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Lesson 4: Theories of Growth of Firm

4.1 4.2 4.3 4.4 Introduction Downies Growth Theory of Firm Penroses Theory of Growth of Firm Marriss Theory

4.4.1 The Steady-state Growth Condition 4.4.2 The Growth in Demand Function 4.4.3 The Cost of Expansion Function 4.5 4.6 4.7 4.8 4.9 Summary Key Concepts Check your Progress Self-Assessment Questions Answers to check your progress

4.10 Suggested Readings

After studying this lesson, you will be able to understand Definition of Growth Need for Growth of the firm Importance of Downies Model Significance of Penroses theory Prominence of Marriss theory

4.1 Introduction:
Growth is an important dimension of a firm whether it is small or a large one. Maximization of growth may be the goal of the firm or an instrument to achieve some other goal like maximization of profit or sales or managerial utility etc. Most of the large firms that we see around were small when they were established. In the course of time they grew continuously and attained their present status. Why do they grow to such an extent? It is a natural inducement which the market provides to the existing firms for growth. There is a strong case for growth of a firm under competitive pressure not only from the potential firms but from the existing ones also. Through growth, the firm will be able to enlarge its size. The larger the firm the more perfect the control it asumes over its environment and the higher the efficiency with which it plans its over-all-activities. A growing firm may be able to increase its market share in the industry. It may acquire more market power which will have favorable effects of the firm. Introduction of new products, new production processes and organizational techniques as parts the growth strategy of the firm, will enhance the competitive power of the firm as a result of which it will be able to withstand or survive in the process of the the creative destruction as

Schumpeter argued. Growth is therefore very much desirable for the firm to stay in business otherwise it will be relegated to non-entity by the dynamic competitive forces of the market. Growth is a long-run survival condition for the firm particularly in an uncertain and constantly changing environment. It is a natural process but reinforced considerably by the competitive environment of the market. Major contributions in the theory of the growth of the firm came from Downie, Penrose and Mrris. The concept of the firm used in theories of these authors is significantly different from the one that has been adopted in the traditional theory of the firm. Marris, for example, defined the firm as administrative and social organization, capable, in principle, of entering almost any field of material activity. The firm is not necessarily limited to particular markets, industries, or countries; indeed, there is no theoretical reason why firms should not venture anywhere in the universe. The firm is a changeable bundle of human and professional resources, linked through the corporate constitution to a corresponding bundle of material and financial assets. What determines the growth and hence size of this type of firm was the task before the growth theorists. Generally, it is an accepted fact that there will be an upper limit to the rate of growth of the firm because growth is subject to various dynamic restraints of which financial, demand and managerial restraints will be crucial. The restraints operate from the cost side of the growth, so it is the equilibrium between gains from the growth and the cost of the growth that sets the upper limit to the rate of the firm, given its objective. Downie, Penrose and Marris developed the theories of the growth of the firm by considering these restraints. The interpretation and combination of the restraints, however, differ in their theories as we will find below.

4.2 Downies Growth Theory of Firm:

Downie was mainly concerned with analyzing the way in which alternative forms of market structure and conventions governing business behaviour, which he calls as rules of the game, affect the dispersion of efficiency between firms and the rate of technical progress. According to him, in an industry, which he defined as a group of firms having similarity of technical process, there will be a dispersion of efficiency across the firms. Those firms having access to technologically superior processes are taken to be more efficient. It is established as a result of its fast innovations which are kept secret by it. The process of growth of firms in his model starts with the postulation of the study encroachment on the market share of the less efficient firms by the more efficient firms. The means of the growth that takes into account by him are capacity of production and customers. To expand capacity finance is needed in turn it depends on the rate of profit. This means that the rate of growth of capacity expansion has a positive relationship with the rate of profit. On customers side attraction of new customers is not possible by sales promotion or advertisement but trough its price reduction strategy it will be fusible only up to certain limit. This implies an inverse relationship between the rate of customer expansion and the rate of profit for the firm. There are now two opposite trends in the growth process of the firm: 1. The capacity side of the growth varies positively with the rate of profit. 2. The market side rate of customer expansion varies inversely with the rate of profit.

These two opposite trends will set the upper limit on the rate of growth of the firm.

Such optimum situation for the rate of growth of the firm would be at the point, where the capacity and the market growth equal each other. In this process inefficient firms share will decline in the industry since it is a matter of survival for them, they adopt innovative mechanism for reversing the efficiency differences. Concluding Remarks: At the outset Downies model provided useful basis for the subsequent works. Further, applicability of the model was well taken into account but it has not considered diversification as a way to remove the market restraint on growth of the firm.

4.3 Penroses Theory:

There is no formal equilibrium growth model for the firm given by Penrose. She assumes a desire to increase total long-run profits as the goal for the firm. Penrose considers the firm as a fool of productive resources organized within an administrative framework. The set of activities which the firm is aware of and able to undertake at a profit, defines its productive opportunity. Penrose has given major emphasis on explanation of restraints on the productive opportunity of the firm in her theory. A brief sketch of how the growth of the firm is restricted in the Penrose frame work is given below: The concept of Productive Opportunity is conceived of as the basic element in the theory of growth of the firm by Penrose. Every individual firm is supposed to have a unique productive opportunity which makes the firm unique itself. To explain this point, Penrose defined productive resources as a bundle of potential services, rather than merely the physical quantities.

How does the growth process proceed in the Penrose frame work? The process of growth is not automatic in the Penrose framework. It is deliberate and conscious choice of the management. The growth process proceeds as follows:


The process starts with the planning stage. Plans for the expansion of the firm are prepared first and then executed.


The existing managerial team will be performing these acts. The team will work as a well co-coordinated administrative structure in organizing the growth of the firm.


The collective experience of the managerial team will determine the character and extent of the productive services available for expansion given the firms productive resources


The nature and availability of managerial services both entrepreneurial and administrative will shape the rate and direction of the firms expansion. If the manager services are adequate, the firm can sustain higher rate of expansion, otherwise not.


It is possible to expand the managerial services by recruitment of the new managerial resources but such resources will take time to gain the required experience to run the firm and thus, in observing into the managerial team at full efficiency.


The existing managerial resources of the firm would not be increased significantly by such recruitments immediately.

In the words of Penrose, if the firms deliberately are inadvertently expands its organization more rapidly than the individuals in the expanding organization can obtain the experience with each other and with the firm that is necessary for the effective operation of the group, the efficiency of the firm will suffer, even optimum adjustments are made in the administrative structures. The managerial restraint limits the productive opportunity of the firm at any given time, which in turn puts an upper limit to its growth. There are some other restraints on the growth of the firm as seen in practice, such as the financial and market restraints. Penrose, however, treated them as insignificant in limiting the growth rate of the firm. She emphasized solely on the managerial for this. In what direction will firm grow? To find the answer of this question, Penrose analyzed the possible eternal and internal inducements and obstacles for expansion of the firm. The External and Internal Inducements and Obstacles enlisted below: i) The external inducements mentioned by her includes changes in demand, technological innovations and other changes in market conditions which help the firm to improve its competitive position. ii) External obstacles including competition from rivals, patent or other restrictions on the adoption of new technology, barriers to entry, and market scarcity of any input etc., iii) Internal inducements such as unused productive services, and other potential of the firm iv) Internal obstacles to expansion will be, by and large, the scarcity of specific managerial services.

It is the balance of the external and internal inducements and obstacles which determines the direction and method of expansion of the firm. Penrose placed much emphasis on the internal factors. A natural process of growth in Penrose model is the diversification. Through the process and/or product diversification in the firm will be able to utilize the productive opportunity fully and grow further till it is restrainted by the availability of certain managerial services. Diversification is an effective strategy to neutralize the effect of the demand restraint on the growth of the firm. According to Penrose, when a firm has achieved the maximum rate of profitable growth by means of internal expansion and constraint by the managerial restraint, it may still grow further through external expansion in the form of merger or acquisition. Concluding Remarks: At the outset, Penrose work is an important contribution in the theory of growth of the firm. Her analysis is very much complex but not rigorous and formal. The effect of the managerial restraint on growth of the firm as postulated by Penrose is well known as the Penrose Effect. She emphasized much on the variables for growth of the firm which are non-economic and often difficult to quantify. But, her ideas on the process of the growth of the firm are logical consistent. However, there is a serious drawback in her work. She has neglected financial and other external constraints on growth of the firm. This is not justified. 4.4 Marriss Theory: A coherent and integrated theory of the growth of the firm has been developed by Morris. His theory is applicable to a corporate firm owned by shareholders but controlled by managers. Shareholders, being owners of the firm, are assumed to have the objective of maximizing the return on their investment in the firm. Managers of the firm, on the other

hand, aspire to maximize their own interests which are taken care of by higher pay perks, power, prestige, etc. all such things are postulated to be positively correlated with the growth of the firm in Marris model. It implies that managers of the firm are assumed to have the rate of growth of the firm as their objective. The return on shareholders investment is realized in the form of dividend and capital gains throughout the life of the firm. The present value of the future stream of such earnings of current share capital determines the value of the firm in stock market. Higher the expectation of the earnings by shareholders from a firm, greater will be its value in stock market and vice-versa. In view of this relationship, one may, therefore, take the growth in market value of equity shares of a firm as a proxy variable to specify the profit maximization goal of its shareholders. Marris used this approach in his model. He specified mazimization of the rate of growth as the overall goal of firm subject to a stock-market valuation constraint. K The constraint takes care of the objective of the shareholders. So, the stock market valuation constraint on growth of the firm is very important in Marris model. The mechanism of the growth of the firm in Marris framework can best be explained with the help of a few relationships which Marris himself specified. They are as follows:

4.4.1 The Steady-state Growth Condition: To simplify the analysis of the growth of the firm, Marris made the assumption of steadystate growth under which all characteristics of the firm such as assets, employment, sales, profits, etc., grow at the same constraint exponential rate over time. The implication of the steady state growth is the both supply and demand sides of the firm grow over time at the same rate. The supply steady growth is represented by its assets-base which includes i) physical assets comprising of fixed assets and stock at replacement value ii) financial assts at current market value in including cash iii) good-will mainly generated by marketing

expenditure; and iv) know-how as a result of R&D investment. The assets and employment grow at the same rate on the supply side. The demand side of the firm is difficult to be specified precisely as the product-structure of the firm would be changing over time because of diversification process. As mentioned earlier, the assumption of steady-state growth is made to simplify the theoretical analysis. In fact, firms rarely show constant growth as defined and constant values for state variables. However, such situations can best be interpreted as moving from one steady-state growth path to another. In a dynamic growth framework this is quite possible. 4.4.2 The Growth in Demand Function: The growth of demand is one side of the growth of a firm. If demand prospective for the existing and potential products of the firm is bright then it will grow, otherwise not. Market restraint will force it to be stagnant or declining over time. If the demand for the product of a firm reaches to its saturation point, then the firm will be stagnant. To avoid this situation, Marris advocated diversification as the most effective way. Diversification is not only a competitive strategy in the market but an effective way to grow further as Penrose advocated in her book. 4.4.3 The Growth supply function: The growth of supply function means an increase in the assets (fixed and current). This can be raise primarily through retained earnings, borrowings and the issue of new equity shares. But Marris assumed the the new investment is financed only by retained earnings. In practice, a firm raises money fro new investment from other sources also. The relationship for growth of supply function may be derived as in the case of retained earnings under the assumption of that the capacity of rising funds from external sources.

If expected rate of return is high, the potential shareholders will buy shares of the firm and creditors will provide money to it, other wise not. 4.4.3 The Cost of Expansion Function: In Marriss model, it is the rate of successful diversification that determines the growth-of demand of the firm. The rate of diversification depends on cost of expansion and, if cost-expansion grows fast, the profit rate on capital likely to decline. Thus, the relationship shows the rate of diversification directly related to capital-output and inversely to the profit margin. The relationship is defined as cost of expansion function for the firm. All the three restraints financial, market demand and managerial- are operative in his model. The theory developed by him is quite realistic and fairly exhaustive. The material presented is only an abstract of his theory of growth of the firm rather than a full description of it. 4.5 Summary:

This lesson was concerned with the growth theories of the firm. The need for growth and theories of the growth of the firm propounded by Downie, Penrose, Marris was examined the theories are elegant and comprehensive in the sense that they take into account several real life factors concerning the operations of the firm rather than pure abstract views as in the case of the conventional theory of the firm. The empirical evidence is, however, not yet adequate to support or reject the theories of the growth of the firm. The positive relationship between growth rate and profitability of the firm is, by and large, supported by the empirical facts but on the other dimensions of the managerial growth theories of the firm, the empirical evidence is not adequate to draw any conclusion.


Key Concepts:

Growth: which is conventionally measured as the annual rate of increase in the gross national product. Innovations: Schumpeter introduced the concept. Examples for Innovations are New Market, New Product etc., Rules of the game: The way in which alternative forms of market structure and conventions governing business behaviour is Downie calls as rules of game. Non-Price Competition: The attraction of customers is possible through Sales Promotion or Advertisement is known as non-price competition. Productive opportunity: Penrose defined productive resources as a bundle of potential services rather than merely physical quantities. Financial restraint: Non-availability of sufficient fianance for industrial development

External inducements: which help the firm to improve its competitive position. External obstacles: which stand as a barriers for the growth of the firm. Steady-state growth : All characteristics of the firm grow at the same constant exponential rate over time. 4.7 Check your Progress: State whether the following statements are True or False

1. According to Marris Growth of Supply means an increase in Fixed and Current Assets 2. Penrose effect reveals the managerial constraint as per Penrose 3. Disequilibrium growth model for the firm given by Penrose 4. Downies model has not taken into account the Managerial restraint


Self-Assessment Questions:

Short answer type questions 1. What is innovative mechanism? 2. What are the limitations of Downies Model? 3. Enlist the important constraints noted by Penrose 4. Write short notes on the following: a) The Steady-state growth condition b) Managerial restraint c) Market restraint Long answer type questions 1. Critically evaluate the Marris model 2. Discuss the concept of Penrose Effect 3. Distinguish between Growth-in Demand function and Growth of supply function 4.9 Answers to check your progress:

1. True 2 True 3 False 4 True

4.10 Suggested Readings

1. Misra, Puri 2. Mahesh Chand & Puri.V.K. 3. Sivaiah & Das 4. Birthwal.R 5. Bhagwati.J.N & Desei.P

Indian Industrial Economy. Regional Planning In India. Industrial Economics. Industrial Economics. India: Planning for Industrialization.

6. Chenery.H.B

Patterns of Industrial Growth, American Economic Review, September, 1960.

7. Isher Judge Ahluwalia

Industrial growth in India- Stagnation since the Mid 60s.

8. Misra.R.P.

Regional Planning.