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 firm’s 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 firm’s 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

firm’s 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 firm’s environment appears to be given a secondary role in the process of growth.

From a totally ‘inside-out’ perspective, firm’s 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 firm’s 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. Interacting with the firm‘s resources,

ii. Subjectively perceiving and creating new uses for resources, and

iii. Driving the rate and direction of the firm‘s growth and strategic experimentation.

Lecture Notes Business Economics Madhav Prasad Dahal, Associate Professor of Economics

Managers Interacting with Resources

Penrose’s growth theory of the firm focuses on “Why do Managerial Resources and Management

Teams Matter?” for the growth of a firm. In fact, firm’s 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 truly―dynamic 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 firm‘s 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 firm. New York: Oxford University Press.