Including internal and external dynamics of growth and decline

When discussing theories of growth, it is logical to start with Edith Penrose and her book

“The Theory of the Growth of the Firm” (1959). I will briefly summarize the most important components of the book as I read it. She is interested in what promotes or limits the growth of a firm. She criticizes traditional economic analysis, especially the neoclassical models of equilibrium that treat growth as “merely an adjustment to the size appropriate to given conditions; there is no notion of an internal process of development leading to cumulative movements in any direction” (Penrose, 1959, p. 1). As the title indicates, the unit of her analysis is the firm. She makes a clear distinction between the firm and the market and defines a firm as a collection of resources bound together in an administrative framework. She concentrated on the internal resources of the firm and saw the environment as opportunities for investment and growth. The external causes of growth, like demand conditions, must be understood in the light of internal incentives for growth, and limits to growth. The limits to growth are determined by the extent to which managers can plan and implement plans for expansion.

Resources are the key factors explaining growth. Human resources, especially managerial, are important: how managers are plan and organize activities and search for

48

opportunities. An important capability is the ability to combine resources to create various forms of innovations. Unused, or “slack,” resources in the organization are viewed as internal stimulus for growth and innovation. Experience is another important resource. It is a firm-specific resource that is difficult to transmit and therefore constitutes a possible competitive advantage. In general, the ability to learn from and develop knowledge, whether it is objective or based on experience, is central to her theory. In her foreword to the third edition (the appendix in the fourth edition), she writes: “One of the primary assumptions of the theory of the growth of the firm is that ’history matters’; growth is essentially an evolutionary process and based on the cumulative growth of collective knowledge” (Penrose, 1959, p. 237). She believes that to learn and develop, one needs prior knowledge and capacity in order to obtain knowledge, and the firm is a better arena in which to create knowledge than the markets.

Later, she realized that collaboration across firms and thereby across networks of relations provides important arenas through which to access resources such as technology and access to markets and knowledge¹⁴. She actually states (in the later foreword) that because the logic of network relations is very different from that of independent firms competing in the marketplace, a new “theory of the firm” (Penrose, 1959) may be necessary. I have no intention to develop such a new theory, but I will describe what I think her theories can still explain and what other theories can explain better, in regard to rapid growth.

In my view, Penrose manages to combine elements of economic theory with elements of organizational theory. She also clears the way for a new strategic theory: the aforementioned resource-based view (RBV). In the RBV, all resources in the firm are possible sources of competitive advantage, and the internal process of coordinating and combining resources creates heterogeneous firms (Barney, 1991, 1995). While both the RBV and Penrose’s theory have important contributions for understanding the importance of internal resources for creating new knowledge and competitive advantage, they are criticized for their inward focus. These theories have an economic focus, where the environment is mostly seen as a market of rising or falling demand more than actors in a system of interplay. Sociological theories, like network theories and social capital, have highlighted the idea that resources are embedded within and available through networks of social relations (Granovetter, 1985;

Inkpen and Tsang, 2005). Similarly, strategic theories have criticized the RBV for ignoring the relational advantages (Dyer and Singh, 1998). However, there are not only advantages but also market failure arguments to consider when deciding to make, buy, or contract in the

14 See both the introduction to the fourth edition by Christos N. Pitelis and the foreword to the third edition by Penrose.

49

market (Williamson, 1981). Economic geography further demonstrates that regions or clusters are arenas in which firms can specialize, compete, and interact to share and create knowledge and thereby generate competitive advantage (Dicken and Malmberg, 2001; Porter, 2000).

Therefore, a theory engaged in the importance of resources to create growth should consider both internal firm capabilities to exploit resources and external opportunities to access resources. In the intersection of these approaches, we find the theory of absorptive capacity:

the firms’ ability to identify external information, assimilate it, and utilize the information (Cohen and Levinthal, 1990).

While Penrose uses organizational theory to explain the internal functions of structure for organizational efficiency, I argue she has an instrumental perspective, focusing on efficient means to achieve specific ends. One reason for this observation is that discussions of internal conflicts are absent in her book. When discussing limits to growth, I think it is insufficient to focus only on managers’ capability to make plans and implement them. The implementation of plans is obviously indirectly related to power, authority, conflict, and trust between members of an organization. However, to really understand the organizational challenges of growth, the perspectives of power and conflict should be central in the discussion. Furthermore, conflicts can be positive for the organization, creating opportunities to re-think assumptions and initiate innovations.

Power, conflict, and trust are essential concepts in organizational theory and different sociological disciplines (like conflict theory), but several other theories can also be used. A potential conflict between shareholders and managers without ownership interest in the firm is discussed in economic theory as moral hazard (Berle and Means, 1932). Agency theory further discusses the problems of an agent acting in his self-interest instead of in the principal’s interest. In extension, this can be further discussed through the institutional perspective and stakeholder theory. In order to survive, organizations must conform to the rules and beliefs of the systems prevailing in the environment (DiMaggio and Powell, 1983).

Particularly new organizations suffer from the liability of newness and need to become accepted by their stakeholders to survive (Stinchcombe, 1965). A firm has to become legitimate and accepted by the environment to be able to grow as well as to develop an acceptable and legitimate firm culture for the members to avoid internal collapse. As such, the firm is pressed by both their internal structures and arrangements and environmental constraints (Hannan and Freeman, 1977).

While Penrose’s theory, and management theories in general, use the individual firm as the unit of analysis, population ecology analyzes aggregates, or populations, of

50

organizations (Hannan and Freeman, 1977). While management theories argue that decision makers optimize profit and create growth, population ecology argues that it is the environment which optimizes and selects optimal combinations of organizations. These arguments may be combined to explain growth, but according to population ecology, the environmental forces are strongest. Or, as Aldrich, McKelvey, and Ulrich (1984, p. 71) explain: “Human purposes and actions are thus necessary, but not sufficient, to explain changes in organizational forms.” To define a population, one must find relatively homogeneous organizations with common characteristics, like formal structures, patterns of activities, geographical locations, markets, etc.

Similar to Penrose and the RBV, population ecology focuses on resources. Hannan and Freeman (1977) assume that the resources available for each population are finite and fixed within a short-term perspective. Therefore, to what extent a unit (firm) can be added to the population of organizations depends on the fixed capacity at the time. If there is great amount of unexploited capacity in the environment, then there are possibilities for a faster rate of growth in the population. To analyze growth, one must consider the capacity of the environment to supply the amount of resources required by the size of the population, which is called the environment’s “carrying capacity.” If two populations are sustained by the same type of resources, they compete. If one of the populations increases, then the other should decrease. Moreover, any exogenous shock or changes which add constraints to a system can result in the elimination of one of the populations. If one of the two populations (dependent on the same resources) is less fit in terms of the environmental contingencies, it will most likely be eliminated.

There are liabilities of newness and smallness, but population ecology further identifies liabilities for the sized firms. Small firms compete with small and middle-sized firms. Large firms compete with large firms and middle-middle-sized firms. Middle-middle-sized firms must compete with smaller and more dynamic ones and at the same time the larger ones with longer histories (legitimacy) and more resources. Even though Penrose does not discuss the middle-sized firms in a similar way, she argues that large and old firms have a competitive advantage because of their monopolistic power. However, the large firms cannot take advantage of all opportunities, allowing for small and dynamic firms. Contrary to Penrose, population ecology holds that excess capacity (slack resources) is too costly. Penrose argues that slack resources can be used to initiate improvements and innovative activities or diversification and that they are critical resources when the environment changes. Population ecology argues that slack resources are used to develop and maintain formalized systems,

51

which hinder innovation and thereby create generalist organizations. When the environment changes rapidly, such organizations will spend most of their time and energy adjusting their structures. The cost, tendency toward formalization, and reduced innovative capability are not favorable either in stable or unstable environments. Therefore, firms should aim for a specialist strategy.

This short discussion indicates that different theoretical elements can explain different aspects of growth when seen from different theoretical angels. At some points, the theoretical elements intersect. The elements then either complete each other or, in certain cases, have conflicting explanations. I argue that researchers should both search for theoretical elements that complete the other and test for conflicting explanations. Moreover, if a grand theory or explanatory model of rapid growth ever should be written, I suggest that it should include both the internal and external dynamics of growth and decline. Different theories represent a continuum ranging from totally internal to external dynamics, which each explain important elements of the whole. The theories range from economic management and strategy theories at the “internal” end to population ecology and economic macro theories at the other end. In between, we find organizational theory, theories of social networks, innovation, learning, social capital and absorptive capacity, institutional theory, agglomeration or cluster theory, etc. These theories in “the middle” link the internal firm dynamics with the external environment.

This categorization is, of course, an oversimplification. It is meant only as an illustration of the continuum and the interrelatedness of the different theories. Earlier, I explained that a multitude of perspectives contributes to our understanding of the rapid growth of firms. This review indicates that economic cycles and market dynamics are important explanations for organizational growth. However, the firms’ internal capabilities and resources also offer important explanations for why some firms are able to grow and continue their growth. Each perspective provides valuable contributions. I further state that different theories in combination can explain internal firm dynamics, external dynamics, and link internal and external dynamics. There is much to learn from combining different theoretical perspectives to reach a better understanding of rapid growth and decline. Too often, researchers use one theoretical explanation without comparing or contrasting it with other—for instance, conflicting explanations. As such, I criticize the one-sided theoretical focus in some of the previous research. However, I am aware that theoretical combinations are seldom welcome in journals. I will further mention the difficulties in combining elements of different theoretical perspectives in the same analysis. Theories are, for example, often

52

built on different basic assumptions, and on consistent and complex sets of mechanisms, and therefore are not always easy to apply in combinations. Nevertheless, this opportunity to combine theoretical perspectives is one of the driving forces in my research and is apparent in all three articles.