The Growth and Diffusion of Knowledege and the Theory of the Firm

We analyze the implications of a market imperfection related to the inability to establish intellectual property rights, that we label "unverifiable communication." Employees are able to collude with external parties selling "knowledge capital" of the firm. The firm organizer engages in strategic interaction simultaneously with employees and competitors, as she introduces endogenous transaction costs in the market for information between those agents. Incentive schemes and communication costs are the key strategic variables used by the firm to induce frictions in collusive markets. Unverifiable communication introduces severe allocative distortions, both at internal product development and at intended sale of information (technology transfer). We derive implications of the model for observable decisions like characteristics of the employment relationship (full employment, incompatibility with other jobs), firms' preferences over cluster characteristics for location decisions, optimal size at entry, in-house development vs. sale strategies for innovations and industry evolution