The Theory of THE GROWTH OF THE FIRM Third Edition EDITH PENROSE With a new Foreword by author (1995) OXFORD UNIVERSITY PRESS TABLE OF CONTENTS Penrose (1 ForEwoaD by Prerace, Chapter 1 Isrropucrion “The purpose of the study and the nature of the argumé Hae Fina i Teton Diferene ways of looking at firms th ce and production and nature of an industrial frm -run profits and growth IL Tae Proovcrive Opronruntry or THE FIRM AND THE “ENTREPRENEUR? Growth limited by a firm’s * product , ‘The role of enterprise and the compet Entrepreneur Entrepreneuri ‘The role of expectations in the productive opportunity of the firm . IV Expansion WrrHour Mercer: Tue Recepinc Mana- assump f the manages ‘The management team Release of managerial services Growth of managerial services - ‘The receding limit and the * static” approach ‘The effect of uncertainty and risk Uncertainty and information Risk and unavoidable uncertainty expansion pagevi TABLE OF CONTENTS Chapter V. ‘Tnnenirep” Resources anb THE Dinecriow oF Exran- ‘Types of inducement to expand The continuing availbibty of ‘uawsed “productive Indivisibility and the ‘balance of processes" The specialized use of resources =. Heterogeneity of resources Interaction between material and human resources. ‘The creation of new productive services “ Demand’ and the productive resources of the firm What is the relevant demand? ‘The dizection of expansion “The economies of size : “Technological economies Managerial economies : Economies in operation and expansion “The economies of growth : Disappearing versus enduring economies VIL_ ‘Tue Economics oF Divestrication ficiency of * integration’ Meaning of diversification .. ‘Areas of specialization es Specific opportunities for diversification Tmpoctance of industrial research ‘The significance of selling efforts Importance of a technological base Some examples “The tole of acquisition 5 ‘The role of competition 5 “The necessity of continued investment in existing fields Full-line diversification es Competition and diversification into new areas Diversification as a solution to specific problems Temporary fluctuations in demand Permanent adverse changes in demand ‘The direction of diversification Diversification as a general policy for growth Vertical integration The firm as & pool of resources Page bs 6s & 68 n " 76 8 Bo fo 8s 88 89 89 2 9 99 104 104 17 109 116 8 17 431 432 134 156 1538 48 141 142 144 14s 149 TABLE OF CONTENTS Chapter VIII Expansion Tiinovet AcQuistrton AND MERGER “The corporation and merger ‘The economic basis of acquisition Personal considerations and special situations Critical points in the ptocess of expansion ‘The competitive expansion of Alpha Where Beta blocks the expansion of Alpha Combination ‘The purchase and sale of ‘ businesses’ that are n Economic basis for the sale of a business Effect on the process of growth ‘The appropriateness of diversification ‘The role of entrepreneurial services : Entrepreneurial temperament and the profit motive Empire-building and merger ‘The role of managerial services ‘The necessity of administrative integration Merger and the dominant firm firms IX. Tue Rare or Growns oF Finws THRouGH Tie Introduction... . " Special assumptions Measurability The fandamentai ratio : Managerial services available for expansion Increase in the administrative task with growth Impact of changing environmental conditions ‘Managerial services required for expansion Character of expansion ; : Relation to existing activities and market conditions, Method of expansion ‘Changes in the rate of growth with increasing size "The growth curve © 1X. Tue Postion oF LARGE axD SMALL Firs in A GrowiNc. Economy The special position of small fms. | Competitive handicaps, especially finance ‘The continued existence of small firms Opportunities for growth “Tnterstices” in a growing economy ‘The principle of comparative advantage 189 190 194 197 197 198 199 204 206 207 209, 23 ats 217 28 235 225vil YABLE OF CONTENTS Chapter XI Growin Fins 1x A Growin Economy: THe Process (OF INDUSTRIAL CONCENTRATION AND THE PATTERN ‘oF Dowinance te Barriers to entry «. General effect on investment in the economy a asa sa whole omy indices of business activity ices of ‘ natural’ imitations on acquisition a tices and the business cycle ‘The process of industrial concent ‘Measuresnent of concentration. Concentcation and growing firms ins growing economy 7 Concentration and dominance The continued dominance of lange f firms Conclusion page 229 230 230 232 335 37 338 240 2a 243 245 aay 247 250 253 256 258 260 FOREWORD TO THE THIRD EDITION By EDITH PENROSE ‘There has long been much discussion of the behaviour, growth, organi ational structures, and managerial problems of firms. One of the earliest and most important was the work of Alfred Marshall both in his Prinples and his Industry and Trade. In 1937 Coase published his classic article in Economica on “The Nature of the Firm’, which was litle noticed for some the few years after the publication of The Theory ofthe Growth of the 9, 4 number of important works came out in which similar ideas to many of my own were independently developed by others. ‘Two eatly books dealing with the factors determining the growth of firms, Chandler's Strategy and Stractre an Masss's Economic Theory of Managerial Capitalism were published in 1962 and 1964 respectively. Chandler's book was finished before The Theory of the Grauth of the Firm appeared, but the analytical struc- ture within which its historical analysis was cast was remarkably congruent ‘with my own work, using much the same concepts and very neatly the same terminology at many points. Although Martis did take account of my work, with generous acknowledgement, his own research and basic arguments had been well developed earlier and constituted a significa empt to refer to much of the work that quickly followed but should like to mention a relatively neglected but splendid pioneering article by G. B. Richardson. “The Organization of Industey, published in 1972 in the Economic Jounal, which anticipated much that was to follow. By the middle ofthis century the neoclassical ‘theory of the frm’, that is to say, the theory of perfectly competitive markets, relative prices and Pareto ‘optimal resource allocation, could reasonably be looked on as a ‘mature sci ‘ence’ in the Kuhnian sense of a set of received propositions, the practitioners ‘of which were trained in a rigorous traditional theory embodying well-estab- lished mathematical and verbal techniques; but they did not deal with institu- tions. They stil form a particularly vigorous culture in economic . dominating the teaching of economic theory but using a definition of eco- nomics very different from that of Alired Marshall’s ‘study of mankis ‘ordinary business of life’ in the opening words of Book I (Sth edit Students of industrial economics existed in a kind of border area of “applied” economics. Sociologists, institutionalists, behaviousal psychologists,x FOREWORD TO THE THIRD EDITION business analysts (and especially business school teachers) dealing with ‘economic matters were clearly of lesser ‘scientific’ standing, They had no “hard” integrated theoretical foundation for their type of economics. The ‘occasional free-thinking economists were treat respect and interest (provided that they had already earned their sp twas difficult to see ‘what could be ‘done’ with their ideas, what use could be made of them for the real problems of theoretical economics, which had largely to do with building models of market equilibrium, resource allocation, prices and wel- fare maximization, In the United States there was often much argument about, and resistance to, the acceptance of business studies ina good depart- ment of economics. Traces of this attitude still exist today, but now it almost seems at times as if ‘business studies’ with their appropriate models and sta- tistical tests are taking over the analysis of the firm almost entirely, leaving the traditional microeconomics to concentrate on perhaps its most useful function as the theoretical foundation of the theory of the macroeconomic bbchaviour of the economy, for which the ‘firm’ as an organization is thought to be irrelevant. Nevertheless, the ‘firm’ in the traditional ‘theory of the firm’ has been @ source of constant theoretical trouble partly because it was extremely diffi- It to see why at its profit maximizing equilibrium it should not be of a size jestroyed the very foundations of the theoretical model of a perfectly smpetitive economy. Without a conceptual equilibrium economists could not predict the ditection of the response of an economy 0 exogenous dis- tutbances, and without the assumed perfect competition they could not assert the superior welfare efficiency Of competitive markets. Few econo- mists thought it necessary to enquire what happened inside the firm—and indeed their firm’ had no “insides” so to speak. I do not say they were wrong, only that, being theoretical economists, they saw reality differently from ‘other people and asked different questions about it. It is not in my opinion useful to attempt to ‘integrate’ the different approaches. “The neoclassical aspect of the subject continued to dominate theoretical economics until the last quarter of this century, and still seems to have the highest prestige. But along side it has come a literal explosion of new liter- ature on the behaviour, management, theories, and policies of business firms 4s organizations. ‘There are many reasons for this: the rise of business schools, the rapid increase in PhDs relating to management and business in Universities and the consequent increase in applied economic studies of fiems, the clear need for new ways of thinking about the emerging nature of 1 different type of industrial society, including the development of new forms of frm organization, which was often stimulated by a burst of inter- FOREWORD TO THE THIRD EDITION xi cst in the Japanese firms and their success, and perhaps mote recently the growth of evolutionary thinking in economies generally and the increasingly perceived limitations of the explanatory efficacy of ‘stati’ neoclassical eco- ‘nomics in the modern world. (See for example the works of Nelson and Winter (1982) and Geoffrey Hodgson (1588)) “Timony oF crown In undertaking an enalysis of the growth of firms in the 19508, the ques- tion I wanted to answer was whether there was something inherent in the very nature of any firm that both promoted its growth and necessarily lim- ited its rate of growth. Clearly a definition of a firm with ‘insides’ was required—a definition more akin to that used by economists working on the structure of industry, such as Alfred Marshall or E. A. G. Robinson, and those ftom other disciplines treating the firm as an organization. The core of the theory of the growth of the firm can be very simply stated. We start with the function of the firm and from this derive the appro- ptiate definition of the firm. The analysis was confined to industrial firms {although it may apply to other types of firm as well). The economic Fune- tion of such a firm was assumed simply to be that of acquiring and orga- nizing human and other resources in order profitably to supply goods and services to the market. It was defined, therefore, as a collection of resources bound together in an administrative framework, the boundaries of which are determined by che ‘area of administrative coordination’ and ‘authoritative communication’. If such a firm should become so large that it reached the point at which coordination became unfeasible, the definition would no longer hold and the growth of the organization would have to be analyzed differently, as we shall see. It is not clear that the theory of the growth of an industrial firm is applicable to financial holding companies ot other sim- but it may be. 1 was not impressed by the reasoning behind, nor the evidence to sup- ptt, the assumption that the managers or directors of large corporations in the modern economy saw themselves in business largely for the benefit of shareholders. Afier all, in the 19508 the phenomenon of the firm rin by the ‘not committed to the firm was not as seemed to be a reasonable assumption at now, some 4o years later, clearly inadequate. The tole of finan jons as shareholders can now be seen to require much careful analysis, as does the role of directors in their financial managerial functions ‘who, as Lazonick (1992) has so clearly shown, may well be more interested in their own financial rake-offs through high salaries, stock options, goldensi FOREWORD TO THE THIRD EDITION handeuffs, bonuses, et. than in the growth of their firms. This seemed not so prevalent then and I therefore elected to deal with what was called the ‘managerial firm’—a firm run by a management assumed to be committed to the long-run interests of the firm, the function of sharcholders being sim- ply to ensure the supply of equity capital. Dividends need only be sufficient to induce investment in the firm’s shares. Following upon the same assumption, I also assumed that managers gua managers were primasily interested in the profitable expansion of the aciv~ ities of their firm. Profits were treated as a necessary condition of expan- sion—or growth— and growth, therefore, was a chief reason for the interest of managers in profits. Moreover, the more profits that could be retained in the fiem the better, for retained earnings are a relatively cheap source of finance; management had! no desire to pay out to shareholders more divi- ends than were necessary to keep the capital market happy. ‘Assumptions such as these were an essential part of the theory of the ‘growth of the firm as I developed it and to the extent that these are not as applicable today as they then were, which seems to be the case in a number cof very large firms, at least in the Anglo-American context, a new manage- rial restraint on the rate of growth of firms arises. Following from the definition of the firm as a coherent administrative organization, I argued that managerial resources with experience within the firm are necessary for the efficient absorption of managers from outside the firm. Thus the availability of ‘inherited managers’ with such experience lim- its the amount of expansion that can be planned and undertaken in any period of time. Such managers, by definition, cannot be acquired from the market but are a necessary input in expansion. (Once a substantial increment of growth is completed, however, the man- agerial services devoted to it become available for farther expansion. There ‘was no obvious and inevitable limit to this process and therefore the limit to its rate of growth would not necessarily limit the ultimate size of a frm. Furthermore, the growing experience of management, its knowledge of the other resources of the firm and of the potential for using them in different ‘ways, ereate incentives for further expansion as the firm searches for ways of using the services of its own resources more profitably. The firm’s exist- ing human resources provide both an inducement to expand and a limit to the rate of expansion. Even growth by acquisition and merger does not escape the constraints imposed by the necessity of using inputs from exist- ing managerial resources to maintain the coherence of the organization. This is the essence of the so-called ‘Penrose curve’, which has been applied in a ‘number of contexts, and even, to my surprise, to agricultural enterprises FOREWORD TO THE THIRD EDITION xii Exrennat. Propucrive OprorTunmies In the development of the theory of growth of firms the influence of the ‘environment’ was put on one side in the first instance in order to per- rit concentration on the internal resources of the firm. The relevant envi- ronment, that isthe set of opportunities for investment and growth that its entrepreneurs and managers perceive, is different for every firm and depends 61 its specific collection of human and other resources. Moreover, the envi- ronment is not something ‘out there’, fixed and immutable, but can itself be ‘manipulated by the firm to serve its own purposes. ‘The relation of the firm to ‘demand’ can be illustrated if one asks the question why the growth of a firm endowed with productive resources that ccan be used in many ways and can be increased by the acquisition of addi- tional resources should be confined by existing demand. I saw no reason why 4 firm should see its prospects of growth, its productive opportunities, in terms of its existing products only; there are many reasons why it should see them in terms of its productive resources and its knowledge and should search for opportunites of using these more efficiently. From this follows «theory of the diversification ofthe firm as its existing markets become less profitable or the prospects of new ones more attractive. ‘The analysis of the process of diversification combined with the analy- sis of the costs of growth on the supply side, seems to have stood up rea- sonably well to the passage of time. Many of the most important extensions and modifications made by others over the past few decades owe a great deal to the superb historical discussion of the growth of major American firms by Chandler, to which T did not have access in writing my oven work somewhat earlier, but which provided strong evidence, atleast in the United States environment, of the applicability of the theoretical analysis while at the same time demonstrating the importance of environmental changes. The Cusutanve Grown oF Kxowtence One of the primary assumptions of the theory of the growth of fems is {hat ‘history matters’, growth is essentially an evolutionary process and based ‘on the cumulative growth of collective knowledge, in the context of a purpo- sive firm. In recent yeats there has been a tremendous revival of discussion of the role of knowledge and of evolution in both applied and theoretical eco- ‘nomics. In a magnificently angued theoretical work, Eguilibinm and Evoltion An exploration of conneing priniples in ecmomicr, Brian, Loasby (2991) discasses my theory of the growth of the firm (Ch.4) in relation to the role of knowledge and describes the administrative structure of the frm as providingan equilibrium structure of theory and policy within which individual knowledge without threatening organisational coherence; but that equilibrium itself is the consequence of an evolutionary process during which managers learn to operate effectively together within a particular environment, It is the evolutionary process which generates the growth of managerial services—or reduction in governance costs—which is so impor shapes the content and scope of those services. (p. ‘Thus he seems to see the growth of knowledge within a framework which consists of a managerial administrative ‘theory and policy’ acting as a sort of rescarch programme, itself representing a kind of temporary evolu. tionary equilibrium of the fiem having ltde to do with any equilibrium of the economy as a whole. In this respect he borrows from Frank Hahn’s def- inition of equilibrium noting (pp. 13-14) that: 1 may help ws to judge the problems and possbiies if we make use of Frank Hahn's proposal to sife the focus of equilibrium from prices and quantities 10 ‘ideas and actions. It will not atempe to present Hahn's arguments or his sup ‘porting definitions, bur come stright to his proposition that ‘an economy isin ‘qulibium when i generates messages which do not cause agents to change the theories which they hold of the policies which they pursue’ (Haba 1973; 984, B59) If this analysis is cartied further it raises the importance of appropriate government macro-economic policy since in practical terms we look at eco nomic equilibrium not as a question of an impossible, and probably ina teal sense, undesirable, neoclassical equilibrium, but merely as a reasonable sta- bility This is in part reminises language and rushes of revolutionary creativity. ‘perennial gales’ are the res ncessantly revolutionises the economic structure from within, incessantly destroying the old one, inces- santly creating a new one. This process of Creative Destruction is the essen- tial fact about capitalism ....’(p. 83) To this he adds a footnote which states that the ‘revolutions’ are not really incessant but occur in ‘discrete rushes’. is modification makes ‘creative destruction’ relevant to his analysis of business cycles. In his The New Compatition (1990), Michacl Best sees Schumpeter as dealing essentially with a capitalism in which the large firms are the engine of creative destruction—entrepreneurs with ‘the big idea— contrasting this with the results produced by the collective interaction of a “Penrosian learning culture’. By applying Schumpeter’s process to successful firms generally Best brings in the concept of the strategic behaviour of firms as a means of ‘insttutionalizing Schumpeterian organizational innovation’ his dramatic action’ and FOREWORD TO THE THIRD EDITION ~ In discussing Japanese firms he argues, for example, ‘that the successful Japanese firm has combined Schumpeter and Penrose, and thereby altered the notion of entrepreneurship from “big ideas by individuals” to a social process of learning within which individual contributions ean come from the bottom up, as well as from specialist staf (p. 138) ‘MutTinaTiona. ConporaTions Finally, a few words about the expansion of firms outside th boundaries. Interest in the international growth of firms—once ign firms, then international firms, multinational corporat pris ational led for. 6 oF enter- bal transnational corporations and now apparently referred to as firms—has grown by leaps and bounds since the 190s. Among the articles devoted explicitly to this subject is my ‘Foreign Investment anc Growth of the Firm’ published in 1956 in the Etonomic Jounal and reprinted in The Growth of Firms, Middle East Oil and Other Essays (Pentose 1971); all of ‘my work on the international oil industry, primarily The Large Intemational Firm in Developing Countries (1968), is a study of the large international firms in that industry and their impact on the world economy as well as on the economies in which they operate, ‘The literature on the subject of multinational firms has burgconed since the middle of the century, in line with the spread of such enterprises them es in their several manifestations. Much of the analysis of the growth of firms as I have presented it seems by and large to apply equally well to 1n by direct foreign investment in its modern form—the processes 1 the role of learning, the theory of expansion based on intctnal resources, the role of administration, the di production, the role of merger and acquisition are all relevant, ‘There are, of course, substantial differences among countries, but if we assume that certain factors of production are not only highly mobile but tend to move in packages containing different proportions and types of cap- ital, managerial services, technology, etc. bound together within the in grated framework of a firm, itis easy to envisage a process of expan international firms within the theoretical framework of the growth of firms 4s outlined in this book. Itis only necessary to make some subsidiary ‘empir- ica’ assumptions to analyze the kind of opportunities for the profitable operations of foreign firms that are not available to firms confining their activities to one country as well as some of the special obstacles. Ma ‘not most, of these assumptions would apply equally to domestic expanding within the United States or even some smaller ones, But of large and diverse countries and th the advent of the very large globalxvi FOREWORD TO THE THIRD EDITION corporations or ‘firms’ there spread what became effectively an extrem sophisticated, though not entirely new, form of organization requiring a ferent analysis of the nature of the firm and the relation between the and the market. “Tue Prostew oF Liners T have considered above the nature of the boundaries of the firm and have defined them in terms of the firm’s managerial and administrative activ- ines if defined in this way, the firm isa unit of planning and as it grows its boundaries expand as do its administrative responsibiles. That a firm has boundases follows from the nature of the categories we think in, however, because we can clearly ‘observe’ them in seat. The fiom is what distinguishes it from the market and there! whether of not itis ‘ea’ sine the frm/market dichotomy has been per haps the major building block of an economist’s analytical thinking In an extremely perceptive and prescient article, G. B. Richardson as carly a5 1972 has shown how very inadequate is this foundation for the analysis of economic organization. He challenges the whole notion of a firm/market dichotomy, pointing out that there are three means of co- ordination: direction, co-operation, and matket co-ordination and that inter firm networking blu the boundaries of firms; that the firm in realty is not an island in a sea of market trans Af part of a network con- sisting of rivals in direct competition, of suppliers of goods and services in special relationship as well as of consumers, be they individuals, orpaniza- 1 or even governments also in special relationship generally, ‘purposes. He gives an excellent account ofthe possibilities how ate we to distinguish between co-operation cr for spe and rhetorically asks * oon the one hand and market transactions on the othe? (p. 886) ‘An argument can be made that when a firm is first organized it has advantages over market organization because transaction costs are less in the organized context on a relatively small scale. The reverse may tend to develop over time as scale increases, dissimilaities develop in the types of activity engaged in and expand so that higher transaction costs may induce 4 fundamental transformation in the nature of the very largest firms as we know them. If s0, how will this come about? The innovation process, growth of knowledge and pressures from ambitious businessmen are cumu- lative and will continue, but with what result? It follows from the argument developed in The Theory ofthe Growth ofthe Firm that a firm's rate of growth is limited by the growth of knowledge FOREWORD TO THE THIRD EDITION within i, but a firm's size by the extent to which admin ness can continue to reach its expanding boundaries. Because the firm is not treated as an organization in neoclassical economic theory, the limit to the size of firm could only be found in the last analysis in an upward sloping cost curve or a dowaward sloping demand curve for existing products. Tf demand is not found v0 be necessuly restrictive of growth in view of the possibility of expansion through continuous diversification, the former remains as the only limit to size. Again, in order to focus on the internal dlynamics of the firm, I assumed constant returns to scale and scope, imp ing that any size of fim is as efficient as any other size. In this respect 1 argued then, without developing the supporting evidence, that as firms grew larger they apparently did not necessarily become less efficient iting there was no indication of t least at seemed to undergo an administrative reorgani: with the increasing growth. In this respect, studies of administrative structure and managerial oper ations have especial relevance and the work of Williamson (1971) has received particular attention. Among other things he described the evolution and growth of the multi-divisional or ‘M-form’ of organization, in which strategic decisions were concentrated in a general office at the top of a large enterprise, served by an ‘elite’ staff whose function was to examine strategic options and exercise a general supervision over operating subsidiaries (called “quasi firms), His analysis rested on the appraisal of transaction costs and hhe demonstrated the way in which firms could expand their managerial capacity and the type of organization required to effect it. ‘Another approach has been recently advanced centering on the ‘culture’ ofa firm to bind together the self-interest of the members of the firm's com- munity, from workers to top management. This is put forward as relatively non-hicrarchical form of administrative organization which is referred to as ‘the new organizational context’. With a philosophical approach very differ- ent from opportunism, much emphasis is placed on the possibilities of enhancing trast and co-operation in the administration of the firm as an alternative to contractual ways of guarding against opportunism. It draws heavily on sociology and organization theory, and on the role of confidence building and responsibility in the social philosophy of the firm. Many, if not ‘most large firms develop a strong social and psychological culture on which heavy reliance is placed for effective internal management. This alternative Approach sees an imaginative development of mutual trust, commitment and shared responsibility as a more effective instrument than finan« jon to enable them to deal contrxviii FOREWORD TO THE THIRD EDITION even contracts as a means of ensuring that the managers ofthe firm sing in “The hierarchy of the administrative steucture is deliberately reduced in order to bring about an extensive decentralization of responsibility and devolution of authority by creating numerous smaller business groups close to the market with their own managers, but still maintained within the firm. ‘As patt of their work on what Bartlett and Ghoshal (r994) calla ‘manager- ial theory of the firm large company removed tight hierarchical administrative controls, substantially reduced numerous layets of management in the firm and created a large number of business ‘units’ consisting of ‘front line’ managers with small teams direcly in touch with customers and suppliers, and backed up by a management whose role was essentially ‘supportive. Such a large number of front line manager-entrepreneuss was established on whom was devolved such a high degree of power and authority to make independent decisions, including investment decisions, that what might be called a collection of sinall ‘quasi firms was created. In this model, the creation of a high degree of trust, extensive social ization of personnel to the values of the firm, personal psychological incen- 8 to excel in meeting targets, which were called ‘stretch’, and effective network relationships throughout the firm are heavily relied on to main the administrative cohesion of sts of this attitude are, o course, characteristics of the organizational culture and ethos of many large firms. This type of operational structure is based on strongly manipulative, but ‘supportive’ guidance and advisory management atthe higher levels. But internal and external pressure for growth remain unlimited and the strongest social and cultural ties may be insufficient to support the coherence of the firm, A point i likely to come when pressures for the development for more independence from the business units arse and new firms are created, But depending on the nature of the felaionship and of the enterprises involved, such developments may foreshadow what I call the metamorphosis of the firm, bringing not only a different frm context but a different market con- text a5 well (MetaorPosis By the 1980s and the 1990s two concepts were in widespread use: the concept of a ‘core’ and that of a ‘network’. The former often referred to what a firm considered to be its primary business or businesses and was commonly used when the firm had decided it had over-reached itself from the point of view of efficient and profitable management and should FOREWORD TO THE THIRD EDITION xix together and depending on cach other for a variety of ser- vices, including technology. The term ‘network’, or ‘business network’ now technically refers to formal contractual arrangements or limited number of firms bound together in an inter framework sometimes even referred 0 as ‘quasi firms’ or ‘virtual corpora- ‘There are a great variety of different forms for business networks based ‘on contraets involving technology licensing, franchising, R&D arrangements, information services, supply, marketing and advertising arrangements, etc. ‘The literature at the time of writing is at an early stage and is rapidly grow- ing, D’Cruz and Rugman (1944) apply a very interesting theory of such net works, which they define a a ‘governance sructare for organizing exchange through cooperative, non-equity relationships among firms and ress institutions’ (p. 276) to the Canadian telecommunications industry, see- ing the network as a way of reducing costs in markets and hierarchies. Gomes-Casseres defines networks as simply ‘groups of companies joined Of global businesses the scal of national boundaries, especi eate evolution of modem technology often makes it necessary fo related areas around the world to be closely in touch with developments in the research and innovations of firms in many centres. Formal relations among such firms may advance the competitive power of each of them; to ‘make alliances may be not only a rational response, but even at times a nec- essary one. Gomes-Casseres argues in a forthcoming book (1996) that what he calls the collective competition among alliances promotes sivalry and in industry as a whole which can be intense idual companies do not lose ther ‘independes boundaries of the linked firms become increasingly fuzzy and the effective extent to which any individual Gm exercises conteol is often not at all clear. Although formal contracts form the legal basis of such groups, their co-operative operations may not be based so much on the ‘exercise of controls as on consensus emerging from shared goals and mutual dependence among the participants. There are advantages for individual firms that join an alliance but there are also costs and the balance betweenx FOREWORD TO THE THIRD EDITION costs and benefits can shift as activities develop and as the individual firms within the alliance continue growing which can lead to difficulties inthe rela- tionships and even to the disintegration of the alliance. ss network is very different from a ture, organization, and purpo: hat this type of organization is likely to continue to spread for some time and continue to engage in a competition very different from that analyzed berween firms in so-called free matkets. This may call for a new ‘theory of the firm’ in eco- nomics and changed views about the behaviour of markets and the effects of ‘fee market’ competition, 1 of independent Err Pennose Weaterbeach, Cambs. January 1995 REFERENCES Bartlett, C. A, & Ghoshal, $. (1994), ‘Beyond the M-Form: Towards ‘Managerial Theory of the Firm’, Srategic Management Jounal, Winter 1993. Best, Michael (1990), The New Competition: Institutions of Industrial Restructuring idge, Ma: Harvard Univ. Pre D'Cruz, J. R & Ragman, A. (1994), Business Network Theory and the Compete’, Harvard Business Review, JulyAi coming work The Alliance Revolution: The New Sbape of Business Rivalry to be published by the Harvard Univ, Press, 1996. Beonomics and Institutions, Cambridge: Polity Press, 1 1994. See ato his forth- snce of Managerial Capitalism’, Indusrial and Corporate No. 5. Exilim and Esolution, Manchester and New York: Univ. Press. 10), Principles of Economics, 8th ed. London: The Economic Theory of Managerial Capital Nelson, RR. & Winter, S.G, (1982), An Evolutionary Theory of Economic Change. ‘Cambridge, Ma: Harvard Univ, Press. | i | | | I | | | | FOREWORD TO THE THIRD EDITION xxi dale Fast Oil and Otber Essays ), Capitaliom, Socialism, and Democracy. New Yorks Malti- 71), The Williamson, O.E., Managerial Discretion, Organisation Form an Division Hypothesis, in Marris, RL. & Wood, A. (eds), Corporate Econony. London: Macmillan.CHAPTER I Inrropuction The purpose of the study. Tha nature of the argument. So far as I know, no economist has as yet attempted a general theory of the growth of firms. This seems to me so very strange that Iam sure anyone attempting it should indeed watch his (or het) step, for naturally there is always a good reason for what economists do or do not do. Perhaps such a theory is impossible to construct, unnecessary, trivial, or outside the pale of economics proper. I do not know, but I offer this study in the hope that all four possibilities will be rejected. We shall be concerned with the growth of firms, and only with their size. The term ‘ growth’ is used in ordinary discourse with two different connotations. It sometimes denotes merely increase in amount; for example, when one speaks of “growth” in output, exports, sales. At other times, however, it is, used in its primary meaning implying an increase in size or an improvement in quality as a result of a process of development, akin to natural biological processes in which an interacting series of internal changes leads to increases in size accompanied by changes jin the characteristics of the growing object. Thus the terms economic growth” and ‘ economic development’ are often used terchangeably where growth’ implies not only an increase in he national product but also a progressive changing of the economy. “Growth” in this second sense often also has the connotation of “natural” or ‘normal’—a process that will occur whenever con- ditions are favourable because of the nature of the ‘ organism becomes a more or less incidental result of a continuous on-going or “unfolding ’ process. But this is not the way the size of firms is looked at in traditional economic analysis, which examines the advantages and disadvantages of being a particular size and explains movement from one size to another in terms of the net advantages of different sizes. Growth becomes merely an adjustment to the size appropriate to given conditions; there is no notion of an internal process of development leading to cumulative movements in any one direction. St2 INTRODUCTION there any suggestion that there may be advantages in moving from | ‘one position to another quite apart from the advantages of being in a diferent position. It is often presumed that there is a ‘ most profit- able’ size of firm and that no further explanation than the search for profit is needed of how and why firms reach that size. Such an approach to the explanation of the size of firms will be rejected in this study; it will be argued that size is but a by-product of the process of growth, that there is no ‘optimum’, or even most profitable, size of firm. As we shall see, traditional theory has always | hhad trouble with the limits to the size of firms, and I think we shall | find the source of the troubl. In addition to the traditional approaches, there have been sporadic attempts to develop theories of the growth of firms using Biological analogies and treating firms as organisms whose processes of growth are essentially the same as those of the of the natural world. There are many difficul analysis, one of the most serious being the fact that human motiva- | tion and conscious human decision have no place in the process of | growth. This alone, I believe, is suffici | such theories of the growth of firms. All the evidence we have | indicates that the growth of a firm is connected with attempts of a | particular group of human beings to do something; nothing is gained and much is lost if this fact is not explicitly recognized.? In spite of the fact that I depart from the traditional methods of, analyzing the behaviour of firms, many of the ideas—indeed some | basic ones—providing the bricks and mortar with which the is built are to be encountered in the 1d applied economics, and many parts of the structure will be easily recognized? What I have don: is to attempt to build a consistent, self-contained theory of the grow! of firms, synthesizing my own ideas and those of others, moulding both into a reasonably formal whole which I hope provides a way of | and ‘ practical” purposes. Much more can be done than I do here by way of refinement of analytical constructions, exploration of | Amuricen Economic | important and experience of ‘subsequently finding the same idea beter expressed by some other ays {0 mention fuch eatlier expositions; I sm sare that there are many I have overlooked, {for which Toffer advance spology. INTRODUCTION 3 ramifications, and development of the theoretical and political significance of the analysis. Some of the concepts used are not defined with great precision, largely because no highly refined definition is required for my purposes; a more detailed or more precise application of the analysis may well justify further effort in this direction ‘Although I am primatily concerned with a theoretical analysis of a process, I have tried to modify the impact of the unavoidable abstraction in two ways, for I would like to appeal to a wider audience than that of professional economists only. In the first place, the fundamental assumptions on which the analysis rests are chosen with a view to their applicability in the ‘ real world ’, and I shall make some effort to justify them, although strictly speaking I suppose no justification of this sort is necessary provided useful results are obtained. Of course, in the process of developing an argument it is often necessary to make patently ‘ unrealistic? assumptions in order to isolate particular problems with which we may be concerned. For the most part such assumptions are, or can easily be, dropped at later stages. Secondly, I shall frequently illustrate the argument with concrete examples. Consistent examples are, of course, no more a proof than are inconsistent examples a disproof of a general argument unless the examples are presented in sufficiently large numbers and selected in such a way that they constitute a representative sample. The theory of the process of growth is, on the whole, susceptible to ‘empirical testing against the experience of individual firms, although the examples presented in the following chapters are illustrative only. ‘There is not sufficient systematic information available as yet to enable any comprehensive testing of the generality of the theory. Although there are many business histories and biographies of individual businessmen, only a handful are really good from this, point of view;? annual reports of corporation: paper reports, and interviews with businessmen are useful if cafe- |, but do not yet provide a systematic and compre- wre precise sty and The Market", Eeonanie Jounal,4 INTRODUCTION hensive body of information. It is not possible in the framework of this study both to develop a theoretical analysis and to carry out an ‘extensive testing of it in the light of available information, although T have tried at every point to satisfy myself that there is sufficient evidence to justify at least a prima facie case for the hypotheses advanced respecting the processes of growth. The analysis of the dimits to growth—the factors determining the maximum rate of growth of firms—on the other hand, cannot, in its present formulation at any rate, be tested against the facts of the external world, partly because of the difficulties in expressing some of the concepts in quantitative terms and partly because of the impossibility of ever knowing for any given firm what is, or would have been, its maximum rate of growth. Perhaps some of these dificulties ‘will be overcome in different formulations constructed by others. At present the validity of the theory of the limits to the rate of growth of firms lies entirely in the extent to which it is consistent with the theory of the process of growth, in its logic, and in its intuitive acceptability. The Nature of the Argument A comprehensive theory of the growth of the firm must explain several qualitatively different kinds of growth and must take account not only of the sequence of changes created by a fitm’s own activities but also of the effect of changes that are external to the firm and lie beyond its control. Not all of these things can be discussed at the same time, however, without creating such a serious confusion between very different types of causal relationships that the dis- cussion degenerates into a generalized description of a sequence of events that appears largely fortuitous and to have been introduced for the convenience of a pre-determined conclusion, like the coinci- dences of a poorly constructed detective story. Hence the develop- ment of the theory must proceed in stages. After a discussion of the characteristics of the business firm, its functions, and the factors influencing its behaviour, we shall turn to an examination of the forces inherent in the nature of firms which at the same time create the possibilities for, provide the inducements ee a ea cre a ta esa oh US, en lonely crit wha tore ely Rosen ite tei he ew of meee a Fer lata aes cre, Troe ts ate bance | INTRODUCTION 5 to, and limit the amount of the expansion they can undertake or even plan to undertake in any given period of time. It will then be shown that this limit is by its nature temporary, that in the very process of expansion the limit recedes, and that after the completion of an optimum plan for expansion a new ‘ disequilibrium ” has been created in which a firm has new inducements to expand further even if all external conditions (including the conditions of demand and supply) have remained unchanged. In ll of the discussion the emphasis is on the internal resources of a firm—on the productive services available to a firm from its ‘own resources, particularly the productive services available from management with experience within the firm. It is shown not only that the resources with which a particular firm is accustomed to working will shape the productive services its management is capable of rendering (where management is defined in the broadest sense), but also that the experience of management will affect the productive services that all its other resources are capable of render- ing. As management tries to make the best use of the resources available, a truly ‘dynamic’ interacting process occuts which encourages continuous growth but limits the rate of growth. In order to focus attention on the crucial role of a firm’s * inherited? resources, the environment is treated, in the first instance, as an ‘image’ in the entrepreneut’s mind of the possibilities and restric- tions with which he is confronted, for itis, afterall, such an ‘image” which in fact determines a man’s behaviour; whether experience confirms expectations is another story! Even ‘demand’ as seen bya firm is largely conditioned by the productive services available to it, and hence the ‘direction of expansion’—the products a firm becomes interested in producing—can be analyzed with reference to the relationship between its resources and its own view of its competitive position. ‘This will be discussed in an extensive analysis of the economics of diversification. The theory of growth is developed first as a theory of internal growth, that is, of growth without merger and acquisition. ‘The significance of merger can best be appraised in the light of its effect fon the process of and limits to internal growth. Some attention to merger is given in the discussion of diversification, but not uatil6 INTRODUCTION Chapter VIII does the full analysis of growth through merger appear, and with this the development of the theory of growth is completed. The emphasis of the analysis is then shifted from the internal resources of the firm to the impact of particular types of external conditions as firms grow larger and to the patticular situation of small as compared with large firms in the economy. ‘This permits the development of an analysis of changes in the rate of growth of firms as they grow, and finally leads to a discussion of the process of industrial concentration, which is, after all, primarily a question of the relative rates of growth of large and small firms in 1 changing economy. Economists are sometimes criticized for not making clear the historical ot institutional environment to which their theories are supposed to be applicable, ‘The present analysis is concerned only with the incorporated industrial firm operated for private profit and unregulated by the state (hence not to regulated public . financial organizations, or even * trading’ firms) and is applicable only to an economy where the corporation is the dominant form of industrial organization; historically, therefore, only to the period since the last quarter of the 19th century. To be sure, the corporation ‘was widely used in certain areas much earlier, but it did not dominate the field of manufacturing as it has since, at least in the western world. ‘The adaptation of the corporation, or limited liability company, to private manufacturing business removed the most important limitation on the growth and ultimate size of the business firm when | it destroyed the connection between the extent and nature of a firm’s operations and the personal financial position of the owners. So long as owners were personally liable for the actions of their agents as well as for the finance of their firms, there was in general a sharp limit to the risk attendant upon extensive financial commit- ments, in particular in illiquid industrial assets, that owners would be willing to assume, as well as a close limit on the delegation of authority in management that could safely be permitted. The business organization or bureaucracy could never become an entity i dependent of the personal position of the firm’s ‘owners, as it has increasingly tended to become to-day. The continued growth of a modern business firm can, I think, be most usefully sd as the continual extension of the range and | nature of the activities of an organization in which the role of the | INTRODUCTION 7 owners may or may not be relevant, and of which even ‘central management’ (or entrepreneur) is only a part, though a very import- ant part. It is at the organization as a whole that we must look to discover the reasons for its growth. This stands in sharp contrast to the traditional economic analysis of the ‘ firm.” in the economist’s “theory of the firm’, and much confusion has atisen because of a failure to distinguish the different meanings in economic analysis of the term ‘firm’; the economist’s firm in the ‘ theory of the firm’ is not at all the economic institution that ordinary people ‘would think of as a fiem. It will be necessary to make the distinction clear at the very beginning in order to avoid compounding the confusion. Finally, a comment on an alleged ‘ tautological problem” which some have feared is inherent in a theory of the growth of firms concerned only with firms that can successfully grow. Many firms do not grow, and for a variety of reasons: unenterptising direction, inefficient management, insufficient capital-raising ability, lack of adaptability to changing circumstances, poor judgment leading to frequent and costly mistakes, or simply bad luck due to circumstances beyond their control. Tam not concerned with such firms, for I am only concerned with the process of growth, and with the limits to the rate of growth, and therefore only with those firms that do grow. 1am not attempting to present a theory which will enable an analyst to examine a particular firm and state in advance whether it will or not successfully grow. One can easily state the necessary and sufficient conditions for successful growth, but how can one deter- mine whether a given firm meets these conditions? In practice one cannot determine it in advance; one must wait to see whether or not the firm grows. Hence little is gained by posing the problem in this ‘way—but one need not so pose it. Tam not asking what determines whether a particular firm can grow, but rather the very different question: assuming that some firms can grow, what principles will then govern their growth, and how fast and how long can they grow? Oralternatively, assuming that there ate opportunities for expansion in an economy, what determines the kind of firm that will take advantage of them and to what extent? For so long as there exist opportunities for profitable investment there are opportunities for the growth of firms. ‘The problem is not unlike the problem of diagnosing the pros- pects for the growth of, say, a tree. Upon examination, one can say,8 INTRODUCTION for example, that the tree will not grow unless certain identifiable conditions are corrected and certain environmental conditions satisfied—but one can never certify in advance whether the tree will ot will not survive all possible vicissitudes and how they will affect its growth—the next winter may be severe, the spring rains ‘may fail, or blight may set in, For a firm, enterprising management is the one identifiable condition without which continued growth is precluded—this is one necessary (though not sufficient) condition for continued growth, as will be demonstrated. Although our analysis is concerned only with growing enterprising firms, it is not on that account circular. | | | | | | CHAPTER II ‘Tue Fram iN THzoRy Different ways of looking at firms—The firm in the theory of Prd and prodecton Link to rge Ta fom "taste an ‘The firm as an administrative organization. The function and ature of an industrial firm. Size and administrative co-ordination. Industrial firms and investment trusts. Continaity in the * bstory” of « firm—The firm as a collection of physical and human tesources—The motivation of the firm. The profit motive. Long-ran profits and growth, In a private enterprise industrial economy the business firm is the basic unit for the organization of production. ‘The greater part of economic activity is channelled through fitms. ‘The patterns of economic life, including the patterns of consumption as well as of production, are largely shaped by the multitude of individual decisions made by the businessmen who guide the actions of the business units we call firms, The very nature of the economy is to some extent defined in terms of the kind of firms that compose it, their size, the way in which they are established and grow, their methods of doing business, and the relationships between them, In consequence, the firm has always occupied a prominent place in economic analysis. It is a complex institution, impinging on ‘economic and social life in many directions, comprising numerous and diverse activities, making a large variety of significant decisions, influenced by miscellaneous and unpredictable human whims, yet generally directed in the light of human reason. In the literature of economics, the firm of the ‘ real world’ has long lived in that uncomfortable no-man’s-land between the high and dry plateaus of ‘ pure theory” and the tangled forests of ‘empiric- realistic’ research. Border skirmishes between the natives of the two areas have been common, supplemented by formal jousts in the medieval manner between noble knights of the opposing allegiances, each warmly defending his faith, ‘These encounters have one remark- asta Goniiring fot feat alto ek ak ofthe ain rar tan ie manage techs, ig an aaa and facilitates expotition in those eases where no distinction is fequited between the fim and the men who ron