Penrose “ Theory of growth of firm (1959)”

Chapter 1 – Introduction

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.

No general theory of growth of firms- impossible to construct, unnecessary or outside economics realm.

“Growth”- increase in amount or size as a result of process of development. Growth, like organisms
happen naturally due to favorable conditions and size is an outcome of this continuous ongoing
process.

Traditional economic analysis - examines the pros and cons of being a certain size and explains size
changes in terms of net benefits. Growth becomes an adjustment to the size appropriate to given
conditions (no focus on internal process of development leading to different positions). Advantages of
"moving" rather than "being" in different positions are irrelevant.

 Penrose : there is no optimum (or most profitable ) size of firm. There are limits to size of firm
and size is just a consequence of growth of firms.

Growth approach (biological analogies) – treating firms as organisms that grow like living organisms.

 Penrose : growth of firm is linked with human efforts, conscious decisions or motivation which
are absent in this biological approach to growth of firms. Need for more comprehensive
approach which is both theoretically and practically relevant.

Reducing abstraction –

1. Making fundamental assumptions more relevant in real world. These assumptions are mostly
dropped at later stages.
2. Use of examples – however difficult to prove theory of process of growth empirically due to lack
of systematic and comprehensive information. Consistent examples should be in large number
and positioned logically to prove something.

However, the analysis of the limits to growth (the factors determining the maximum rate of firm
growth)—cannot be tested against external facts in its current formulation, partly due to - the inability
to quantify some concepts and the impossibility of ever knowing a firm's maximum growth rate.
The nature of the argument - stage wise development of theory.

1. Firm-inherent growth forces. which restrict expansion over time. This limit is temporary,
recedes during expansion, and creates a new "disequilibrium" after an optimum expansion plan
is completed, giving a firm new incentives to expand even if all external conditions (including
demand and supply) remain unchanged.
2. Emphasis on internal resources - productive services, particularly from experienced
management. It is shown that a firm's experience with its resources will shape the productive
services its management (defined broadly) can provide, as well as the productive services its
other resources can provide. As management makes the best use of resources, a truly
"dynamic" interacting process encourages continuous growth but limits growth rate.
3. Growth without merger and acquisition initially.- because it is relevant to consider when there
are limits to internal growth and effects on process. later considered for diversification. Allowing
analysis of change in the rate of growth as they grow -> process of concentration of industries
(relative size in changing economy).
4. When the corporation, or limited liability company, was applied to private manufacturing
businesses, it broke the link between a firm's operations and its owners' finances, removing the
biggest limit on its growth. As long as owners were personally liable for the actions of their
agents and the finance of their firms, there was a sharp limit to the risk owners would be willing
to assume for extensive financial commitments, particularly in illiquid industrial assets, and a
close limit on the delegation of authority in management that could safely be permitted.
5. Only concerned with incorporated industrial firms – profit motive, unregulated by the state.
Corporation – dominant form of industrial organisations.
6. Continued expansion reasons– at the level of organization at whole level and not specific to
central management only
7. Tautolgical problem – TGF believed to be only about firms can successfully grow. But penrose is
Only concerned with those firms which grow to understand the process of growth and the limits
to the rate of growth. (not which firm can grow meeting such conditions). Many firms do not
grow for a number of reasons. Enterprising management is the one condition necessary (but
not sufficient) for a firm's continued growth. Our analysis only covers growing enterprising firms ,
but it is not circular.

Chapter 2 - The firm in theory

Firm – basic unit for organization of production. (“no-man’s land”). It is a complex institution
that affects economic and social life in many ways, involves many activities, makes many
important decisions, and is influenced by random and unpredictable human whims but
generally guided by human reason.
 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 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 Firm in the Theory of Price and Production

TOF —how prices and resource allocation are determined (Part of value theory). Since the
theory of value is concerned with the factors determining prices, the "equilibrium" of the
"firm" is the firm's "equilibrium output" for a given product (or group of products).

What limits the size of firm is defined by its production amount wrt the cost and revenue
schedules.

 The Limits to Size – limits are set with decrease in revenue to produce additional units
of products. Thus, economists have limited firm size based on
o Management limitations (which raise long-term production costs) – but only if
we treat management as fixed factor (fixity based on coordination task)
o Market conditions (which lower sales revenue) – only if there are limited
products offer by the firm for a specific group of markets. But firm can create
demand and develop resources, so on. Net revenue can rise with increasing
investments - > rise in production.
o Uncertainty about the future - These expectations are held with varying
degrees of uncertainty, which rise as output rises and a firm must account for
the possibility of being wrong in its calculations
 The 'Firm' is not a Firm - Applying the theory of firm to study the growth of "flesh-and-
blood" organizations that change and make new products.
o TGF views a firm as a growing organization, not a "price-and-output decision
maker" for certain products. (Adaptation attributes)

The Firm as an Administrative Organization

Penrose: what makes a company a "whole firm" depends on what its main function as an
economic entity in the economy and not only economic function.

 The Function and Nature of the Industrial Firm – Mostly, an industrial firm's main
economic purpose is to use its productive resources to supply goods and services to the
economy based on internal plans. An organization manages economic activity inside a
company, but not on the "market." The larger the industrial administrative unit, the less
direct market forces are in allocating productive resources to different uses and over
time, and the more room there is for economic activity planning.
o TGF - a firm is an autonomous administrative planning unit whose activities are
linked and coordinated by policies that affect the enterprise as a whole.
o Central management – responsible for structural and policy changes. Mainly
related to major investment of financial decisions or top management. Changing
environment – varied tasks of central management but in stable environment
the firm can operate without any overt acts of central management after
forming appropriate structure and policies.
o Different problems related to adaption – some delegation of decision making to
handle short run and long run conditions in large firms.
 Size and Administrative Co-Ordination - Earlier, management or coordination was a
fixed factor based on the assumption that human capacity is finite, resulting in
diminishing returns as firms grow. People with common tradition, familiar with
organization, and past inheritance can achieve this "single-mindedness" through
appropriate organization (bureaucratic).They work efficiently in broad areas without
one person understanding and directing its details. To make non-routine decisions
require large number of people without affecting its unity is difficult.
o At present – as firms grow they require changes in both managerial and
administrative functions which differs for small and big firms (different genes).
The organization becomes different as firms grow and we can’t simple relate size
with inefficiency. Big firms working efficiently.
 Industrial Firms and Investment Trusts – the former organizes production and later
holds financial instruments. As industrial firms becomes larger decentralized won’t
become a financial holding company as these two require different functions – (selling
goods vs dealing with money). So, the "area of coordination" or "authoritative
communication" must define the firm's limits. But exceeding this limit doesn't mean an
organization is "inefficient." A different organization may require a different analysis.
o Unclear lines of control in modern business make it harder to decide what a firm
should include.
 o Larger firms with subsidiary usually face problem related to authoritative
coordination and administrative - The firm's concept doesn't depend on stock
ownership or control only but Long-term contracts, leases, and patent license
agreements may give as much control. Just by making decisions (extension of
economic power) jointly for two firms doesn’t make it part of larger firm, there
has to be administrative coordination as well. Having financial stake doesn’t give
it an identity of a firm.
o Economic power vs firm size - Buying financial stake doesn’t mean extension of
area of control. From growth analysis – it is unclear in what economic sense this
financial group could be seen as firm, how reinvestment would change this type
of firm. It is a matter of legal opportunies, in some way it is growth! Difficult to
trace boundaries.
 Continuity in the 'History' of a Firm - difficulty in tracing growth - to determine when a
succession of legally distinct firms should be considered events in the history of a single
firm. Just as the state "survives" many changes of government and many
reorganizations of its administrative organs, but not partition or complete annexation by
other states, so the firm can maintain its identity through many changes, but it cannot
survive the dispersal of its assets and personnel or complete absorption in an entirely
different administrative framework.
o Merger (of profitable firm) – losing identity without failing in financial sense.
Vodafone and idea – new firm created. But in other form acquiring firm absorb
other in its administration (one loses identity and another maintains it). This
depends on regulatory environment. Legality may prevent big firms to fail.

The Firm as a Collection of Productive Resources

The firm is not merely an administrative unit but collection of productive resources which
defines size of firm.

 Physical resources – tangible and intangible, durable or non durable, intermediary or

final goods
 Human resources- skilled or unskilled, casual or permanent. Not owned by firm but loss
if experienced and most capable employees leave the firm.
 In the production process, resources are only "inputs" when they provide services.
Resources yield different services depending on how they are used and in combination
with other resources. Resources consist of a bundle of potential services and can be
defined independently of their use, while services cannot because the word "service"
implies a function or activity.
  Best way to measure size of firm is by looking at present value of its total resources but
it is impossible. So, this book has taken growth of firm as growth of fixed assets. Merely
using total asset will distort the size of firm as the placement of such assets matters.

The Motivation of the Firm

Why it acts as it does?

Usefulness of TGF at 2 levels- observable actual events as growth or understanding actions

behind these events. She assumed that Firms act for a purpose.

 The Profit Motive – investments decisions are guided by opportunities to make money.
Why firms wants to have more profit? – to pay dividends, to attract investors (future funds).
But why is it important in “management controlled” (widely shared equity or less ownership
control over administration to achieve so) firms today?
o Mangers’ personal growth is attached to growth of firms - more responsible and better
paid positions, and wider scope for their ambitions and abilities.
o Firms make financial and investment decisions to maximize total long-term profits.
Profits are needed to grow the company and make more money.
 Long-Run Profits and Growth – to increase total long run profit = increase in long run rate
of growth.(investment policy perspective). Invest only to get positive returns. (growth =
profit). Other objectives are also important like power, reputation, etc but again means to
attain such goals depend on profitability. This requires enterprise quality!

Chapter – 3 The Productive Opportunity of the Firm and the 'Entrepreneur

Firms = administrative organizations + collection of productive resources

Productive opportunities depends on entrepreneurial abilities to take act upon them. TGF
examines this changing productivity opportunity of firms, limit to such limits growth of firms.
Direction of growth depends on competent management qualities.

Enterprise, or "entrepreneurship," is a slippery concept that is hard to put into formal economic
analysis because it is so tied to personality or other personal qualities. It's difficult to develop a
general theory of company growth because each company's growth is unique.

The productive opportunity of the firm and the 'entrepreneur' . 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). The first of entrepreneurial
services is entrepreneurial versatility, which comprises of imagination and vision, manifested in
terms of vigorous, experimental 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 judgment, 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

The Role of Enterprise and the Competence of Management

Enterprise is the psychological tendency to risk and invest in speculative activity. The firm's
"enterprise" determines this decision, not sober calculations about whether the investigation
will yield promising opportunities. In any case, searching for opportunities requires
entrepreneurial intuition and imagination and must precede the "economic" decision to
examine expansion opportunities.

 Entrepreneurial versus Managerial Competence - No ambition but still can be

managed well. (esp small firms). Sometimes successful firms with creative and
competent management fails due to ignorance to expansion opportunities. (palaroid
case).
 Wage theory suggests that higher wages may discourage work after a certain point.
Entrepreneurs and employees are similar in this way. Good businessmen may value a
higher income less than a comfortable position in the community. but a company run by
men who don't want to make money won't grow. Because avoiding new experiences
and locations is the best way to lower an entrepreneur's service quality. Thus, a firm's
managerial competence depends largely on its entrepreneurial services.
 Productive pportunity

The Quality of Entrepreneurial Services

 Entrepreneurial Versatility - related to imagination and vision may or may not be

practical. Specificity of entrepreneurial resources – unavailability of some productive
services required for expansion. All managerial services required for efficient operations
 are available. Versatility leads to developing new markets instead on failing with
limitations on market for those products which company product.
 Fund-Raising Ingenuity – difficulty in capital raising may limit the expansion of firm.
Successful raising capital depends entrepreneur’s ability to generate confidence. Varied
results in same circumstances by different entrepreneur.
 Entrepreneurial Ambition –
o Product/workmanship – minded : goodwill builders- make profits through
improvements and extension of existing activities of the firm. Through
technology, quality, market penetration,etc
o Empire-builders : extension of scope of business inaddition to maintain
competitive advantage. Through acquisitions, eliminating competitors. He needs
a keen instinct for financial manipulations and a shrewd judgment in assessing
not only the value of other firms but also the minimum cost at which they can be
acquired, as whole firms may be bought and sold for "quick profits."
 Entrepreneurial Judgment: No focus on firms that consistently make mistakes,
overestimate what they can do, and guess wrongly about the future. Entrepreneurial
judgment requires more than imagination, "good sense," self-confidence, and other
traits. It is closely related to the organization of information gathering and consulting
facilities within a firm and raises the question of risk, uncertainty, and expectations in
firm growth.

The Role of Expectations in the Productive Opportunity of the Firm

 The "objective" productive opportunity of a firm is limited by what it can do, but the
"subjective" is what it thinks it can do.
 ‘Expectations' and not ‘objective facts' are the immediate determinants of a firm's
behavior, the success of a firm's plans depends partly on execution and partly on
whether they are based on sound judgment about the possibilities for successful action.
 The "environment" rejects or confirms the soundness of judgments about it, but
economists cannot predict it unless they can predict how a firm's actions will "change" it
in the future. Firms know they can change the environment and that their actions affect
it. Thus, environmental conditions cannot explain firm behavior or predict success
except within very broad limits.
 the environment - as a "image" in the entrepreneur's mind to determine how economic
versus "temperamental" factors influence entrepreneurial environmental judgments.
 If we can discover what determines entrepreneurial ideas about what the firm can and
cannot do, that is, what determines the nature and extent of the firm's "subjective"
productive opportunity, we can at least know where to look to explain or predict
specific firms' actions. If we can prove that significant factors increase a firm's
 productive opportunity and change it in a systematic way over time, we'll have a theory
of firm growth.

Chapter- 4 Expansion Without Merger: The Receding Managerial Limit

Why there are limits to growth of firm – Managerial ability (internal factor), product or factor
market(external) and uncertainty (both). Excluding inorganic growth for this analysis. External
limits can be ruled out if we assume inputs to be not fixed and there are always investment
opportunities for different firms to expand.

Labor, managerial services, capital, and profitable investment opportunities are likely fixed in
any economy, though they may grow over time. Because it is not constrained by same supply
and demand functions (as economy), the individual firm should be treated differently from
the economy as whole.

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).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).
 The Nature of the Managerial Limit

Planning requires a goal and resource organization to achieve it. An "optimum" expansion plan
requires a firm's resources, whether acquired or obtainable. The firm cannot, and will not,
extend its expansion plans and "management team" to take advantage of all such
opportunities. These has to be some experienced based planning which could gain confidence
in that planning.

 The Management Team - The firm's managerial existing staff's capacities limit its
growth because they cannot be hired in the market.
o Working within the firm and with each other allows them to provide services
that are uniquely valuable for the group with which they are associated. People
with experience within a group cannot be hired from outside the group, and it
takes time for them to gain experience. The managerial group's experience is
crucial to a firm's expansion because it creates new productive services.
o The services from "inherited" managerial resources limit the amount of new
managerial resources that can be absorbed, putting a fundamental and
inescapable limit on a firm's expansion.
 Release of Managerial Services - Assuming that a firm will expand only in accordance
with expansion plans and that the extent of these plans will be limited by the size of the
experienced managerial group, managerial services absorbed in the planning processes
will gradually be released and become available for further planning.
o 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).In small firms such a planning and execution function of expansion
in sporadic, while in large firms it is continuous
o Planning services could be integrated into operations, reducing expansion
increments. It's unclear why a firm would adopt such a policy, especially if it's
influenced by Chapter II. In small firms with owner-managers who want to work
less, excess managerial services can be easily removed.
 The Growth of Managerial Services –
o As a company grows, more authority is delegated "down the line." Delegation
cannot be final. Companies share responsibility. For a firm to grow beyond a
small size, it must decentralize authority and subordinate responsibility while
 retaining ultimate responsibility. As executives become more familiar with their
work and integrate into the organization under their control, their effort will
decrease and their capacity will be used less. The experience gained not only
helps a group of individuals work together, but it also increases knowledge of the
group's, or firm's, action options. Knowledge increases a firm's productive
opportunity in ways unrelated to environmental changes and makes each firm's
opportunity "unique."
o People learn two ways. One kind can be taught, learned, and communicated.
Learning through personal experience creates the other kind. First is "objective"
knowledge. It is conceptually independent knowledge about things. It differs
from the second form of knowledge—experience—in this. Because of his
intimate knowledge of the firm's resources, structure, history, operations, and
personnel, a former employee can provide services to that firm that he could not
provide to any other firm without additional experience. The unused services
created in old and newly acquired personnel through increases in "objective"
knowledge and experience are often hidden as unused abilities rather than idle
man-hours.
 The Receding Limit and the 'Static' Approach - a firm's productive opportunity is "fixed"
because there is a limit to expansion in any given period. Thus, a "static" analysis can
explore "equilibrium" conditions. If external conditions, knowledge, and the internal
supply of productive services don't change, the firm's productive opportunity will be
fixed.
o Managerial diseconomies do not occur because firms cannot subdivide functions
and decentralize. Experience is needed to create new and unique services.
o "Complete rationality" or "perfect knowledge" don't matter. This assumption has
never meant that all men have experienced everything or that all is known that
ever will be known, but only that men "are supposed to know absolutely the
consequences of their acts when they are performed, and to perform them in
the light of the consequences."
o In Once it is recognized that the very processes of operation and expansion are
intimately associated with a process by which knowledge is increased, it
becomes immediately clear that the productive opportunity of a firm will change
even without any change in external circumstances or fundamental technological
knowledge.

The Effect of Uncertainty and Risk

"Uncertainty" refers to the entrepreneur's confidence in his estimates or expectations, while

"risk" refers to the possible outcomes of action, specifically the loss that may be incurred.
Thus, uncertainty and risk impact a firm's expansion plans. The most common simple answer
assumes that entrepreneurs simply make allowances in their cost and revenue calculations by
deliberately and somewhat arbitrarily using lower demand or higher cost estimates than those
they consider most likely to prevail. As a firm invests more, its "wealth" position becomes
endangered if it operates on borrowed money, and its liquidity, or ability to meet unexpected
cash demands, becomes precarious as it depletes its reserves and if its ability to raise money is
affected by its heavy illiquid investment. Thus, "increasing risk" limits firm expansion.

 Uncertainty and Information –

o Subjective uncertainty—the entrepreneur's state of mind—affects a firm's
behavior. It comes from "temperament" (like self-confidence) and the
entrepreneur's awareness that he doesn't know enough about the factors that
will shape the future. Thus, knowing more about the factors that could influence
the future is one of the best ways to reduce subjective uncertainty. (‘managerial
research'). A businessman does not like to take responsibility for action in areas
he considers within his competence, but he may accept the judgment of people
he knows and trusts and who can explain their judgment, especially if they also
share a general responsibility for the outcome. The more the group trusts each
other and subdivides areas of expertise, the more activity can be planned. As a
firm grows, "group action" becomes more important than "temperament" and
personal attitudes of individual managers. Information does not affect risk, and it
cannot eliminate uncertainty for any expansion plan. Thus, we must consider risk
and unavoidable uncertainty.
 Risk and Unavoidable Uncertainty-
o Given the irreducible uncertainty, the firm must decide how much to invest in
the activity. expansion-related financial risk. This problem requires distinguishing
two broad responses to risk and unavoidable uncertainty. One type causes a firm
to adopt conservative financial policies and limit its expansion programs to the
extent permitted by funds from specified sources, while the other minimizes risk.
Both entrepreneurs seek "risk-avoidance," but the firm's expansion program is
affected differently. For instance, whether a firm refuses to borrow because it is
conservative and dislikes risk or because it thinks debt is immoral makes no
difference. We have seen that enterprise quality affects firm expansion plans for
many reasons. Enterprise requires risk-taking, so risk-taking and enterprise are
opposites.
o Enterprise goes beyond this, including the willingness to avoid risk and grow.
Thus, it is difficult to separate the effects of risk and uncertainty on expansion
from those of limited managerial services. A distinction is possible only when it
 can be shown that managerial services are inefficiently used because expansion
is held up not only by risk attitudes, which are responsible for extremely
conservative financial policies, but also by an absence of enterprising attempts to
reduce expansion risk. The same "unwillingness to bear risk" affects expansion
differently depending on other enterprise qualities.
o These conclusions will estimate risk and unavoidable uncertainty for each course
of action. If this is so high that the firm refuses to act or acts only in a limited
way, then managerial services that would otherwise have been used in
perfecting and executing expansion plans either remain unused or are devoted
to alternative plans, including plans for programs that reduce total risk. If
managerial services are fully used, their limited supply limits expansion as much
as risk and uncertainty. Only if they are not fully used and there are no other
"bottlenecks" can risk and uncertainty be identified as the final limiting factor.

Chapter-5 'Inherited' Resources and the Direction of Expansion

Focus - Limits on expansion to direction of expansion. External inducement (growing demand,

technology, etc) and external obstacles (competition, patent, etc) to expand. Internal
inducement ( pool of unused resources, specialized knowledge, etc) and internal obstacles
(unavailability of specialized services , skills, etc.) to expand. Nature of these external and
internal influence direction and method of expansion. Ex – Ambitious entrepreneur with ideas
but firm lacks the managerial ability to execute it.

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 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.
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 Continuing Availability of Unused Productive Services

Thus, a resource is a set of services. The firm will use fixed plant and market resources to
provide some services. A firm with resources for current and future operations has an incentive
to maximize profit from each unit of each resource type. Thus, a firm should expand if it can use
its resources more profitably. Unused productive services from existing resources are "waste,"
but if they can be used profitably, they can give a firm a competitive advantage. Will a firm will
have no incentive to expand? firm's all available services are fully used is unlikely to reach,

 Indivisibility and the 'Balance of Processes' - Least common multiple may involve an
enormously large output (tend to be greater the larger the variety of resources and the
more diverse the units in which they come).
o If a firm wants to get the most out of a set of productive resources (indivisible), it
must produce at least the least common multiple of the maximum outputs that
can be gotten from the smallest unit of each type of resource.
o A firm would have to produce on a vast scale if it were to use fully the services
of all the resources required for much smaller levels of output.
o This "least common multiple" may require a very large and different output for
even a moderate-sized one. Resources must be purchased in full. Even if a
company doesn't need a full-time salesperson, engineer, or "trouble shooter,"
buying a resource and using it part-time may be better than not having it.
o If we consider all of a firm's resources, its expansion limit may force it to forgo
many of its services.
o However, a company's growth limit is diminishing. As the company grows, it will
gain more resources, many of which will offer different services. Thus, the
"multiple" will change again, requiring the company to expand. Before
expanding, the company may know this will happen, but it may not be able to
prevent it because it needs the resources but can't plan a big enough program to
use them all.
 o IN imperfect market -> full use of resources requires diversification, as there may
be saturated demand in existing product line.->adding more services to
collection of resources -> problem of balancing processes sets in ( some
resources used partly or less efficiently. Idle services thrown away and by
product of services gives expansion scope.
 The Specialized Use of Resources -
o A firm has an incentive to use its most valuable specialized services and engage
in operations large enough to eliminate pools of idle services. Shopkeeper's idle
hours, but the firm's output is too low to use his most valuable services. The
smaller a firm's output, the less it can specialize its resources.
o Large markets encourage division of labor, which improves resource efficiency.
Inconsequently, growth, which necessitates at least some specialization, raises
"lowest common multiples" for output that fully utilizes the acquired resources'
specialized services. The "virtuous circle" of "specialization leads to higher
common multiplies, higher common multiples to greater specialization" is called
this.
o The process is much more than this, as using specialized resources may lead a
firm to diversify its output. If a group of products share costs, specialization at
the common cost may lower production costs for any one of them. As shown,
managerial resources will create new services, but this also changes the nature
of productive services from other resources and the firm's management of
existing services.
 The Heterogeneity of Resources – Man-hours and services rendered by men are
different. Land, labor capital – are categorized for convenience of analysis.
o Research staff, higher-ranking managers, and similar human services. Each
resource and many of its services are unique in that they cannot be repeated.
o Each firm's uniqueness comes from its resources' heterogeneity, not
homogeneity, of productive services. This heterogeneity in a firm's material
resources' services allows the same resources to be used for different purposes if
the people who work with them have different ideas.
 Interaction between Material and Human Resources –
o Knowledge can expand a resource's services, but only a few are profitable. As
knowledge of resource physical properties, uses, and profitable products grows,
so do service possibilities (improving efficiency and profitability) . The firm's
material resources and staff knowledge are linked. Economists have recognized
that increasing knowledge dominates economic processes, but they have not
studied how changes in traditional economic variables affected by change in
 knowledge. Entrepreneurs understand the value of resources and the services
they can provide, and they believe they can learn more.
o This belief motivates knowledge acquisition and guides it. Researching a source's
characteristics or ways to combine them with other resources can reveal its
productive services. Economic resources include "free" goods, which are
excluded from any "productive" classification. A "good’s free availability "' may
encourage innovations that use its services in production, but its services are not
free.
o Firms with entrepreneurial resources have an automatic increase in knowledge
and an incentive to seek new knowledge. Physically describable resources are
bought for their known services, but once they join a firm, their capabilities
change. Resources yield services based on men's capacities, but resources shape
men's capacities. They create a firm's unique productive opportunity.
 The Creation of New Productive Services
o Growth can’t be seen in reference to external conditions only. Process of new
productive service depends not only on availability of physical resources linked
with managerial services. For enterprising firm, New profitable expansion
opportunities create constant expansion pressure. Since expansion is limited, a
firm may not be able to take advantage of all the opportunities created by new
services.
o External changes can also affect a firm's "stock of knowledge" and resource
value. Market knowledge, competitor technology, and consumer tastes and
attitudes are crucial. Changes in entrepreneurial expectations about productive
potential affect firm growth.

'Demand' and the Productive Resources of the Firm

 The truly enterprising entrepreneur has not taken demand as "given" but as
something he can influence. Advertising and sales issues were ignored until formal
economic analysis and monopolistic competition theory. Later theory gave
economists better analytical tools to deal with the fact that few industrial firms can
be in "pure competition" and understand the firm's subjective view of demand.
Selling costs and competitor retaliation can affect product demand. Neither
expands cumulatively. In the former, the cost of selling rises as the firm tries to
reach more customers, until the additional revenue no longer justifies further
expansion; in the latter, the question is whether there is a determinate equilibrium
price and output or whether fluctuations will continue indefinitely as firms jockey for
position.
 What is the Relevant Demand? Demand is highly subjective from firm’s point of view.
 o A firm's "demand" includes both the quantities and types of products it can sell
profitably. No company produces whatever is in demand at any given time. but
will look into supply possibilities—the firm's resources and productive services.
o Growth of demand for existing products of a firm is largely impacted by prices
and market information but Advertising and other sales efforts can boost
product demand. Expanding into existing production is cheaper. Growing
Demand is the biggest factor in expansion, and current investment plans depend
on entrepreneurial sales projections. In a growing economy, existing firms may
grow due to increased demand for their original products, but in a contracting
economy, curtailed expansion plans can affect growth.
o Very few firms stick to one product even there is growing demand in the long
run. Over time, large companies' "demand" and "product-mix" goes through
changes significantly. Consumers don't know about or "want" the products firms
make. Entrepreneurs believe they can create new products or new uses for old
products that consumers will want and buy at profitable prices and quantities.
Entrepreneurs' success depends on consumer acceptance, but incentive to
innovate comes from firm’s desire to use its available resources more efficiently.
The firm's innovation (including production innovation) is closely related to its
resources (including capital equipment) and the productive services they can
provide.

The Direction of Expansion

 This chapter examined how a firm's resources affect its expansion. A firm considers its
own and market-sourced resources. A firm's resources influence its managers' and
entrepreneurs' ideas, experience, and knowledge. How changing experience and
knowledge affect resource productivity and firm "demand". Unused productive services
encourage innovation, growth, and competitive advantage. Like people, firms have a
position in the world- determined by time, space, and the "intellectual" horizon, which
provides the frame of reference for external phenomena and the starting point for all
action plans. The resources and services of a firm determine its plans.
 External inducement- New inventions, consumer tastes, and product demand may
influence a firm's expansion, but this doesn't tell us their importance. Firms must
examine the traits of firms that enter such industries and the factors that determine
their longevity and growth. Internal and external inducements and obstacles (together)
shape a firm's productive potential. Thus, no firm ever sees the full range of services
available from any resource because management's ideas about possible combinations
limit what is seen. When demand for existing products drops, entrepreneurs no longer
want to put all their resources into expanding existing product lines, so the importance
 of existing resources becomes apparent. Analyzing internal and external inducements
helps explain the relationship between "internal economies of growth" and "size."

Chapter-6 The Economies of Size and the Economies of Growth

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.
o Technological economies is determined by the cost of technology, cost of capital
and raw material, and will affect the size of the plant.
o 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). 
 Unlike the idea of a "optimum" firm size, enterprising firms have a continuous incentive
to expand and no absolute size limit. Larger firms may be more efficient than smaller
firms because they have more opportunities to use productive resources more
efficiently. This summary provides a background for some important distinctions and
relationships between size and growth economies, which have been extensively and
competently described by others.

The Economies of Size

A larger firm can produce and sell goods and services more efficiently than a smaller firm, as
well as introduce new products and larger quantities. In discussions of economies of size,
"technological economies"—derived from producing large amounts of given products in large
plants—are distinguished from "managerial" and "financial" economies—derived from
improved managerial division of labor and from reduced unit costs made possible when
purchases, sales, and financial transactions can be made on a large scale. Plants and firms have
different economies of size, but technological and managerial economies do not.
Technological economies relate most directly to plant organization, but managerial and
financial economies also affect plant size.
 Technological Economies - Technological economies occur when production resource
changes allow for higher output at lower average cost. These technological changes
affect costs depending on the physical productivity of the combination of "inputs" and
the prices of the factors of production. Technological economies of scale only mean that
with given prices of productive resources, a larger scale of output allows changes in
productive techniques or resources that lower the average cost of output.
Management, output, and expansion plans affect plant size. It can be measured in
employment, capital equipment, and output. To determine how plant size affects firm
size and growth, it must be measured in the same units as firms.
 Managerial Economies - Multi-plant firms must look beyond technology for economies
of scale. A larger firm can take advantage of an increased division of managerial labor
and mechanization of certain administrative processes, make more intensive use of
existing managerial resources by "spreading" overheads, obtain economies from buying
and selling on a larger scale, use reserves more economically, acquire capital on cheaper
terms, and support large-scale research. Managerial economies occur when a larger
output can be produced cheaper than a smaller output without changing production
methods. Costs rise at higher output levels without managerial and technological
reorganization. However, managerial economies may not explain the lower cost of
higher output.
o When specialized salespeople are used and production is large enough, selling
efficiencies are achieved. Large firms' superior selling strength is certainly
"monopolistic" in the economist's sense, but selling efforts on a sufficient scale
to meet consumers' real needs are surely an economy for the consumer as well
as an economy of scale for the firm. Larger firms have more security, capital
market access, public knowledge, and cheaper borrowing. The larger firm can
support more expensive research personnel and laboratories than the smaller
firm, and it can more easily manage research operations that require a large
organization.
 Economies in Operations and Economics in Expansion
o The "theory of the firm" has rigorously analyzed the economies of large-scale
production of a given product. A "reversible cost curve" shows economies of
scale by decreasing as output increases and rising as output decreases. Compare
the average cost of a firm's larger output to its smaller output. Economies of
operation are the average cost of producing and distributing additional output
after an expansion. Expanding production and creating a market for it are called
economies of expansion.
o Cost per unit of output must be compared, and economies of size include the
ability to separate productive activities and continue without cost. Large-scale
 production and operation rely on resource efficiency in product production and
distribution. If a large firm with an extensive research organization perfects and
introduces a new product, it may be possible to separate the production of the
new product from the firm, reducing its size without increasing its production
costs. If production is moved to another firm, there is no cost increase for the
firm or consumers. These economies apply only to growth and can be enjoyed by
society even after the tree that bore them dies.
o The distinction between economies in operations and economies in expansion
illustrates the difficulties of defining a "optimum" firm size. Not all firms benefit
from economies of scale in production or operation. As production scale
increases, product costs may decrease, but when all costs, including resource
opportunity costs, are considered, they must increase. Economies of expansion
don't have "decreasing costs" unless the new output is cheaper than the old.

The Economies of Growth

An individual firm's growth economies make expansion profitable in certain directions. The
firm's unique set of productive services gives it a competitive advantage in launching new
products or increasing production of old ones. If there are substantial economies in the large-
scale production of particular products, small firms may survive in the market's interstices but
may not be able to compete with larger firms if they cannot expand enough to obtain the lower
costs of large-scale operation. Economies of growth depend on a firm's productive resources
and its ability to exploit them, regardless of size. Even though they have no advantages over
other larger or smaller firms, expanding may be profitable. In smaller firms, management may
think a larger size would improve production.

 Disappearing versus Enduring Economies

Growth economies that don't produce and operate on a large scale don't last long. Internal
economies of growth can be used to help new products, industries, and plants grow. But the
success of the expansion may depend on advantages that will likely go away as the new
activities are set up and grow, especially if they involve making new types of products or
setting up plants and subsidiaries in new places. The resources for the new activities become
specialized and have nothing to do with the old ones. The most important facts are that
splitting up the bigger old company wouldn't lower or raise costs and that economies of scale
can make it easier and cheaper for an established company to set up a second plant in a
different place.

It doesn't mean that production costs will go down in either plant. Economies of growth are
also called economies of size if they apply to both old and new activities or if they need to
organize old activities. But it's hard to compare the costs of different companies, and if the
size of the company doesn't matter, the fact that a country's economy is dominated by big
companies and that the companies that are already there are good producers and seem to
keep getting bigger doesn't mean that economies of scale are the main force at work. This
paradox shows that firm growth might be the most efficient way for society to use its
resources, but it has no benefits.

Contribution

1. Outside mainstream economics – canonical reference to current dominant resources

(knowledge, dynamic capabilities, theory of multinational enterprise, IB, Strategic human
resources.)
2. The theory of the firm, business strategy, and organization scholarship use TGF to explain the
nature of the firm and its ability to create and capture value.

Limitation –

1. Initially it was considered as the footnote to neo-classical theory due to lack of generalizations
about the economic environment that firms are embedded into. (Andrew,1961). But this is again
based on economist focus on market based equilibrium analysis. Penrose book was written for
wider audience. (inability to fit into neo-classical or failure of state of economics?)
2.