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Lesson 4: Theories of Growth of Firm 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, maximization of profit or sales or managerial utility etc. may be the goal of the firm. Most of the large firms were small when they were established.

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-allactivities.

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. Major contributions in the theory of the growth of the firm are: Downie, Penrose and Marris. The concept of the firm used in theories of these authors is significantly different from the traditional theory of the firm. Marris, for example, defined the firm as ...an 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, 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, Rule of Game affect the dispersion of efficiency between firms and the rate of technical progress. According to him, in an industry, 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 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 two opposite trends in the growth process of the firm:
The capacity side of the growth which varies positively with the rate of profit.

The market side rate of customer expansion which varies inversely with the rate of profit.
These two opposite trends will set the upper limit on the rate of growth of the firm. (See Figure on next page) In figure such optimum situation for the rate of growth of the firm would be at the point G where the capacity and the market growth curves intersect. 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, 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.