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“The Theory of the Growth of the Firm”* William Lazonick

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“The Theory of the Growth of the Firm”* William Lazonick Working Papers R & D THE US INDUSTRIAL CORPORATION AND “THE THEORY OF THE GROWTH OF THE FIRM” by W. LAZONICK* 2001/16/SM * Professor, University of Massachussetts-Lowell, Visiting Scholar at INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex, France. A working paper in the INSEAD Working Paper Series is intended as a means whereby a faculty researcher’s thoughts and findings may be communicated to interested readers. The paper should be considered preliminary in nature and may require revision. Printed at INSEAD, Fontainebleau, France. The US Industrial Corporation and “The Theory of the Growth of the Firm”* William Lazonick University of Massachusetts Lowell and INSEAD (The European Institute of Business Administration) February 2001 * This paper reflects ongoing research on corporate governance, innovation, and economic performance done in collaboration with Mary O’Sullivan at INSEAD (see http://www.insead.fr/projects/CGEP) with funding from The European Commission DGXII (Contract no.: SOE1-CT98-1114; Project no: 053), Commissariat Général du Plan of the French Government, and INSEAD Association for Research (sponsoring a conference on “The Penrosian Legacy: The Work of Edith Penrose, Her Contributions to INSEAD, and Research on Business Enterprise and Economic Development”, INSEAD, Fontainebleau, France, May 10-11, 2001). I am grateful to Christos Pitelis for comments on an earlier draft. To appear in Christos Pitelis, ed., Edith Penrose’s Theory of the Growth of the Firm Forty Years After, Oxford University Press. Lazonick ABSTRACT Today, more than four decades after its initial publication, Edith Penrose’s The Theory of the Growth of the Firm fits the definition of a “classic” work: a book that everyone cites but few have read. In this paper I evaluate The Theory of the Growth of the Firm as a contribution to a theory of innovative enterprise. First I identify three essential social conditions -- organizational integration, financial commitment, and strategic control – that are at the core of a theory of innovative enterprise. Next, I summarize Penrose's theory of the growth of the firm as a contribution to the theory of innovative enterprise. Then I provide an historical overview of how the social conditions of innovative enterprise have changed in the US corporate economy over the past 40 years. On this basis, I evaluate Penrosian theory in historical perspective by focusing on its ability to explain 1) the overextension of the scale and scope of corporate activity, especially through conglomeration; 2) the emergence and impacts of new international competitors; 3) corporate responses to a new financial environment oriented toward "shareholder value"; and 4) the changes in the dynamics of the growth of the US corporate enterprise in the shift from the "old economy" to the "new economy". Finally, I show that, writing later in her career, Edith Penrose herself understood that the continued relevance of her perspective depended on the employment of a research methodology that could integrate the elaboration of the theory of the growth of the firm with the ongoing study of the historical evolution of the modern corporate economy. 1 Lazonick Introduction Today, more than four decades after its initial publication, Edith Penrose’s The Theory of the Growth of the Firm fits the definition of a “classic” work: a book that everyone cites but few have read. Written in an abstract theoretical style that reflects the author’s training as an economist, the book is nevertheless rich in “real world” insights into a complex social phenomenon. The prime purpose of this paper is to argue that to make full use of The Theory of the Growth of the Firm requires an understanding of both the substance of her theory of the modern industrial corporation and the actual social conditions of the industrial corporation that, when the book was written in the late 1950s, her theory sought to capture. Penrose wrote the book in the United States in an era when the US economy, with its powerful industrial corporations, was unchallenged in its dominance of the world economy. At the same time, especially in the United States, the dominant theory that guided the thinking of economists on the role of the large firm in the economy was the “monopoly model”. Derived from the neoclassical theory of the firm, the monopoly model had much to say about the impact of “imperfect competition” on prices and output in the economy but virtually nothing to say about the growth of the firm -- that is, how a particular company, by accumulating productive resources, came to be dominant in its industry (see Lazonick 2000). The empirical reality of the long-lived and dominant corporate enterprise in the United States in the 1950s and the obvious gap in microeconomic theory that it implied combined to set the stage for Penrose’s classic book. I shall argue that The Theory of the Growth of the Firm represents a seminal work on “the theory of innovative enterprise” (see Lazonick 2000; O’Sullivan 2000a). As such, Penrose’s theory of the growth of the firm can provide the basis for a devastating attack on the relevance of neoclassical price theory to an economy in which such growth on the basis of innovative enterprise is a characteristic feature. For if a firm grows into a position of dominance in an industry through technological and market transformations that give it the ability and incentive to produce more output at lower prices than “perfectly competitive” firms, then the orthodox performance comparison of a restrictive, price-making monopolist with a more expansive, price-taking perfect competitor no longer holds (see Lazonick 2000; also Schumpeter 1950: 90, 109). Yet the purported prescriptive power of neoclassical price theory, which in turn has justified the overwhelming preoccupation of economists with so-called “market imperfections”, assumes that an economy characterized by more rather than less “perfect competition” yields superior economic performance. The monopoly model can and has been criticized without invoking a theory of innovative enterprise. In particular, over the past three decades the monopoly model and the structure-performance-conduct approach to industrial organization to which it gave rise have been the subject of a major critique by proponents of transaction-cost economics, foremost among them Oliver Williamson. Transaction-cost models advance beyond the monopoly model by making behavioral and cognitive assumptions concerning the binding constraints that firm decision-makers face in choosing the particular activities that their organizations should undertake. In transaction-cost theory, there is an absence of perfect competition, not because a theory of innovative enterprise makes it irrelevant, but because the existence of “opportunism” (the behavioral assumption) and “bounded rationality” (the cognitive assumption) render it impossible. From this perspective, it is “human nature as we know it” (Williamson 1985, 80), not monopoly, that accounts for the absence of perfect markets. Nevertheless, in sharp contrast to the innovative-enterprise critique 2 Lazonick of the monopoly model, the transaction-cost critique admits that perfect competition would yield superior outcomes if "human nature as we know it" did not make it a utopian fantasy (see Lazonick 1991, chs. 6-7; Lazonick 2001). Given these behavioral and cognitive conditions, the transaction-cost approach (like the monopoly model that it critiques) ultimately relies on exogenously determined “sunk costs” – Williamson’s “asset specificity” -- to explain the scale and scope of the modern industrial enterprise. In contrast to the transaction-cost model, the theory of innovative enterprise shows how by choosing to engage in innovative investment strategies that rely on the transformation of behavioral conditions (“opportunism”) and cognitive conditions (“bounded rationality”) for their success, an enterprise can potentially generate superior economic outcomes – specifically more output at lower unit costs – that enable it to emerge as dominant in the industries in which it competes. Instead of viewing the firm’s assets as exogenously determined, a theory of innovative enterprise analyzes them as strategic investments. Unlike constrained optimization models, be they of the monopoly or transaction-cost varieties, a theory of innovative enterprise seeks to analyze how, in certain times and places, a business enterprise strategically seeks to transform organizational (cognitive and behavioral) and industrial (technological and market) conditions that might otherwise impose constraints on its ability to generate higher quality, lower cost products. As such, a theory of innovative enterprise does not provide a set of decision rules for choosing the "optimal" course of action; by definition, the innovation process generates a superior course of action that has yet to be learned -- otherwise it would not be innovation -- and hence what might be viewed as "optimal" at the outset of the innovation process will likely be viewed as "sub-optimal" at the end. Rather than be trapped by adherence to existing "optimality" conditions, the theory of innovative enterprise provides a set of principles concerning the social organization of the innovation process that constitutes a basic framework for analyzing the relation between business organization and economic performance in particular historical – i.e., institutional and industrial -- contexts (Lazonick 1991 and 2000). In this paper I shall evaluate
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