The firm as a subeconomy

This article explores the economic role of the firm in a market economy. Th e analysis begins with a discussion and critique of the property rights app roach to the theory of the firm as exposited in the recent work by Hart and Moore ("Property Rights and the Nature; of the Firm"). It is argued that t he Hart-Moore model, taken literally, can only explain why individuals own assets, but not why firms own assets. In particular, the logic of the model suggests that each asset should be free standing in order to provide maxim al flexibility for the design of individual incentives. These implications run counter to fact. One of the key features of the modern firm is that it owns essentially all the productive assets that it employs. Employees rarel y own any assets; they only contribute human capital. Why is the ownership of assets clustered in firms? This article outlines an answer based on the notion that control over physical assets gives control over contracting rig hts to those assets. Metaphorically, the firm is viewed,as a miniature econ omy, an "island" economy, in which asset ownership conveys the CEO the powe r to define the "rules of the game," that is, the ability to restructure th e incentives of those that accept to do business on (or with) the island. T he desire to regulate trade in this fashion stems from contractual external ities characteristic of imperfect information environments. The inability t o regulate all trade through a single firm stems from the value of exit rig hts as an incentive instrument and a tool to discipline the abuse of power.