Division of Labor, Transaction Cost, Emergence of the Firm and Firm Size

Abstract

In this paper a general equilibrium model is constructed to explain the emergence of firms and change in firm size by the tradeoff between economies of specialization and transaction cost. We show that firms emerge from the development of division of labor if the transaction efficiency for labor is smaller than that for intermediate goods. Given the emergence of firms, change in the average size of firms (average employment) will depend on the change in transaction efficiency for intermediate goods relative to that for labor. If the transaction efficiency is improved in such a way that the transaction efficiency for intermediate goods becomes higher than that for labor, average employment will decrease. We present evidence showing that it is not uncommon that average employment declines as the economy develops. The general equilibrium model provides an explanation for the concurrent increase of productivity and decrease in average employment which is observed in a number of countries. Models based on economies of scale instead of economies of specialization would have yielded the opposite prediction.