INTRODUCTION

Economic activities can be organized through markets via arm's-length market transactions or outside of markets within the confines of firms. The boundary that separates the two is determined by the relative efficiency of each (Williamson, 1975). Externalities that are unpriced affect these boundaries because they provide an incentive for internalization — by shifting the boundaries of a firm.

Innovation is commonly seen to involve substantial interactions between firms that arise during the course of knowledge diffusion. Previous chapters have described the nature of the diffusion process. The innovation system involves a considerable flow of ideas among firms. Market transactions serve to diffuse many innovations. Industries in the core sector tend to diffuse the innovations that they have produced to downstream industries, which buy either innovations in the form of machinery and equipment or intermediate products from the core sector. As previous chapters have stressed, the most important sources of ideas for innovations involve customers and suppliers — a diffusion that is associated with commercial transactions. But knowledge that is not imbedded directly in products is also transferred via commercial contracts. And contractual problems can be severe when it comes to the transfer of knowledge.

The transfer of knowledge involves particularly difficult assessment and enforcement problems that are sometimes best handled within a firm, rather than through commercial arm's-length transactions.