The Managerial Limitation to the Growth of Firms

Author(s): Martin Slater

Source: The Economic Journal, Vol. 90, No. 359 (Sep., 1980), pp. 520-528
Published by: Wiley on behalf of the Royal Economic Society
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 The Economic Journal, go (September I980), 520-528
Printed in Great Britain

THE MANAGERIAL LIMITATION TO THE

GROWTH OF FIRMS*

In the analysis of the growth of business firms, a most impor

the assumption that there exist certain 'costs of growth' which prevent firms
moving instantaneously to any desired size. One of the most comprehensive
analyses employing this assumption is that by Williamson, (I 966), who considers
both pricing/output policy and growth/investment policy. He concludes that
both profit-maximising and growth-maximising firms will adopt the same
(profit-maximising) pricing/output policy in the short run,' only differing in
their policies on investment and retention of profits. However I shall argue that
Williamson's conclusion is the result of his particular formulation of the costs of
growth and does not hold for more general formulations.
Williamson's assumption about the total costs of the firm is that they are
additively separable in the two variables current output and growth rate: i.e. total
costs may be broken down into two separate components, one of which might be
called 'Current Costs', depending on current output alone and not at all on the
growth rate of the firm; and 'Growth Costs' which depend only on the growth
rate and not on current output.2 It is this separation which allows price-output
policy to be optimised independently of growth policy in the Williamson model
because it means that marginal cost, which is the important cost variable for
price-output decisions, is independent of the rate of growth of the firm. Rapid
growth simply increases overhead costs, which have no importance in price-
output decisions.
There is a parallel here in the investment literature. Investment theorists have
had to face the very similar problem of explaining why firms do not adjust
instantaneously to any change in their desired level of capital stocks. One sol-
ution has been to postulate the existence of' adjustment costs' which make rapid
adjustment more expensive than a slower approach to the desired stock. Firms
are then assumed to choose that rate of adjustment which maximises their
profits. In the initial papers on the subject (e.g. Eisner and Strotz (I963), Lucas
(I967), Gould (I968)) these adjustment costs were also assumed for simplicity
to be separable in current output and investment, but later writers (Treadway
(1970; I97I), Mortensen (I973), Brechling (I975)) have questioned this as-
sumption, and analysed the case of non-separable adjustment costs. Their
argument is that the installation of new plant and equipment might require the
diversion of other factors of production from their normal tasks, disrupting
current production. Therefore the adjustment costs include the value of the lost
current production, and are consequently not independent of current output
* I would like to express my thanks to Edith Penrose, Ahmed Aykac, colleagues at Bristol, the
Editor and the referee for comments on earlier drafts, and to Michael Lowcock and Pat Shaw.
1 Of course this comparison is possible only at one point of time, for if the two firms grow at different
rates, they will not remain of comparable size.
2 Williamson (I966), p. 5.

[ 520 1

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 [SEPTEMBER i980] MANAGERIAL LIMITATION TO GROWTH 521

rates. Similarly current costs are not independent of the rate of installation of new
plant. One important conclusion from these analyses is that where adjustment
costs are not separable, the results from dynamic optimisation analyses do not
always produce optimal decision rules that are qualitatively similar to those
derived from comparative static analyses.
Now the 'costs of growth' are a particular type of adjustment cost, and I shall
argue that they are unlikely to be separable. When one reads in the literature of
firms that have grown too fast, one does not get the impression that the extra
costs of rapid growth are entirely an addition to overheads which do not affect
the efficiency of the operating divisions of the firm. The story is more that too-
rapid growth causes loss of coordination throughout the enterprise, with both
overhead and current costs being higher than they might otherwise have been.
To establish the case more firmly, a very simple model of how costs of growth
might arise will be constructed and analysed. Edith Penrose (1959) and many
other writers (e.g. Richardson (I964)) have all stressed that the main limitation
on a firm's growth is a managerial one. There are other problems of course, but
generally they are of a secondary nature: the firm's growth is ultimately restrained
by its inability to find, train and absorb new management of sufficient quality
faster than a given rate. The increasing costs of growth are due to the deterior-
ation of effective control by management in the face of too rapid change.
However, a significant problem arises when one attempts to incorporate this
phenomenon into a formal model of the growth of firms: in all the models of
firms usually employed by economists, there is no explicit recognition of manage-
ment having any role to play which bears upon the firm's performance. Thus we
have 'Hamlet' without the Prince - management is recognised to be the crucial
factor that limits the growth of firms, but our models do not normally include a
management variable.
In the absence of such a management variable, the 'Penrose Effect' has had to
be imposed on models from outside as it were, in various ad hoc ways, using its
impact either on total costs, or on profitability.' Although almost all writers
justify the inclusion of growth costs by reference to Mrs Penrose's work, it is my
belief that these ad hoc procedures have not in fact captured the essence of the
Penrose Effect, which relies on the special nature of management as a factor of
production. To overcome this problem, the model presented here does give
management an explicit role to play. The Penrose Effect will be seen to arise
naturally from within the model as the firm attempts to grow, and it will be
found that the resulting costs of growth will not be simply separable from the
current costs of the firm.

A SIMPLE MODEL OF THE PENROSE EFFECT

Assume that a firm produces an output (Q) using two inputs, Labour (L) and
Management (M). The role of management is to organise the labour force to
1 E.g. Baumol (I962), p. io8o, Williamson (I966), p. 5, Solow (I97I), p. 32I, use the cost formulatio
Marris (I964), pp. 249 ff., (I97I) p. i8, Heal and Silberston (I972) p. I38, use the profitability method
To my knowledge, only Lesourne (I972) uses a formulation similar to the one used here.

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 522 THE ECONOMIC JOURNAL [SEPTEMBER

work in the most effective way. However, the crucial distinction between these
two factors of production is the way in which the firm may acquire them. Labour
is readily obtainable in the market at a constant wage w, and may be hired and
fired instantaneously and costlessly. Management, however, cannot be obtained
instantaneously and costlessly: raw management 'material' can be so obtained
at wage s, but this material must undergo a training and assimilation process
before it can be used effectively by the firm, and this process requires the
services of some of the existing management.
It follows that if the firm wants to expand it cannot use all of its existing
managerial services in the organisation of its current production activities; some
managerial services must be diverted to the training of new managers. This
diversion of management effort from production activities will mean that these
activities are less well controlled than they might otherwise be, and that therefore
the costs of current production are higher than they might be. It is these higher
current costs that are the opportunity costs of expansion to the firm, and consti-
tute Mrs Penrose's increasing costs of growth.
Let M1 be the managerial services engaged in current productive activity, and
M2 be the managerial services engaged in the training of new managers. Then the
firm's production function is assumed to be Q = Q(L, M1), with constant returns
to scale, and diminishing returns to each factor taken singly.
However, the creation of new members of the management team is not simply
a question of management training. Edith Penrose continually emphasises that
management must work as a team, and not as a collection of individuals skilled in
management. Teamwork can only be developed by giving individuals ex-
perience in working together. Training pure and simple is necessary, but not
sufficient; the same goes for getting to know your colleagues and for getting to
know the quirks of the business. All these are necessary, but if they were to be
acquired independently of each other, they would still not be enough. What
really counts is getting to know how to work-with your colleagues on the problems o
firm, and how they work with you, and this experience can only be gained by
working on actual problems.
The experience of working together is not just a requirement for the new
managers; the existing management must also find out how to work with the
newcomers, how far they can rely on them, how much they can delegate to their
subordinates, etc. Unless they do this their own efficiency will suffer. Again, the
only way in which this experience can be gained is by observing the newcomers
in action. If there are few possibilities for gaining this experience, the rate at which
the effective managerial team can be augmented will be severely limited.
The conclusion is therefore that existing management limits the rate of intake
of new managers in two ways. Firstly some of the existing management team
(A2) must be allocated to hiring and training the newcomers, and secondly the
rate at which the newcomers can gain relevant experience is limited by the
amount of productive work that the remainder of the existing management team
have in hand.' A good measure of this amount of productive managerial work
going on is simply M1.
1 This is most clearly set out in Penrose (1959), pp. 46, 47.

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 1980] MANAGERIAL LIMITATION TO GROWTH 523

Therefore, we may formalise the managerial limit to growth as:

M =f (M1, M2) (assuming M > o). (I)

We shall assume that this function has constant returns to scale, with diminish-
ing returns to either factor taken on its own. If we also write

M2 = cM (o < a I) (2)
then
M~ J M1 M2\
M \ M ~7'MJ'

M f [(I -oc),oc],
M
M - g (a) (3)
That is, the rate of growth of the stock of effective managerial services is a
function of a alone. The assumptions made about f imply that g is a concave
function of ac, d2g/dc2 < o. It seems also reasonable to assume that g(o) = o, and
that dg/dac(o) > o. g may be an increasing function of ac throughout the range
O < a <- I, or it may have an internal maximum within that range. However,
no profit- or growth-maximising firm would ever consider operating where
dg/dac < o, so we can confine attention to the positively-sloped section.

PROFIT MAXIMISATION

Having formulated the managerial constraint on the growth of the firm, we can
now investigate the optimal decisions of a profit-maximising firm subject to such
a constraint. We take profit-maximisation to mean the maximisation of the
present value of the flow of distributed profits through time. For simplicity we
assume that the firm is able to expand its sales at a constant price. This is not
altogether an unreasonable assumption, and has been used by several previous
writers who justify it by the firm's ability to diversify into new markets instead
expanding down the demand curve of its initial product against the competition
of the other firms in the market. However, it is used here purely to simplify the
analysis - more realistic treatments of demand could be employed, but they
complicate matters without adding anything to the general conclusions to be
drawn here.
The profit-maximising firm's problem may now be written as:
Maximise

T (pQ-wL-sMf)e-rrt dt (4)
subject to
Q = Q (L, Ml)) (5)
M=Mg((a) O < a < I, (6)

M(o) = M, (7)
L,M>o, (8)

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 524 THE ECONOMIC JOURNAL [SEPTEMBER

where
Q = output at time t,
L = labour employed at time t,
M = managerial services available to the firm at time t,
Ml = (I - aC) M = managerial services employed in production at time t,
M2= cM = managerial services employed in training at time t,
M = initial stock of managerial services available at t = o,
p = price of output,
w = wage of labour,
s = wage of management,
r = rate of interest.

Set up in this way, the problem is very suitable for analysis using optimal
control methods. However, in this simple model only steady-state growth paths
are optimal,' so that for simplicity of exposition here we can derive the opti-
mality properties from the much simpler analysis of steady-state paths. For
steady-state growth the firm will choose an initial value LO for labour input, and
select a value for ac which will be held constant for all time. This defines both
M1f and the steady-state growth rate g, and henceforward Q, L, M1, M2 all gro
exponentially at that rate.
The present value of the profits accruing along this path is:
00

PV= (pQO- wLO-sM) egtertdt

- [pQ0(L0, M10) - wL0 - sM] (assuming r > g). (9)

(r -g)
The profit-maximising growth path is found by maximising this expression
with respect to LO and x:2

aLO (r-g) aL (IO)

aPv -(r-g) p M --0

acx- (r -g)2

1 The state of the system at the end of the

original state of the system magnified by i +g (a). Since there are constant returns to scale everywhere,
the problem of choosing an infinite optimum path from this second state is formally identical to the
initial problem, and therefore will have the same solution for a in its first period. Consequently, if an
internal solution for a is initially chosen, it will continue to be chosen to infinity. This result depends on
there being only one state variable and constant returns to-scale - if there were two state variables, the
growth during the first period might alter the ratio between them, so that the second-period problem
would not be a simple magnification of the first-period problem. In such a case, non-steady-state
behaviour would arise, and a complete analysis would require the full Pontryagin treatment.
2 The following analysis assumes an internal optimum solution for a. However, boundary solutions
might occur. For some parameter values the firm will find it most profitable not to grow at all, and on
the other hand if g (a) exceeds r at any feasible value of a the most profitable course will be to grow as
fast as is physically possible. A third boundary solution possibility occurs if g((a) has an internal maxi-
mum. A growth-maximiser would not want to operate at levels of a beyond the internal maximum even
if its profit constraint allowed it to. The possibility of these boundary solutions does not make any
significant difference to the general conclusion.

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 1980] MANAGERIAL LIMITATION TO GROWTH 525

From Euler's Theorem,

pQO =pMO? Qo +pL aLO (12)

andso from (IO): PQO=p(I--)MaMo +wLO. (3)

0 ~ ~ -aQ0
Substituting this int'o (I I):

_Q_ aQ0 ]dg_

-(r- g)PMaMj?+ [t( -) am1? ] da (14)
Rearranging:

aQo s (dg /da-) (5

aM1 g + (I-a) (dg/dc)- (I5)

From(Io): PLO -W (I6)

Equations (15) and (I6) are the optimality conditions, being conditions for the
efficient usage of management and labour respectively. The condition for
labour usage is the familiar one, and the rather complicated condition for
management may be explained intuitivelyin this way: if one managerwere taken
from M1 and put into M2 for one time period, the revenue that would be lost to
the firm would be paQO/aM1O. On the other hand, the firm would gain an extra
influx of dg/dac new managers during that time period. The best way of employing
these extra managers would be to split them in the same proportions as the rest of
the management, so that the group of extra managers would grow at the same
rate g as the firm as a whole. The initial flow of profits to the company from these
extra managers would then be:

[(I-OC) Q sQ dg

This flow would grow at rate g through time and be discounted at rate r. If
we equate its present value to the opportunity cost of the extra managers,

PQO we obtain equation (I 5).

GROWTH MAXIMISATION

We shall assume that growth maximisation means maximising the steady-state

rate of growth subject to some profitability constraint. Let the profitability
constraint be that the present value of profits must be at least as great as some
arbitrarily chosen value PV. Then the growth-maximiser's problem may be
written as
maximise g(a) (17)
subject to
pQO-wL?-sM >P (I8
r-g

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 526 THE ECONOMIC JOURNAL [SEPTEMBER

This may be solved by normal Lagrangean methods. The Lagrangean is:

Vt = g(x)-A [PV_ (PQ Q-wL j-sM)] ('9)

The first-order conditions are:

- a..~~-aQ -d
@grdg
dg [-(r-g)pM
+ A,+ (pQ?_-wL
L i d- sM)-](0
0 (20)

aL (r-(g) a )
Assuming that the profitability constraint is binding, the labour productivity
condition is the same as in the profit-maximising case. The management con-
dition may be derived as before from (20), using Euler's Theorem and (2I):

(r - g)2dg P AQ dg] dg
AM = p (g- r) +(i -ad)g - dci
therefore
[ (r-g)2] dg

@Q1O WE A-4 dg a (22)

Therefore, so long as A is not infinite (i.e. some deviation from maximum

profits is allowed) the growth-maximiser's condition for efficient use of manage-
ment is different from the corresponding condition for the profit-maximiser
(I5). A growth-maximiser will obviously adopt a higher growth-rate, and the
fore a higher value of a and a lower value of M,0 than the profit-maximiser. Given
the production function assumptions and the marginal productivity of labour
condition (2I), this implies that the growth-maximiser will produce a lower
output than the profit-maximiser at time zero (although with his higher growth-
rate, his output will eventually overtake the profit-maximiser's).

CONCLUSIONS

Analysis of the model has demonstrated that similar growth-maximising and

profit-maximising firms will set different outputs. The reason is that in this model
the firm's marginal cost is a function of both Q and g. This may be readily seen by
noting that marginal cost is equal to the wage rate divided by the marginal
product of labour. Unless the production function itself is separable, MPL will be
a function of L and M1, and substituting for L from the production function, we
can write MPL instead as a function of Q and Ml. Since M is given in the short
run, M1 depends on ac and a is of course a function of g. Thus marginal cost is
affected by the growth rate, and total costs are not separable. Therefore, although
the growth-maximiser does indeed try to get the maximum short-run profit out

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 I980] MANAGERIAL LIMITATION TO GROWTH 527

of his current operations (as evidenced by the efficiency condition for labour
usage), if he is in fact growing faster than the equivalent profit-maximiser he will
be trying to maximise his short-run profit with reference to a higher marginal
cost curve, and therefore will choose a lower output than the profit-maximiser. In
the Williamson model, where marginal cost is unaffected by the growth rate,
both firms choose the same output.
The model presented here has been kept as simple as possible for purposes of
clarity, and there are several obvious extensions that might be considered de-
sirable: the incorporation of fixed capital and a less restrictive treatment of the
demand side are two that spring quickly to mind. However, these do present
quite serious problems of analysis without affecting in principle the point
at which this paper has been directed: that the correct formulation of the
managerial limit to growth will in general imply a total cost function which is
nonseparable in Q and g.
Nor is the general result entirely dependent on the particular assumptions
employed here. If we combine equations (5) and (6) to eliminate ax, we may
rewrite the production function as

Q = 0(L,M,M)
and in this form the similarity with the original Treadway (I970) analysis is
obvious. The results derived here therefore hold true for any production-cum-
growth process for which 92Q/9L aM < o, whereas in the Williamson analysis,
the implicit assumption is that 92Q/9L AM = o.
The advantage of the particular formulation used here is that it points directly
to the opportunity costs of growth: a fast-growing firm uses its managerial resources
(and in the real world other resources as well) in coping with the problems of
growth itself, when they might otherwise be employed in solving problems and
reducing costs within the current operations of the firm. In the light of the grow-
ing literature on the unprofitability of mergers, and the evident control problems
of such merger-created firms as British Leyland, this is perhaps an important
practical point that deserves more attention. On the theoretical side, the im-
portant implication is that price and output decisions cannot be dissociated
from the growth policy of the firm.

St Edmund Hall, Oxford MARTIN SLATER

Date of receipt of final typescript: January 1980

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