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ABSTRACT
Edith Penrose’s The Theory of the Growth of the Firm provides an intellectual foundation for a theory of innovative enterprise, which is essential to any attempt to explain productivity growth, employment opportunity, and income distribution. Penrose’s theory of the firm is also an antidote to the absurdity that has been taught by PhD economists to millions of college students for over seven decades: the most unproductive firm is the foundation of the most efficient economy. The dissemination of this ‘neoclassical fallacy’ to a mass audience began with Paul A. Samuelson’s textbook, Economics: An Introductory Analysis, first published in 1948. Over the decades, the neoclassical fallacy has persisted through 18 revisions of Samuelson, Economics and in its countless ‘economics principles’ clones. This essay challenges the intellectual hegemony of neoclassical economics by exposing the illogic of its foundational assumptions about how a modern economy operates and performs. To get beyond the neoclassical fallacy, economists must be trained in a ‘historical transformation’ methodology that integrates history and theory. It is a methodology in which theory serves as both a distillation of what we have learned from the study of history and a guide to what we need to learn about reality as the ‘present as history’ unfolds.
Disclosure statement
No potential conflict of interest was reported by the author.
Notes
1. Edith T. Penrose, The Theory of the Growth of the Firm, Blackwell, 1959
2. Alfred D. Chandler, Jr., Strategy and Structure: Chapters in the History of the American Industrial Enterprise, MIT Press, 1962; Alfred. D. Chandler, Jr., The Visible Hand: The Managerial Revolution in American Business, Harvard University Press, 1977. Like Samuelson, Chandler was on the faculty of MIT from 1950 to 1963 as he researched and wrote his seminal work on U.S. business history, including his article, highly influential among historians, “The Beginnings of ‘Big Business’ in American Industry,” Business History Review, 33, 1, 1959: 1–31. In 1963 Chandler moved to a professorship at Johns Hopkins University, where Penrose had researched TGF in the 1950s. By this time, Penrose had a joint appointment to the faculties of the School for Oriental and African Studies (SOAS), University of London and the London School of Economics. Penrose was unaware of Chandler’s work when she published TGF. Chandler first mentions Penrose in a 1968 comment as one of a number of economists whose work is useful to historians, but goes on to say, ‘alas, such writings were too late for my work in investigating the rise of the large corporation [in Strategy and Structure].’ Alfred D. Chandler, Jr., “Comment [on a paper by Alfred H. Conrad],” Explorations in Economic History, second series, 6, 1, 1968, p. 66. To my knowledge, the first time that Penrose and Chandler met was in 1986 at the International Economic History Congress in Berne, Switzerland (I saw them there, chatting). Michael Best proposed that Chandler and Penrose share a plenary session at the Business History Conference at Harvard Business School in 1993. For some reason, the conference organizers did not act on this suggestion, and Penrose and Chandler only appeared together as discussants on a panel of papers in a parallel session. For an illuminating biography of Penrose, see Angela Penrose, No Ordinary Woman: The Life of Edith Penrose, Oxford University Press, 2018.
3. Chandler, Strategy and Structure.
4. Edith Penrose, “The Growth of the Firm – A Case Study: Hercules Powder Company,” Business History Review, 34, 1, 1960: 1–23. This article won the Newcomen Prize for best article in Business History Review in 1960. Hercules Powder Company became an independent company in 1911 when the Du Pont explosives monopoly was broken up under U.S. antitrust law. Du Pont itself was a key company in Chandler’s analysis of the evolution of the multidivisional structure from the 1920s to the 1950s.
5. See Mary A. O’Sullivan, Contests for Corporate Control: Corporate Governance and Economic Performance in the United States and Germany, Oxford University Press, 2000, ch. 4; William Lazonick, “Corporate Restructuring,” in Stephen Ackroyd, Rose Batt, Paul Thompson, and Pamela Tolbert, eds., The Oxford Handbook of Work and Organization, Oxford University Press, 2004: 577–601; William Lazonick, “Alfred Chandler’s Managerial Revolution: Developing and Utilizing Productive Resources,” in William Lazonick and David J. Teece, eds., Management Innovation: Essays in the Spirit of Alfred D. Chandler, Jr, Oxford University Press, 2012: 89–121.
6. See Michael H. Best, The New Competition: Institutions of Industrial Restructuring, Harvard University Press, 1990, p. 125. In contemporary business schools, Penrosian learning is central to the “dynamic capabilities” perspective, developed by David Teece and his colleagues. See David J. Teece, Dynamic Capabilities and Strategic Management: Organizing for Innovation and Growth, Oxford University Press, 2009; David J. Teece, Strategy, Innovation, and the Theory of the Firm, Edward Elgar Publishing, 2012.
7. On the “managerial limit” in the neoclassical theory of the firm, see William Lazonick, Business Organization and the Myth of the Market Economy, Cambridge University Press, 1991, p. 164. The notion was articulated in E. A. G. Robinson, The Structure of Competitive Industry, Harcourt, Brace, 1932, ch. 3; and E. A. G. Robinson, “The Problem of Management and the Size of Firms,” Economic Journal, 44, 174, 1934: 242–257.
8. Chandler, The Visible Hand.
9. William Lazonick, Competitive Advantage on the Shop Floor, Harvard University Press, 1990; William Lazonick, “Organizational Learning and International Competition,” in Jonathan Michie and John Grieve Smith, eds., Globalization, Growth, and Governance, Oxford University Press, 1998: 204-238. See also William Lazonick, Philip Moss, and Joshua Weitz, “How the Disappearance of Unionized Jobs Obliterated an Emergent Black Middle Class,” Institute for New Economic Thinking Working Paper No. 125, June 15, 2020, https://doi.org/10.36687/inetwp125; William Lazonick, Philip Moss, and Joshua Weitz, “The Unmaking of the Black Blue-Collar Middle Class,” Institute for New Economic Thinking Working Paper No. 159, May 20, 2021, at https://www.ineteconomics.org/research/research-papers/the-unmaking-of-the-black-blue-collar-middle-class.
10. Alfred D. Chandler, Jr., Scale and Scope: The Dynamics of Industrial Capitalism, Harvard University Press, 1990; Alfred D. Chandler, Jr., Inventing the Electronic Century: The Epic Story of the Consumer Electronic and Computer Industries, Harvard University Press, 2001; Alfred D. Chandler, Jr., Shaping the Industrial Century: The Remarkable Story of the Evolution of the Modern Chemical and Pharmaceutical Industries, Harvard University Press, 2005.
11. William Lazonick, Sustainable Prosperity in the New Economy? Business Organization and High-Tech Employment in the United States, Upjohn Institute for Employment Research, 2009; William Lazonick and Öner Tulum, “US Biopharmaceutical Finance and the Sustainability of the Biotech Business Model,” Research Policy, 40, 9, 2011: 1170–1187.
12. William Lazonick, “The Theory of Innovative Enterprise: Foundations of Economic Analysis,” in Thomas Clarke, Justin O’Brien, and Charles R. T. O’Kelley, eds., The Oxford Handbook of the Corporation, Oxford University Press, 2019: 490–514.
13. For the sake of argument, in , the innovating firm chooses to ‘make’ rather than ‘buy’ the input at a point at which the deterioration in the quality of the input that it previously purchased has gone so far as to create internal diseconomies of scale, as depicted by the innovating firm’s U-shaped cost curve. But a much less dramatic increase in AVC (one that does not outweigh the decrease in AFC) may trigger this vertical-integration decision.
14. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, fifth edition (edited by Edwin Cannan), Methuen, 1904, ch. 1 (‘On the Division of Labour’); originally published in 1776.
15. William Lazonick, Philip Moss, Hal Salzman, and Öner Tulum, “Skill Development and Sustainable Prosperity: Collective and Cumulative Careers versus Skill-Biased Technical Change,” Institute for New Economic Thinking Working Group on the Political Economy of Distribution Working Paper No. 7, December 2014, at https://ineteconomics.org/ideas-papers/research-papers/skill-development-and-sustainable-prosperity-cumulative-and-collective-careers-versus-skill-biased-technical-change; Matt Hopkins and William Lazonick, “Who Invests in the High-Tech Knowledge Base?” Institute for New Economic Thinking Working Group on the Political Economy of Distribution Working Paper No. 6, September 2014 (revised December 2014), at http://ineteconomics.org/ideas-papers/research-papers/who-invests-in-the-high-tech-knowledge-base.
16. William Lazonick, “Labor in the Twenty-First Century: The Top 0.1% and the Disappearing Middle Class,” in Christian E. Weller, ed., Inequality, Uncertainty, and Opportunity: The Varied and Growing Role of Finance in Labor Relations, Cornell University Press, 2015: 143–192.
17. Lazonick, Competitive Advantage on the Shop Floor; Lazonick, “The Theory of Innovative Enterprise”.
18. William Lazonick and Jang-Sup Shin, Predatory Value Extraction: How the Looting of the Business Corporation Became the U.S. Norm and How Sustainable Prosperity Can Be Restored, Oxford University Press, 2020.
19. Joseph A. Schumpeter, Capitalism, Socialism, and Democracy, Harper, 1950, third edition, p. 106; originally published in 1942.
20. Lazonick, “Alfred Chandler’s Managerial Revolution”.
21. Carl Kaysen, The American Corporation Today, Oxford University Press, 1996, p. 25.
22. United States Census Bureau, “2017 SUSB Annual Data Tables by Establishment Industry,” May 2021, at https://www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html. In 2017, 514 firms with 20,000 or more employees (average, 57,428) in the United States accounted for 8% of establishments. 23% of employees, 25% of payrolls, and 28% of revenues.
23. I would be pleased to be informed of any microeconomics textbook that rejects what I have called the neoclassical fallacy and provides an alternative theory of the firm.
24. “Economics (textbook),” Wikipedia, at https://en.wikipedia.org/wiki/Economics_(textbook).
25. Paul A. Samuelson, Economics; An Introductory Analysis, first edition, McGraw Hill, 1948, p. 124.
26. Ibid., p. 125.
27. Ibid.
28. Ibid., pp. 126–131.
29. Ibid., p. 132. For the passage that he quotes, Samuelson cites J. A, Schumpeter, “Capitalism, Socialism, and Democracy“, Harper & Brothers: New York 1942. (This passage appeared on page 82 of the 1942 edition of Capitalism, Socialism, and Democracy.)
30. Samuelson, Economics, first edition, p. 132.
31. In the 1940s, economists could have built on Schumpeter’s focus on innovation as the fundamental phenomenon of economic development, a proposition put forward in Joseph A. Schumpeter, The Theory of Economic Development, Harvard University Press, 1934 (first published in German in 1911). See William Lazonick, “What Happened to the Theory of Economic Development?” in Patrice Higgonet, David S. Landes, and Henry Rosovsky, eds., Favorites of Fortune: Technology, Growth, and Economic Development since the Industrial Revolution, Harvard University Press, 1991: 267–296. By the 1960s, as I have indicated in the introduction to this essay, Samuelson could have found powerful explanations, both theoretical and historical, for the growth of the firm in Penrose, The Theory of the Growth of the Firm, and Chandler, Strategy and Structure. In its 19 editions, spanning 1948 to 2009, Samuelson, Economics, never references these scholars or the body of research on the growth of the firm and managerial capitalism that their writings inspired.
32. N. Gregory Mankiw, Principles of Microeconomics, Cengage Learning, eighth edition, no date, p. 259.
33. Ibid., p. 254.
34. Paul Krugman and Robin Wells, Essentials of Economics, Worth Publishers, fourth edition, 2017, p. 189.
35. Ibid., p. 185.
36. I am grateful to Wynn Tucker for searching through the first edition of Samuelson, Economics, to locate the explanation of the U-shaped cost curve.
37. Paul A. Samuelson, Economics: An Introductory Analysis, fifth edition, McGraw-Hill, 1961, p. 524.
38. Paul A. Samuelson, Foundations of Economic Analysis, Enlarged Edition, Harvard University Press, 1983.
39. Samuelson, Economics, 1961, p. 12.
40. Ibid.
41. Ibid., p. 25.
42. Ibid., p. 26.
43. Ibid., p. 27.
44. Note that in the first three editions of Economics, the section in Chapter 2 on “The Famous Law of Diminishing Returns” appears just after the section on “Economies of Scale: Mass Production and Decreasing Costs” (‘Economies of Mass Production and Decreasing Costs’ in the first edition). In the fourth edition, however, Samuelson reverses the order of these two sections, placing “The Famous Law of Diminishing Returns” first, while changing the subhead for the section on decreasing costs to “Economies of Scale and Mass Production: A Digression.” Samuelson then repeats this formulation in the fifth and sixth editions. A separate paper would be required to document Samuelson’s changing portrayal of the large corporation in Economics. But these changes made in the fourth edition, and particularly the addition of the term “a digression,” appear to be an attempt by Samuelson to diminish the role of big business in his presentation of how a modern economy operates and performs.
45. Penrose, The Theory of the Growth of the Firm; Chandler, Strategy and Structure.
46. See Avner Offer and Gabriel Söderberg, The Nobel Factor: The Prize in Economics, Social Democracy, and the Market Turn, Princeton University Press, 2016.
47. William Lazonick, “Innovative Enterprise or Sweatshop Economics?” In Search of Foundations of Economic Analysis,” Challenge, 59, 2, 2016: 65-14.
48. See Jason Hickel, “Rethinking Sweatshop Economics,” Foreign Policy in Focus, 1 July 2011, at https://fpif.org/rethinking_sweatshop_economics/; Christopher Blattman and Stefan Dercon, “Everything we knew about sweatshops was wrong,” New York Times, 27 April 2017, at https://www.nytimes.com/2017/04/27/opinion/do-sweatshops-lift-workers-out-of-poverty.html?emc=eta1.
49. Lazonick, Business Organization and the Myth of the Market Economy; William Lazonick, “The Theory of the Market Economy and the Social Foundations of Innovative Enterprise,” Economic and Industrial Democracy, 24, 1, 2003: 9-44; William Lazonick, “Varieties of Capitalism and Innovative Enterprise,” Comparative Social Research, 24, 2007: 21–69.
50. See, for example, Lazonick, Competitive Advantage on the Shop Floor; William Lazonick, “The Functions of the Stock Market and the Fallacies of Shareholder Value,” in Ciaran Driver and Grahame Thompson, eds., What Next for Corporate Governance? Oxford University Press, 2018: 117–151.
51. William Lazonick, “The Investment Triad and Sustainable Prosperity,” in Peter Creticos, Larry Bennett, Laura Owen, Costas Spirou, and Maxine Morphis-Riesbeck, eds., The Many Futures of Work: Rethinking Expectations and Breaking Molds, Temple University Press, 2021: 120–151.
52. Lazonick, Competitive Advantage on the Shop Floor; Lazonick, Sustainable Prosperity in the New Economy?; Lazonick, et al., “Skill Development and Sustainable Prosperity”; Lazonick, “Labor in the Twenty-First Century”; Lazonick et al., “How the Disappearance of Unionized Jobs Obliterated an Emergent Black Middle Class.”
53. Economic Policy Institute, “The Productivity-Pay Gap,” updated August 2021, at https://www.epi.org/productivity-pay-gap/; Lazonick and Shin, Predatory Value Extraction, ch. 1.
54. Lazonick et al., “Skill Development and Sustainable Prosperity”; Lazonick “Labor in the 21st Century”; Lazonick et al., “How the Disappearance of Unionized Jobs Obliterated an Emergent Black Middle Class.”
55. Lazonick, Sustainable Prosperity in the New Economy?; Lazonick “Labor in the Twenty-First Century”; William Lazonick, “Stock Buybacks: From Retain-and-Reinvest to Downsize-and-Distribute,” Center for Effective Public Management, Brookings Institution, April 2015, pp. 10–11, at http://www.brookings.edu/research/papers/2015/04/17-stock-buybacks-lazonick;
56. William Lazonick and Mary O’Sullivan, “Maximizing Shareholder Value: A New Ideology for Corporate Governance,” Economy and Society, 29, 1, 2000: 13–35; Lazonick, “The Investment Triad and Sustainable Prosperity.”
57. Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American Economic Review, 76, 2, 1986: 323–329 (the term ‘disgorge’ is used on pages 323 and 328).
58. These economists fail to recognize the potential productivity benefits of labor as a fixed-cost investment even though, as tenured professors, the very same economists have occupied the most secure career employment positions that exist.
59. For a pioneering exploration of these issues, influenced by the work of Penrose and Chandler, see David J. Teece, “Economies of Scale and Scope of the Enterprise,” Journal of Economic Behavior and Organization, 1, 3, 1980: 223–247.
60. William Lazonick, “Profits Without Prosperity: Stock Buybacks Manipulate the Market and Leave Most Americans Worse Off,” Harvard Business Review, September 2014, pp 46–55; Lazonick, “Stock Buybacks: From Retain-and-Reinvest to Downsize-and-Distribute”; Lazonick, “The Investment Triad and Sustainable Prosperity”; Lazonick and Shin, Predatory Value Extraction; Ken Jacobson and William Lazonick, “A License to Loot: Alternative Views of Capital Formation and the Adoption of SEC Rule 10b-18,” The Academic-Industry Research Network, in progress, January 2022.
61. For a recent statement of my MSV critique, see Lazonick, “The Investment Triad and Sustainable Prosperity.”
62. Lazonick and O’Sullivan, “Maximizing Shareholder Value.” In the foreword to the third edition of TGF, published in 1995, Penrose recognizes the possibility of the financialization of the firm since she originally researched the growth of the firm in the 1950s. See Edith T, Penrose, The Theory of the Growth of the Firm, 4th edition, 2009, p. 236. As part of his PhD dissertation at SOAS University of London, Matt Hopkins is completing a study of the financialization of Hercules in the 1990s and 2000s, analyzing the demise of the chemical company that was the subject of Penrose’s 1960 Business History Review article, “The Growth of the Firm – A Case Study.”
63. Penrose, Theory of the Growth of the Firm, p. 9.
64. William Lazonick, “Factor Costs and the Diffusion of Ring Spinning in Britain prior to World War I,” Quarterly Journal of Economics, 96, 1, 1981: 89–109; William Lazonick, “Production Relations, Labor Productivity, and Choice of Technique: British and U.S. Cotton Spinning,” Journal of Economic History, 41, 3, 1981: 491–516; William Lazonick, “Competition, Specialization, and Industrial Decline,” Journal of Economic History, 41, 1, 1981: 31–38: William Lazonick, “Industrial Organization and Technological Change: The Decline of the British Cotton Industry,” Business History Review, 57, 2, 1983: 195–236; Bernard Elbaum and William Lazonick, “The Decline of the British Economy: An Institutional Perspective,” Journal of Economic History, 44, 2, 1984: 567–583.
65. See William Lazonick, “Innovative Enterprise and Historical Transformation,” Enterprise & Society, 3, 1, 2002: 35–54.
66. William Lazonick, “The Integration of Theory and History: Methodology and Ideology in Schumpeter’s Economics,” in Lars Magnusson, ed., Evolutionary Economics: The Neo-Schumpeterian Challenge, Kluwer, 1994: 245–263; Lazonick, “Innovative Enterprise and Historical Transformation.”
67. Richard Caves, “Industrial Organization, Corporate Strategy and Structure,” Journal of Economic Literature, 18, 1, 1980, p. 88. Caves was a professor in the Harvard Economics Department from 1962 to 2003, and chair of the PhD in Business Economics, a joint degree of the Harvard Economics Department and Harvard Business School, from 1984 to 1997. “Richard E. Caves,” Wikipedia, at https://en.wikipedia.org/wiki/Richard_E._Caves.
68. Caves, “Industrial Organization, Corporate Strategy and Structure,” p. 66.
69. Penrose, No Ordinary Woman, pp. 116–117, 142–146, 172–181.
70. Fritz Machlup, “Theories of the Firm: Marginalist, Behavioral, and Managerial,” American Economic Review, 57, 1, 1967: 1–33. Nor does he mention Penrose or her work in Fritz Machlup, The Production and Distribution of Knowledge in the United States, Princeton University Press, 1962.
71. Machlup, “Theories of the Firm,” p. 29.
72. Ibid., p. 13.
73. Ibid., p. 4.
74. Ibid., p. 10.
75. Ibid., p. 29.
76. Penrose, No Ordinary Woman, p. 145.
77. Paul M. Sweezy, The Present as History: Essays and Reviews on Capitalism and Socialism, Monthly Review Press, 1953. As Sweezy puts it: “Everyone knows that the present will some day be history. I believe that the most important task of the social scientist is to try to comprehend it as history now, while it is still the present and while we still have the power to influence its shape and outcome.” Ibid., p. v.
78. Edith Penrose, “History, the Social Sciences and Economic ‘Theory,’ with Special Reference to Multinational Enterprise,” in Alice Teichova, Maurice Lévy-Leboyer, and Helga Nussbaum, eds., Historical Studies in International Corporate Business, Cambridge University Press, 1989: 7–14, quoted from p. 11.