Edith Penrose and the Future of the Multinational Enterprise. Christos Pitelis and Alain Verbeke

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1 Edith Penrose and the Future of the Multinational Enterprise. Christos Pitelis and Alain Verbeke Edith Penrose (1959), in her landmark study, The Theory of the Growth of the Firm (TGF) - which had earned 2747 citations on Google Scholar at the time of writing the present piece - observed that external demand per se limits neither firm-level growth rates, nor absolute size, as firms can normally search for investment opportunities inside ànd outside their present markets. Rather, the key constraints to rapid firm-level growth and to firm size originate inside the firm: A firm s rate of growth is limited by the growth of knowledge within it, but a firm s size by the extent to which administrative effectiveness can continue to reach its expanding boundaries (Penrose, TGF third ed., 1995, xvii). The question arises whether Penrose s thinking on firm-level growth is (still) applicable to the international business (IB) context, and whether this context requires an extension or refinement of her ideas. Here, we should mention that Penrose was well aware of the international context, as she had already published a paper on foreign investment in the Economic Journal in 1956, half a century ago, and before Dunning s (1958) and Hymer s (1960, published 1976) landmark studies. In an entry to the Palgrave in 1987, Edith Penrose claimed that both Hymer-based and Coase-based perspectives on international growth through foreign direct investment (FDI) and multinational enterprise (MNE) activity, fail to distinguish between domestic investments and cross-border ones. She concluded: There are differences between national and international firms but the differences are not such as to require a theoretical distinction between the two types of organization, only a recognition that national boundaries make an empirical difference to their opportunities and costs. (Penrose, 1987, p. 563) 1

2 Later, in the 1995 Preface to the third edition of TGF, Penrose went on to claim that: Much of the analysis of the growth of firms as I have presented it seems by and large to apply equally well to expansion by direct foreign investment in its modern form - the processes of growth, the role of learning, the theory of expansion based on internal human and other resources, the role of administration, the diversification of production, the role of merger and acquisition are all relevant. (Penrose, 1995, xv) (emphasis added), and it is easy to envisage a process of expansion of international firms within the theoretical framework of the growth of firms as outlined in this book. It is only necessary to make some subsidiary empirical assumptions to analyze the kind of opportunities for the profitable operations of foreign firms that are not available to firms confining their activities to one country as well as some of the special obstacles (Penrose, 1995, xv) (emphasis added). Penrose s views address the core of IB scholarship; they challenge its very raison d être. Stephen Hymer s (1976) ownership advantage - based theory of the MNE, whereby FDI is selected over alternatives such as licensing, in part for its firm-level, market power enhancing attributes, dominated IB thinking from 1960 (when Hymer completed his thesis) to the mid-1970s. At that time internalization scholars, most notably Buckley and Casson (1976), building upon Coasean thinking, started to emphasize the transaction cost economizing benefits of internalizing knowledge-based, intangible assets/advantages. The transaction cost economizing perspective gradually became the dominant IB theory, and remained in that position until the time of Penrose s (1987) critique noted above. It is correct that IB scholars had not fully addressed Penrose s (1987) point about what makes IB unique as compared to domestic business. Both Hymer s (1976) and Buckley and Casson s (1976) explanations for FDI were largely compatible with the 2

3 reasons for intra-country integration (horizontal and vertical), diversification and/or cooperation. The point is thus that both Hymer s (1976) and Buckley and Casson s (1976) work have a broader applicability than the MNE and its FDI decisions. The additional complexity specific to the MNE is the impact of national borders, i.e., location, as identified by Penrose. Dunning s (1958, 1998) focus on the importance of location advantages (the L, in his OLI framework, whereby O stands for ownership advantages, and I for internalization advantages), largely addresses Penrose s observations. Yet, L too has an intra-country, as well as an inter-country element. In this context, it is not L per se, but differences in L between countries that count. These differences were in fact already recognized by Hymer (1976), as reflected in his discussion of the additional costs of doing business abroad. Hymer s focus on the additional costs of doing business abroad is consistent with the prevailing view, at that time, that MNEs would go abroad to exploit their O (Hymer-type monopolistic, ownership advantages). There was little appreciation of the benefits of being foreign, in addition to those associated with exploiting extant advantages. These additional benefits include those resulting from upgrading the firm s extant, asset-based advantages and those resulting from emerging transactional advantages associated with operating an international network. Interestingly, Penrose s views, as expressed in TGF, can help us to understand better these additional benefits of international activities. For example, recent IB scholarship on strategic asset seeking FDI and institutional asset seeking FDI, as well as work on MNEs as agents of institutional change (Dunning, 2005; Dunning and Lundan, 2006), could benefit from adopting a Penrosean lens, to the extent that these new types of FDI require melding existing, non- 3

4 location bound knowledge from the host country with new knowledge, some of it location-bound, in host countries, see below. The aim of this MIR Focused Issue is to explore and critically assess instances whereby Penrosean thinking can contribute to explaining FDI patterns, and more generally MNE growth, in a world of imperfect integration, where national borders do matter, and where entrepreneurial acts can greatly benefit the firm. Despite Penrose s (1956) very early, pre-hymer contribution to the literature, her conviction that a specific conceptual framework to describe MNE growth would yield little benefits, led her to underplay the importance of the additional conceptual work required to address fully issues related to FDI and MNE expansion. In the context of this additional conceptual work in IB, we will focus here on three major research areas of relevance to explaining FDI and MNE growth, where Penrosean thinking can usefully be augmented and refined. These three research areas address respectively technology-related firm-specific advantages (FSAs), dynamic capabilities, and the melding of location-bound and nonlocation bound knowledge, especially through international human resources management. First, a firm s technology-related firm-specific advantages (FSAs) and their rejuvenation over time, or the absence thereof, critically determine the firm s growth rate. This is especially true in the context of (horizontal) geographic diversification, whereby transferring bundles of proprietary technological knowledge is key to success in foreign markets. Buckley and Casson (2006) suggest that Penrose over-emphasized the importance of entrepreneurial capabilities to uncover and exploit investment opportunities in the environment - thereby allowing diversification - at the expense of 4

5 R&D and the resulting product innovation. In their view, scale effects in R&D, though neglected by Penrose, are critical to understand firm-level growth. Firms often set up relatively large R&D labs with high fixed costs, rather than following a Penrosean growth logic in this area. In addition, after an optimal size has been reached, decreasing returns to R&D constrain growth. Scale diseconomies are likely to occur: these are related to research scientists facing incentives to engage in discretionary behavior, as well as coordination and monitoring costs. In addition, R&D stimulates related diversification, as opposed to unrelated diversification, since technological relatedness leads to knowledge spillovers from one product to the next. The point is that a stream of technological innovations, especially in rapidly changing industries, ultimately determines firm-level growth rates. Absent continuous and systematic replenishing of technological knowledge, building upon R&D investments, firm-level growth will be severely constrained, even in the presence of entrepreneurial capabilities. Ultimately, the firm s rate of growth is determined by the trade-off between product quality improvements and R&D cost increases. Buckley and Casson (2006) point out, in their brilliant integrative model, that a theory aimed to describe MNE growth should take into account both (incremental) geographic diversification into new markets, following a Penrosean logic, ànd product innovation. Penrose would be correct to argue that the former simply requires a number of subsidiary empirical assumptions : the outcome of the search for productive opportunities in new geographical markets depends upon elements such as evolving trade and investment barriers, national property rights regimes, etc., but ultimately, constraints 5

6 to expanding the MNE s management team determine the extent to which the firm can take advantage of foreign market opportunities. This is entirely consistent with TGF. However, the Penrosean analysis alone is insufficient to explain firm-level growth. Superior technological knowledge, both R&D and marketing related (including brand name development) is critical to foreign market penetration and profitable growth in those foreign markets. Even the most advanced entrepreneurial capabilities and an available large supply of productive services to be provided by the MNE s management team cannot substitute for such technological knowledge. In fairness to Penrose, she did acknowledge the importance of R&D and innovation, both in TGF and in the Hercules Powder case (Penrose, 1960), where unrelated diversification resulted from accidental innovations applicable to apparently unrelated activities. However, the systematic upgrading of technology-related FSAs resulting from R&D is not only costly to achieve, the FSAs are also expensive to transfer across borders because of cultural, administrative, economic and geographic distance between the home country and host countries (Ghemawat, 2001). A theory of MNE growth therefore needs to address the impact of distance on the internationalization process. For example, Rugman and Verbeke (2004) have explored the reasons for limited inter-regional as compared to intra-regional MNE growth of the Fortune Global 500 companies in a Triad-context (with the triad referring to the presence of three large, advanced economic regions in the world, namely the NAFTA-zone, the EU and Asia). They concluded that most MNEs face a rapid decay of their FSAs, and thus implicitly a reduction of their growth rates, once they attempt to expand outside of their home region. There are several reasons for this. First, the lower value attributed by consumers in host 6

7 regions to the MNE s proprietary - and internationally transferable - knowledge. Second, the difficulty of transferring this proprietary knowledge if it is tacit, thereby imposing additional transfer costs on the transferor of this knowledge as well as higher absorptive capacity requirements on the recipient. Third, the need to create bundles of locationbound knowledge, allowing national and regional responsiveness, to complement the non-location bound knowledge transfers from the home nation/region. Fourth, the challenge to address the three issues above in organizational capability terms. Johnston and Paladino (2006) discuss the MNE s organizational capability challenge in international markets. They identify the determinants of knowledge management systems usage, including groupware (e.g., intranets), knowledge repositories (e.g., ITdatabases) and intellectual capital audits. The determinants of such usage, which is instrumental to mobilizing unused productive resources, and therefore constitutes a transactional FSA, include the MNE s level of technology (in many cases the result of R&D), and the prevailing level of electronic communication. They also identify the determinants of the foreign affiliates contribution to the MNE s R&D efforts and its internal innovation adoption, and conclude, inter alia, that the affiliates local embeddedness is an important predictor of such contribution. This result suggests the complementarity between each affiliate s contribution to non-location bound FSA creation ànd its location-bound FSA development, as a pre-condition for new technology adoption inside the broader MNE network. Subsidiary location, and in a broader sense economic geography, thus critically determines the potential contributions of affiliates to new technology-related FSA development and adoption by the MNE network, and affects MNE growth. 7

8 Second, Penrose s perspective on new resource development and usage can be enriched by taking on board recent insights from the dynamic capabilities approach to strategy, as advocated by Augier and Teece (2006): Dynamic capabilities refer to the particular (non-imitable) capacity firms have to shape, reshape, configure and reconfigure [their] assets so as to respond to changing technologies and markets. Dynamic capabilities relate to the firm s ability to adapt in order to generate and exploit internal and external firm-specific competences and to address the firm s changing environment. Pitelis (2006) and Steen and Liesch (2006) suggest that TGF already embodied foundational components of the dynamic capabilities approach. Pitelis (2006) reinterprets Dunning s (1993) eclectic (or OLI ) paradigm using a Penrosean approach. He argues that the MNE s international expansion trajectory is not determined simply by a given set of ownership advantages (O, the equivalent of the FSAs discussed above), location advantages (L) and internalization advantages (I). Rather, the MNE to a large extent shapes the OLI-parameters itself and engages in a sophisticated adaptation process to link its internal strengths with external opportunities. First, the productive opportunity set identified by managers, and linked to O, determines any strategic decision to expand abroad rather than domestically. Here, the managerial search process is as important as the substance of the MNE s ownership advantages. Second, the choice of a foreign location to establish value added activities is determined by the perceived match between productive opportunities and the assumed attractiveness of that location (L) to exploit such opportunities. Again, cognitive elements prevail in this assessment of proper match. Finally, internalization (I) in the sense of internal growth through foreign expansion is driven by the availability of excess resources and the managerial services they provide. 8

9 Here, specific entrepreneurial efforts are critical to actually link managerial services with productive opportunities. Similarly, Steen and Liesch (2006), when revisiting the Uppsala internationalization model, argue that international expansion is not simply a process of learning about markets but, also, it is a process of learning about the firm s own internal resources, thus suggesting that MNEs develop higher order capabilities to manage the resources under their control. They propose to infuse Penrosean insights into the original Uppsala model. Here, the conventional view of gradual internationalization in function of experiental learning about foreign markets is complemented with a Penrosean perspective: entrepreneurial capabilities will drive the search for new productive opportunities, the design of new internal routines and ultimately, changes in the MNE s position in its external network, thereby strongly affecting the MNE s international growth pattern. Pitelis s (2006) and Steen and Liesch s (2006) analyses indicate that Penrose s work already exhibited aspects of a dynamic capabilities approach to MNE growth. Both analyses point to the importance of sophisticated adaptation routines in MNEs. Augier and Teece (2006) point out that Penrose did not address the necessity (as opposed to the opportunity) of learning so as to stay ahead of competitors. Penrose viewed learning as instrumental to growth, but she did not provide a reflection on either the importance of knowledge inimitability (by rival companies) or the intentionality involved in knowledge creation processes to shape the business environment and to create new markets. In an era when many fast growing MNEs increasingly rely on [t]he development and astute management of intangible assets/intellectual capital (Augier/Teece, 2006), the issues of 9

10 knowledge inimitability and purposeful shaping of the environment are increasingly critical to survival, profitability and growth, especially when these firms are faced with large rivals from other Triad regions. Again in fairness to Penrose, she had actually observed that the Schumpeterian process of creative destruction had not destroyed the large firm, but on the contrary, forced it to become more and more creative! Moreover, In the United States, where the process seems to be more highly developed, a kind of competition in creativity has become a dominant motif in the pattern of competitive behaviour in many industries, where consumers and producers alike are caught up in an almost compulsive obsession for what is new. (Penrose, 1959, p.106). The point is thus that Penrose actually did recognize the intentionality of knowledge upgrading, but was not convinced that such intentionality would necessarily always serve the consumer and society at large. Further, Penrose s view on building impregnable technological bases (see Pitelis, 2004) and her claim that firms try to shape their external environment (whereby she criticized biological analogies for failing to account for firm intentionality), suggest that her work is actually consistent with the dynamic capabilities approach, which should now be expanded further in the context of MNE behavior and FDI patterns. Third, the differentiated network MNE increasingly imposes new requirements on melding location-bound and internationally transferable FSAs, especially through international human resources management as a pre-condition for growth. Human resources do play an important role in TGF, as expressed by the entrepreneurial capabilities critical to diversification and growth, and the size of the management team setting the limits to the firm s growth rate. The question arises whether the insights 10

11 contained in TGF are sufficient to address the key human resources management challenges affecting MNE growth today. In this context, Verbeke and Yuan (2006) demonstrate the continued relevance of Penrose s insights. Building upon TGF, they identify the problems associated with a new normative approach to MNE growth, called the Metanational. Following a Penrosean logic, they show that the quantity of managerial services required by the Metanational structure is particularly high, therefore making its large scale adoption in industry unlikely. Specifically, entrepreneurial expansion in many new markets with a low similarity to existing markets, as a key ingredient of the Metanational approach to international growth, requires a large volume of managerial services from the firm s top management team. Members of this team will need to spend substantial time in those new markets so as to facilitate successful market penetration and to guarantee effective intra-mne coordination. TGF thus exhibits continued relevance as a generic tool to assess the validity of normative MNE growth models, for example, in terms of their human resources management implications. Penrose did not herself provide an in-depth discussion of the role of human resources in the international diffusion of the firm s knowledge. However, Tan and Mahoney (2006) and Beamish and Goerzen (2006) provide detailed accounts of the value of expatriates as instruments of tacit knowledge transfer and as facilitators of linking extant internationally transferable knowledge with new locationbound knowledge in MNEs. Expatriates represent critical knowledge linkages between geographically dispersed economic activity centres inside the MNE. 11

12 Tan and Mahoney (2006) demonstrate, building upon Penrose s insights, that expatriate managers sent to host countries can influence the learning by host country managers. While host country managers may be effective in developing location-bound knowledge on a stand-alone basis, their absorbing of the tacit knowledge component embedded in extant firm-specific routines is greatly facilitated by expatriates from the parent company. Expatriates are thus instrumental in melding internationally transferable knowledge from the parent company with location-bound knowledge held by host country managers, and this melding positively affects the MNE s sustained growth potential, at least in the initial entry stage in a new market. Goerzen and Beamish (2006) investigate the impact of a higher-than-industryaverage use of expatriate managers, and call this expatriate slack. They find that higher expatriate slack, as a reflection of non-location bound FSAs, in combination with more host country experience, i.e., a longer time window enjoyed by the MNE for developing location-bound knowledge, translates into superior performance. The missing element in the above empirical studies is the analysis of the type of expatriates sent to host countries. Penrose (1959) made a clear distinction between entrepreneurs and managers, whereby the former were viewed as critical to firm-level growth. In this context, future empirical studies should attempt to decompose the expatriate population into two categories. First, the managers focused on increasing the internal efficiency of foreign subsidiary operations. Second, the entrepreneurs sent to strengthen the subsidiary s ability to take advantage of local, productive opportunities. We should also emphasize that the determinants of excess resources in those studies differ from the Penrosean one. In Penrose s work, excess is defined in effect as 12

13 already having been paid-for, and thus available for use at (near) zero marginal cost. Having said this, the new perspective on the excess concept, as described above, leads to useful insights and should thus not be discarded. Penrose s work, and especially TGF, may not address fully the international growth challenges faced by the MNE today, as we have acknowledged above. International business scholars and managers alike now need to focus on R&D investments and the systemic rejuvenation of technology-related FSAs, on dynamic capabilities and on the related melding of internationally transferable FSAs with location-bound FSAs, inter alia through international human resources management practices such as the usage of expatriates. These elements go beyond the TGF, and in our view represent more than simply a few subsidiary empirical assumptions. In spite of the above, Penrose s extensive and lucid views on firm-level growth and the limits thereof are likely to remain, in the decades to come, a valuable and indispensable intellectual foundation for all those studying international business expansion, whether from an academic or practitioner perspective. Paradoxically, Penrose s main contribution to contemporary IB studies is that she asked why IB should be considered an academic discipline in its own right, which is equivalent to asking what the big question in IB should be, and why this big question is IB-specific. This paper (and the entire MIR Focused Issue) provides a tentative answer to Penrose s question: only IB studies can address appropriately the environmental context of semiglobalization. Here, continuous upgrading is required of both the firm s non-location bound knowledge, providing benefits of international/global integration (especially scope economies), and location-bound knowledge, providing benefits of local 13

14 responsiveness. The MNE is the only governance structure specialized in recombining and melding these two generic knowledge types, and only the study of the MNE can provide insights on the systematic upgrading at the firm-level of the relevant recombination and melding processes. In fact, such systematic upgrading reflects the dynamic capabilities held solely by MNEs. References Augier, M./Teece, D., Strategic Management, Entrepreneurship, and Design: The Evolving Influence of Edith Penrose and its Implications for Multinational Enterprise Strategy Analysis, Management International Review, 2006 (this issue). Buckley, P. J. / Casson, M., The Future of Multinational Enterprise, London: Macmillan, 1976 Buckley, P.J./Casson, M., Edith Penrose s Theory of the Growth of the Firm and the Strategic Management of Multinational Enterprises, Management International Review, 2006 (this issue). Dunning, J.H., American Investment in British Manufacturing Industry, London: Allen and Unwin, Dunning, J.H., Multinational enterprises and the global economy. Wokingham, England: Addison-Wesley Publishing Company, Dunning, J.H., Location and the Multinational Enterprise: A Neglected Factor? Journal of International Business Studies, 29(1), 1998, pp

15 Dunning, J.H., Towards a New Paradigm of Development; Implications for the Determinants of International Business Activity, Mimeo, Universities of Reading and Rutgers, 2005 Dunning, J.H./Lundan, S. M., The MNE as a Creator, Fashioner and Respondent to Institutional Change, Mimeo, Universities of Reading, Rutgers and Maastricht, Ghemawat, P., Distance Still Matters: The Hard Reality of Global Expansion, Harvard Business Review, 79, 2001, pp Goerzen, A./Beamish P.W., The Penrose Effect: Excess Expatriates in Multinational Enterprises, Management International Review, 2006 (this issue). Hymer, S., The International Operations of National Firms: A Study of Foreign Direct Investment, Cambridge, MA: MIT Press, 1976 Johnston, S./Paladino, A., Knowledge Management and Involvement in Innovations in MNC Subsidiaries, Management International Review, 2006 (this issue). Penrose, E. T., Foreign investment and the growth of the firm. Economic Journal, 66, 1956, pp Penrose, E. T., The Theory of the Growth of the Firm, Oxford: Basil Blackwell, Penrose, E. T., The Growth of the Firm a Case Study: the Hercules Powder Company, Business History Review, 34, 1960, pp Penrose, E. T., Multinational corporations, in The New Palgrave: A Dictionary of Economics, London: Macmillan, 1987, pp Penrose, E. T., The Theory of the Growth of the Firm, third edition, Oxford: Oxford University Press, Pitelis, C. N., The Growth of the Firm ; The Legacy of Edith Penrose, Oxford: Oxford University Press, Pitelis, C. N., Edith Penrose and the resource-based view of (international) business strategy, International Business Review, 13, 2004, pp Pitelis, C. N., Edith Penrose and a Learning-Based Perspective on the MNE and OLI, Management International Review, 2006 (this issue). Rugman, A. M./Verbeke, A., Regional and Global Strategies of Multinational Enterprises, Journal of International Business Studies, 35, 2004, pp Steen, J. T./Liesch, P.W., A Note on Penrosean Growth, Resource Bundles and the Uppsala Model of Internationalisation, Management International Review, 2006 (this issue). Tan, D./Mahoney J.T., The Dynamics of Japanese Firm Growth in U.S. Industries: The Penrose Effect, Management International Review, 2006 (this issue). Verbeke, A./Yuan W., Entrepreneurship in Multinational Enterprises: A Penrosean Perspective, Management International Review, 2006 (this issue). 15