and managing permanent adverse changes in demand. Existing markets

may be profitable and growing, but all that is required to induce diversification is that

they do not grow fast enough to use fully the productive services available for the

individual firm (pp.145). When efficient management is a scarce resource, there is a

strong tendency to integrate in order to reduce managerial difficulties not only of

planning and controlling existing operations, but also of planning future investments.

Hence, necessity of maintaining a competitive position in its basic fields restricts the

rate of diversification of a firm (pp.150).

Expansion through acquisition and merger

So long as fortunes of firms depended on the fortunes of individuals or families on

whom rested a personal responsibility for their firm's operations, both the rate of

growth and the size of individual firms were severely restricted. For a firm there is

always a choice of recombining the old and building anew, and that's why M&A

is an alternate. Acquisition is considered if it is a cheaper mode of expansion where

one firm over-values certain resources another one possesses. The entrepreneurial

activities play a significant role in such decisions.

The distinction between entrepreneurial and managerial services is that the former is

responsible for creation or acceptance of proposals for innovation and expansion,

whereas latter offers services to operate a concern and to draw up and execute plans.

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Expansion must be understood from the entrepreneurial drive spurred by the vision to

organizing and controlling the use of economic resources of a grand scale. The limits

to inorganic growth is set by the conflict between the speed of expansion and

the maintenance of efficient managerial coordination.

A merger leaves a pool of unused resources, which may further lead to growth.

The rate of growth of a firm through time

The problem with measuring the rate of growth of a firm is that the productive

services that entrepreneurs and managers of any given firm are capable of rendering to

that firm are not reducible to any common denominator, for they are heterogeneous.

The managerial service is available partly for managing current operations, and rest

for expansion programs. The possible rate of growth of a firm can be determined by

the ratio of managerial services available for expansion and the managerial services

required per dollar of expansion (pp.201). In general, as the firm grows, it continually

gains additional managerial service, through accumulation of experience, and

induction of new managers. Further, a larger firm may not require a commensurate

increase in administrative (organizing and coordinating) tasks, because of increase

efficiency of usage of existing managerial services, adoption of decentralized

management, and growing levels of automation. But a diversified firm will have to

have very high administrative services required to maintain its spread, and hence

available managerial services may shrink. Similarly, the managerial experience

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required for an unrelated expansion is higher than a related one. As firms grow in

size, the managerial requirement per unit expansion will rise to manage the spread of

its operations.

Penrose concludes '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 also higher than

that of very large firms' (pp.112-13).

The position of large and small firms in a growing economy

Typically for small firms, environmental conditions (competitive powers) would limit

the growth of small firms, regardless of their resources or entrepreneurial abilities.

The environment is the one perceived by the entrepreneur, and not given. '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' (pp.216).

One of the biggest problems for growth of small firms is access to capital and credit

rationing. Only smaller firms where the promoter entrepreneur has a capital-raising

ingenuity can grow favorably. Still small firms continue to exist, for there are certain

activities not suitable for large firms to get into, could exist as a matter of public

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relations and protection by the large firms, or the industry could be characterized by a

low entry-barrier, or lastly the large firms haven't yet mopped up the smaller ones.

Most small firms operate in the interstices in the economy, left by the large firms as

they grow and are unable to capture every single opportunity coming their way. The

productive opportunities of small firms are thus composed of those interstices left

open by the large firms which the small firms see and believe they can take advantage

of (pp.223). Further, as technological knowledge grows and becomes increasingly

diffused it will inevitably create innumerable and unprecedented opportunities for

smaller firms. The rate of growth of large firms is severely restricted by the continued

efforts and investment which are required for the maintenance of their competitive

position in the 'areas of specialization' (pp.227).

Conclusions

1. No evidence available that large firms suffer from 'diseconomies of scale' as

they grow, which means size doesn't automatically lead to inefficiencies

2. A smaller administrative framework can still realise the benefits of production

and operations that a large firm does, and hence most large firms are larger than

the minimum scale required to carry our profitable operations

3. No matter how large a firm grows, economies of growth are still available to it

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4. Growth economies exist for all sizes of the firms

5. The capacity of the existing management sets a limit to the rate of growth of

any firm

6. Growing large firms consequently leads to creation of interstices where small

firms can enter

7. Entry restrictions imposed by large firms lead to inefficient utilization of

resources in the economy

8. Large firms can not exploit all the opportunities that they create during their

growth