October 10, 2016

The Theory of the Growth of the Firm

Theory Developed Edith Penrose

Firms are collections of productive resources that are organized in an administrative framework which partly determines the amount and type of services that the resources yield. As they go
along with their productive operations, firms - or, more precisely, the management team - obtain increased knowledge of the services that may be obtained from resource. The results of such learning processes is, first, the expansion of the firm’s “productive opportunity set” (the opportunities that the
firm’s management team can see and can take advantage of) and, second, the release of managerial excess resources that can be put to use in other, mostly related, business areas. Since the opportunity costs of excess resources are zero, there will be a strong internal incentive for such diversification which in turn causes the firm to grow - an idea that according to Penrose destroys the notion of
the firm’s optimum size

However, the managerial resources inherited from the past set a limit to the firm’s rate of growth - what has become known in the literature as “the Penrose effect” (Slater 1980). (In mergers and acquisitions we see the point. Firms with manageral slack, that is excess managerial resources do acquisitions).

 In Penrose (1959), this is rationalized by pointing to the difficulties of socializing new managers that are needed for the expansion of the firm.

Later models (Baumol 1962; Marris 1964) imposed the Penrose effect exogenously (Gander 1991), but eventually it became subordinated under supposedly more general theories of adjustment costs in the theory of investment of the firm (Treadway 1970). Given this, and using a dynamic control theory
approach, the Penrose effect arises naturally as the profit-maximizing firm calculates its optimal time-profile of outputs.

The resource-based analysis of (sustained) competitive advantages may be seen as starting out from two basic empirical generalizations, namely that 1) there are systematic differences across firms in the extent to which they control resources that are necessary for implementing strategies, and 2) that these differences are relatively stable. The basic structure of the RBP emerges when these two generalizations are combined with fundamental assumptions that are to a large extent derived from economics. Among these assumptions are that 3) differences in firms’ resource endowments cause
performance differences, and 4) that firms seek to increase their economic performance. The fundamentals of the resource-based analysis of the conditions for sustained competitive advantage are basically simple (Peteraf 1993).

Some argue that Penrose's theorizing leads us to what would in modern management studies be called “strategic human resource management” where the focus is on the development of the firm’s pool of talents with particular goals in mind.

Imposing the requirement of choosing the optimal trade-off between the gains from diversification and the costs of managing a diversified firm then allows one to derive the optimal/equilibrium degree of diversification of the firm.

If services are produced endogenously (and continuously) through various intra-firm learning processes involving increased knowledge of resources, “new combinations of resources” (1959: 85), and an expanding productive opportunity set, there is no equilibrium size. Moreover, because of the difficulties of managing new resources and services, and of assimilating new managers in the firm, firm growth is not smooth or “balanced” (as in Marris 1964; Slater 1980). On the contrary, growth rates in succeeding periods will typically be negatively serially correlated, so that high growth in one period is followed by low growth and vice versa. In fact, this is the true “Penrose effect”, and a first indication that even on this fundamental level, Penrose has been partly misrepresented in the literature.

“In the long run”, Penrose explains, ... the profitability, survival and growth of a firm does not depend so much on the efficiency with which it is able to organize the production of even a widely diversified range of products as it does on the ability of the firm to establish one or more wide and relatively impregnable ‘bases’ from which it can adapt and extend its operations in an
uncertain, changing and competitive world (1959: 137).

A firm is basically a collection of resources. Consequently, if we can assume that businessmen believe there is more to know about the
resources they are working with than they do know at any given time,
and that more knowledge would be likely to improve the efficiency
and profitability of their firm, then unknown and unused productive
services immediately become of considerable importance, not only
because the belief that they exist acts as an incentive to acquire new
knowledge, but also because they shape the scope and direction of the
search for knowledge (Penrose 1959: 77).

Thus, firm
development is essentially an evolutionary and cumulative process of “resource
learning” (Mahoney 1995), in which increased knowledge of the firm’s resources
both help create options for further expansion and increases absorptive capacity
(Cohen and Levinthal 1990), or, to use Penrose’s terminology an expanding
“productive opportunity”.

The firm’s productive opportunity, arguably the key concept of The Theory of
the Growth of the Firm (cf. also Fransman 1994: 744), is “... the productive
possibilities that its ‘entrepreneurs’’ see and can take advantage of. A theory of
the growth of the firm is essentially an examination of the changing productive
opportunity of firms” (1959: 31-32). Thus, the notion of productive opportunity
is quite a central notion in The Theory of the Growth of the Firm.

 Penrose notes that “... 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” (1959: 34).

Source: Paper by Foss

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