Internal markets and the theory of the firm

A growing number of companies are explicitly replacing bureaucratic internal resource allocation with internal markets. But if markets work well within firms, why are there firms at all? Why does not all allocation take place on 'external' markets? This paper seeks to resolve this apparent anomaly by viewing the firm as a membership club rather than as a command structure. Members join the firm and pay its membership fee when the value of the local public goods they receive exceeds the opportunity cost of joining. Some of the most important public goods provided by firms are variously referred to as organizational capabilities, competencies, or routines. These can often be characterized as public goods because they are ultimately based on knowledge, and hence involve a degree of nonrival consumption. A firm survives when its internal environment generates value-creating capabilities, competencies, and routines. The firm will continue to exist as long as the owners of its human and physical capital find it more profitable to transact inside this environment than outside. Copyright © 2001 John Wiley & Sons, Ltd.