Lecture Notes

Business Economics

Madhav Prasad Dahal, Associate Professor of Economics

Growth of the Firm Theory

British economist Edith Tilton Penrose (1914-1996) hypothesized the growth of the firm in her book, The Theory of the Growth of the Firm [Edith Tilton Penrose (1959). The Theory of the Growth of the Firm. John Wiley & Sons, New York, 1959].This theory formed part of managerial theories of the firm. The theory relates growth of the firm to economic expansion due to processes taking place within the firm. Penrose claims that the problems that the conventional theory of the firm could not address are the identification of the internal drivers and hindrances to firms growth. She clearly states in her

book that unless the market of a firm is restricted in view of the fact that the kinds of products it can produce are somehow limited, the possibilities for an expansion are totally driven by the flexibility and versatility of the firms own resources. Penrose describes a firm as a bundle of human and non-human resources under administrative and authoritative coordination, selling products in the market for a profit. So, the factors leading to the firms expansion are rather internal than external. She explicitly suggests that the interaction of human resources and between human and non-human resources stimulates knowledge creation within firms through specialization and the division of labor, learning and teamwork. Specifically, it is the availability of unused resources within the firm which leads the firm to diversification or expansion of existing lines. Unused resources can vary, and they can originate sales, managerial, research or productive excess capacity. Excess resources result from increased productivity for the latter allows less time to be required in order to perform current activities. Therefore, they can be profitably used at zero marginal cost thus providing management with an incentive to innovate and expand. The process is simple. As people become accustomed to their jobs, formerly difficult task tend to become more or less routine so that management is free to assume new responsibilities. In such a situation, expansion may occur by absorbing the unused or partially used resources.

Lecture Notes

Business Economics

Madhav Prasad Dahal, Associate Professor of Economics

Penrose developed a theory of the growth of firms based on internal factors, while also recognizing the interaction between internal and external factors. In fact, she states that: In a certain sense each one is decisive, but nothing can be determined by looking at one of them in isolation (1995, p. 87).External factors (e.g. the pull of demand) shape the direction of growth, but they are unable to lead of themselves to expansion. [...] External influences may be the decisive factor in determining the particular direction of expansion of a given firm [...] If there are profitable opportunities for increased production anywhere in the economy they will provide for some firm an external inducement to expand. But this alone tells us nothing about their significance for any given firm. New inventions, changes in consumers tastes, growing demand for particular products are external inducements to expand only for what might be termed qualified firms firms whose internal resources are of a kind either to give them a special advantage in the profitable areas or at least not to impose serious obstacles (1995, p. 86). Thus, the firms environment appears to be given a secondary role in the process of growth. From a totally inside-out perspective, firms growth is conceived as the endogenous outcome of continuing intra-firm knowledge creation. Penrose engages in a detailed analysis of the rationale and mechanisms of expansion. She examines the link between diversification and growth, then asking into the topic of acquisition and mergers from the viewpoint of both buyer and seller. More specifically, the main point that Penrose puts forward is that a firms survival in a dynamic changing environment is related to the development of an area of specialization, a foothold, a productive base or technological base (1995, p. 109), a basic position (1995, p. 123) or relatively impregnable bases (1995, p. 137). Critical roles played by managers and entrepreneurial management teams are: i. ii. iii. Interacting with the firms resources, Subjectively perceiving and creating new uses for resources, and Driving the rate and direction of the firms growth and strategic experimentation.

Lecture Notes

Business Economics

Madhav Prasad Dahal, Associate Professor of Economics

Managers Interacting with Resources

Penroses growth theory of the firm focuses on Why do Managerial Resources and Management Teams Matter? for the growth of a firm. In fact, firms growth can be studied as a dynamic process of management interacting with resources. In the words of Penrose (Penrose, 1959, p.5), As management tries to make the best use of resources available, a trulydynamic interacting process occurs which encourages continuous growth but limits the rate of growth There is a close relation between the various kinds of resources with which a firm works and the development of ideas, experience, and knowledge of its managers and entrepreneurs (Penrose, 1959, p. 85) Managerial resources and management team are cognitive drivers for strategy. Compared to managers who are relatively new to a firm, managers with tacit knowledge of the firms capabilities and organizational routines may envision a superior subjective productive opportunity set for the firm (Penrose 1959, p. 42). References Penrose, Edith Tilton (1959). The Theory of the Growth of the Firm. New York: John Wiley & Sons. Penrose, Edith Tilton (1995). The theory of the growth of the rm. New York: Oxford University Press.