The Division of Labor and The Theory of the Firm

We extend the classical teams framework to the case where team size is endogenous and workers can specialize within a division of labor. We consider two institutions: equal-division partnerships and the firm with a budget-breaker. In contrast with the previous literature, we show that effort and team size in partnerships can be greater or less than first best. Our results for the firm are driven by two main insights. First, the budgetbreaker can increase effort with an increase in incentives and/or specialization. Second, incentives and employment are strategic substitutes. We show that the budget-breaker offers incentives that are weaker than first best or equal-division partnership incentives, so that shirking is more prevalent in the firm. Since incentives and team size are substitutes, the budget-breaker increases employment above the first best and partnership levels, so the firm is inefficiently large. The role of the budget-breaker is therefore to reduce agents' exposure to risk and to promote and coordinate specialization and the division of labor. The comparative statics of the firm are consistent with several institutional stylized facts (e.g., the size-wage effect) and recent organizational trends.