Examining the penrose effect in an international business context: the dynamics of japanese firm growth in u.s. industries

Examining the penrose effect in an international business
context: the dynamics of japanese firm growth in u.s.
industries
Danchi Tan
Joseph T. Mahoney
National Chengchi University
University of Illinois at Urbana−Champaign
Abstract
Penrose (1959) theoretically developed the research proposition that the finite capacities of a
firm’s internally experienced managers limit the rate at which the firm can grow in a given
period of time. One empirical implication that follows logically from this line of reasoning is
that a fast−growing firm will eventually slow down its growth in the subsequent time period
because its firm−specific management team, which is posited to be inelastic at least in the
short run, is unable to handle effectively the increased demands that are placed on these
internally experienced managers due to increased complexity as well as the time and
attention that the new managers require from these internally experienced managers.
Consequently, inefficiency in the firm’s current operations will follow if the firm maintains
its high rate of growth. The research proposition that a firm cannot remain operationally
effective if it maintains high rates of growth in successive time periods, and that
consequently those firms with foresight typically will slow down their growth in the
subsequent time period is known as the “Penrose effect” in the research literature, and this
effect of dynamic adjustment costs has been examined and corroborated in a few empirical
research studies. However, researchers have not yet examined the Penrose effect in an
international business context. The current paper examines the Penrose effect in an
international business context by exploring whether Japanese firms achieve high growth in
consecutive time periods in the entered U.S. industries. The empirical results indicate that,
consistent with Penrose’s (1959) resource− based theory prediction, in general, Japanese
firms did not maintain high employment growth in two consecutive time periods following
their entry into U.S. industries. We also find empirically that for Japanese multinational firms
that entered in U.S. industries where the extent of knowledge tacitness, globalization, and
unionization was high, rapid expansion growth in one time period had negative impacts on
growth in the subsequent time period. Thus, dynamic adjustment costs limit the rate of the
growth of the firm and the development of dynamic capabilities in this international business
context, which suggests that the Penrose effect may be widely applicable to international
business and corporate strategy.

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We are grateful to Richard Levin, Alvin Klevorick, Richard Nelson, and especially Sidney Winter for providing us with the data
from their paper in Brookings Papers on Economic Activity (1987).
Published: 2003
URL: http://www.business.uiuc.edu/Working_Papers/papers/03−0113.pdf

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EXAMINING THE PENROSE EFFECT IN AN INTERNATIONAL BUSINESS CONTEXT:
THE DYNAMICS OF JAPANESE FIRM GROWTH IN U.S. INDUSTRIES


BY


Danchi Tan
Assistant Professor
National Chengchi University
64, Chih-nan Rd., Sec. 2
Wenshan, Taipei 11623
Taiwan
Tel: +886 2 2939-3091 ext 81139
Fax: +886 2 2938-7699
Email: dctan@nccu.edu.tw

and

Joseph T. Mahoney
Professor of Strategy
Department of Business Administration
College of Business
University of Illinois at Urbana-Champaign
339 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
217-244-8257 (office)
217-244-7969 (fax)
josephm@uiuc.edu


We are grateful to Richard Levin, Alvin Klevorick, Richard Nelson, and especially Sidney Winter for
providing us with the data from their paper in Brookings Papers on Economic Activity (1987).

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EXAMINING THE PENROSE EFFECT IN AN INTERNATIONAL BUSINESS CONTEXT:
THE DYNAMICS OF JAPANESE FIRM GROWTH IN U.S. INDUSTRIES

Abstract
Penrose (1959) theoretically developed the research proposition that the finite capacities
of a firm’s internally experienced managers limit the rate at which the firm can grow in a given
period of time. One empirical implication that follows logically from this line of reasoning is that
a fast-growing firm will eventually slow down its growth in the subsequent time period because
its firm-specific management team, which is posited to be inelastic at least in the short run, is
unable to handle effectively the increased demands that are placed on these internally
experienced managers due to increased complexity as well as the time and attention that the new
managers require from these internally experienced managers. Consequently, inefficiency in the
firm’s current operations will follow if the firm maintains its high rate of growth. The research
proposition that a firm cannot remain operationally effective if it maintains high rates of growth
in successive time periods, and that consequently those firms with foresight typically will slow
down their growth in the subsequent time period is known as the “Penrose effect” in the research
literature, and this effect of dynamic adjustment costs has been examined and corroborated in a
few empirical research studies. However, researchers have not yet examined the Penrose effect in
an international business context.
The current paper examines the Penrose effect in an international business context by
exploring whether Japanese firms achieve high growth in consecutive time periods in the entered
U.S. industries. The empirical results indicate that, consistent with Penrose’s (1959) resource-
based theory prediction, in general, Japanese firms did not maintain high employment growth in
two consecutive time periods following their entry into U.S. industries. We also find empirically
that for Japanese multinational firms that entered in U.S. industries where the extent of
knowledge tacitness, globalization, and unionization was high, rapid expansion growth in one
time period had negative impacts on growth in the subsequent time period. Thus, dynamic
adjustment costs limit the rate of the growth of the firm and the development of dynamic
capabilities in this international business context, which suggests that the Penrose effect may be
widely applicable to international business and corporate strategy.

Keywords: The Penrose effect, dynamic adjustment costs, dynamic capabilities

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Section 1: Introduction
How a firm evolves over time has been an important issue in the fields of strategic
management and industrial organization economics (Kor and Mahoney, 2000; Nelson and Winter,
1982). Looking at the historical business record from an organizational capabilities and
technology trajectories perspective, Chandler (1990) suggests that modern business enterprises
arise from the economies of scale and scope that are made possible by the development of new
technologies. Furthermore, a number of researchers who approach these business issues more
deductively in economic science come to a similar conclusion to Chandler’s (1990) more
inductive business history methodology by maintaining that a firm’s behavior is best understood
as a path-dependent process, and that organizational capabilities develop dynamically (see e.g.,
Nelson and Winter, 1982; and Teece, Pisano, and Shuen, 1997). All agree that history matters.

In the current paper, we contribute to the dynamic capabilities research literature (Teece,
Pisano and Shuen, 1997) and maintain that the history of a firm’s strategic moves will matter a
great deal in the operational effectiveness of their subsequent moves. In particular, we argue
from a resource-based perspective (Penrose, 1959) that a firm that attempts to alter its resource
base and to develop its organizational capabilities to meet market change adaptively is likely to
incur dynamic adjustment costs, and we examine empirically to what extent a firm that expands
internationally incurs such adjustment costs.
Dynamic adjustment costs occur when adjustments of productive resources (such as
hiring new employees and new managers) disrupt current operations (Hamermesh and Pfann,

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1994; Lucas, 1967; Mortensen, 1973; Treadway, 1970). Due to dynamic adjustment costs, there
are limits to the growth rate at which a firm can increase its resource base at any point in time.
Our primary goal in the current paper is to make clear that dynamic adjustment costs need to be
in the foreground for both empirical testing and theorizing about the rate of the growth of the
firm and the development of firm-specific resources and dynamic capabilities.
We focus on a major source of dynamic adjustment costs: the inability of a firm to adjust
its managerial resources to the desired level in a timely way to match adaptively to a change in
the market (Hay and Morris, 1991; Ingham, 1992; Penrose, 1959; Rubin, 1973; Slater, 1980).
Penrose (1959) argues that a firm’s expansion requires the services from managers who have
experience internal to the firm. Since such managers must be developed within the firm over
time and could not be hired from the outside, a firm that needs to maintain effectiveness in its
current operations could only increase its managerial resources in a controlled and incremental
fashion. A fast-growing firm is likely to incur managerial problems (Slater, 1980), and
consequently can achieve only little growth in the subsequent time period. Otherwise,
inefficiencies in current operations would result because the new managers will require too much
time and attention from the experienced managers.
Thus, in the current paper we emphasize that the research on dynamic adjustment costs
(Hay and Morris, 1991) should be joined with research on the firm building dynamic capabilities
(Teece, Pisano and Shuen, 1997). To be even more precise, we argue here that Penrose (1959)
is the seminal work that connects the dynamic adjustment cost research literature and the

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dynamic capabilities research literature. Indeed, both research literatures cite Penrose (1959) as
a seminal contribution (see Hay and Morris, 1991 for dynamic adjustment costs; and Teece
Pisano and Shuen, 1997 for dynamic capabilities).
When considering some of the empirical research literature on dynamic adjustment costs,
the impact of the managerial constraint on firm growth has been cited as the “Penrose effect” in
the research literature (Hay and Morris, 1991), and has been examined in a number of empirical
research studies (e.g., Gander, 1991; Orser, Hogarth-Scott and Riding, 2000; Shane, 1996; Shen,
1970; and Thompson, 1994). However, there has been little empirical work in examining the
Penrose effect in an international business context, which is the focus of the current paper.
The current paper attempts to fill this research gap by examining the Penrose effect in
international expansion. The Penrose effect arises from the lack of suitable management for
coordinating increased complexity of an organization during its expansion. However, the use of
new organizational innovations, such as a multidivisional organizational structure (Chandler,
1962), may help reduce this complexity and hence the need for managerial resources, which in
turn may mitigate the Penrose effect. In addition, the need for closely coordinating subsidiaries
might be reduced if the subsidiaries are located overseas (Penrose, 1959). As a result, the time
and efforts that managers must spend in managing international operations may be reduced.
However, the Penrose effect may still exist as the head office must plan international expansion
and may have to maintain a certain level of coordination among its overseas units. The current
paper, thus, not only tests empirically for the existence of the Penrose effect that has been

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corroborated in previous empirical studies, but also suggests a new path for future business
research that explores theoretically the conditions under which the Penrose effect is more likely
to prevail, and then tests these conditions empirically.
In the next section, we briefly summarize Penrose’s (1959) argument on the limitations to
the growth of firms and empirical studies that have examined this proposition. We then explore
the applicability of Penrose’s (1959) argument in an international business context and we
propose several conditions that may moderate the Penrose effect in international expansion.
Section 3 provides the theory and hypotheses. Section 4 outlines our methodology and section
5 presents our empirical results. We then provide our discussion and conclusions in Section 6.

Section 2: Background

Penrose suggests that a firm can be viewed as “a collection of productive resources”
(1959: 24). No matter what industries a firm is in, the firm relies on its managers to direct and
coordinate its productive resources, and to capitalize on production opportunities for the firm.
However, to provide proper service to the firm, managers must have experience internal to the
firm and experience working with other people within the firm as a team (Becker, 1964;
Castanias and Helfat, 1991; Penrose, 1959). Consequently, the capacities of these managers
(henceforth, internal managerial capacities) shape the scope and complexity of activities that a
firm can undertake. Since internally experienced managers cannot be hired from outside and
must be developed within the firm over time, there are limits to the rate at which a firm can

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expand its activities at any time. A fast-growing firm is thus likely to encounter managerial
problems because it cannot adjust its managerial resources to the desired level in a timely fashion.
To express these ideas compactly: managerial time and attention are the scarce resources that are
the binding constraint on the rate of the growth of the firm (Penrose, 1959; Slater, 1980). In other
words, dynamic adjustment costs place a limit on the rate of developing and deploying dynamic
capabilities
The impact of this managerial constraint on the growth of the firm has been cited as the
“Penrose effect” in the research literature and has been empirically examined in a number of
studies (Hay and Morris, 1991). One strategic management implication of the Penrose effect is
that a fast-growing organization tends to stagnate in the subsequent time period due to
managerial limitations. Shen (1970) finds empirically that the Penrose effect was responsible for
the negative correlation coefficients between growth rates of 4000 Massachusetts manufacturing
plants in 1948-53 and in 1953-57. Shen’s (1970) study shows empirical evidence of the Penrose
effect at the plant level.
Nevertheless, a firm can also grow via establishing new plants. The use of organizational
innovations, such as a multidivisional organizational structure (Chandler, 1962; Williamson,
1975), may help reduce organizational complexity that potentially arises from increased
organizational size. Orser, Hogarth-Scott and Riding (2000) report that among the 1,004 small
and medium-sized Canadian firms studied, fewer than one quarter of these firms had two
consecutive years of revenue increases. However, this empirical study does not provide reasons

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why there were firms that were not subject to the Penrose effect and were able to achieve growth
in consecutive time periods.
Gander (1991) examines empirically the managerial limitations on firm growth by
investigating whether there are decreasing (growth) returns to managerial resources (i.e.,
managerial diseconomies). Gander (1991) suggests that as the firm doubles its size, the firm has
to utilize more than double its managerial resources to maintain effective coordination. Hence,
Gander (1991) expects that managerial intensity in an industry (proxied by the ratio of
managerial employment to industry asset size) should increase with the size of firms in the
industry. Gander (1991) tests this hypothesis using aggregate two-digit SIC U.S. industry data,
and finds this hypothesis supported empirically for the 1977-1980 period, but not for the
1983-1986 period.
Two studies explored empirically the Penrose effect of firm expansion by franchising.
Thompson (1994) suggests that different forms of firm expansion require different levels of
managerial resources. Thompson (1994) expects that a firm is likely to expand via franchising
initially in order to economize on its managerial resources. As the managerial limit decreases
with experience, the firm will replace its franchised outlets by hierarchical ones. Based on a
sample of 200 franchise chains in 15 U.S. industries, Thompson (1994) finds empirically that the
proportion of hierarchical outlets of these firms had a convex relationship with franchise
experience. Similarly, Shane (1996) suggests that contractual organizational forms such as
franchising economize on the costs of monitoring employees. Since such monitoring costs

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