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15 Internalization theory Mark Casson and Nigel Wadeson 15.1 INTRODUCTION Internalization is a theory of the boundaries of a firm. It does not claim to be a complete and self-sufficient theory of the firm, but rather a necessary component of any comprehensive theory of the firm. The basic principle is that there are two main ways of coordinating economic activity. One is through the market and the other is through management. Each mechanism tends to be preferred when it is the more efficient. Which mechanism is most efficient depends on specific circumstances. Identifying the circumstances that favour markets and those that favour management is one of the key contributions of internalization theory. Internalization relates to both intra-plant coordination and inter-plant coordination. The need for intra-plant coordination arises when different resources are co-located within the same plant and are used in conjunction with each other. The resources might be different workers that make up a team, or different machines carrying out related activities, or a combination of machines and their operatives. The theory of intra-plant coordination explains the nature of the employment contract under which labour is hired, the terms under which capital equipment is rented or leased, and the arrangements under which other factors of production, such as land, are supplied. It is therefore concerned with arrangements that prevail in factor markets (Alchian and Demsetz, 1972; Demsetz, 1988). The theory of inter-plant coordination, by contrast, is concerned with product markets – in particular, intermediate product markets. In this case the related...
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