Property rights, internal labor markets and the organizational form of the firm

The current economic theory of the role of the organization of the firm is based in the traditional transaction cost theory of the firm as well as discretionary theories of managerial behavior. According to the transaction cost theory, the firm serves as an administrative substitute for costly market mechanisms. Meanwhile, discretionary theories assume that managers operate under a costly-to-impose capital market constraint.

Given these underlying theories, the multidivisional form of firm organization is valued within the current theory for its ability to internalize (within the firm) the capital market constraint. The internal capital market constraint is said to be less costly to impose than the external constraint, leading to more efficient outcomes.

The theory presented in this dissertation, based upon property rights theory, argues that it is a labor market and not a capital market constraint that ultimately mitigates the incentive problems associated with the separation of ownership and control. The large modern corporation is modelled as an internal labor market in specific human capital. The organizational form of the firm is determined by the cost of monitoring individuals within the internal labor market. More decentralized forms of organization are valued for the reduction in monitoring costs that may be associated with increased decentralization. Under certain circumstances, the firm may adopt organizational forms that resort to internal competition to determine the value of performance.

This approach generates two significant departures from the current theory. First, the firm is not characterized, in general, as an administrative substitute for costly market price mechanisms. In fact, when the firm faces a highly uncertain environment, the firm has an incentive to internalize labor market forces.

Second, rather than describing the modern corporation as a miniature internal capital market, it is more accurate to describe it as a labor market. Ultimately, the organizational form of the firm can be characterized as an internal property rights system, interacting with the labor market outside the firm. Any change in the property rights system is brought about by the interaction of individuals who wish to achieve more utility.