Equity and Efficiency in the Organization of Firms

Using a series of laboratory experiments, this paper shows that fairness concerns of potential co- founders may lead to failure to undertake profitable joint production opportunities. Inefficiency occurs more often when equal division of the firm’s profit would leave one co-founder worse- off relative to her outside option. We find that framing an opportunity as an employment relationship rather than a partnership significantly reduces these inefficiencies and increases subjects’ welfare. Evidence from division of profits and communication logs from free-form negotiations between subjects suggest that only some subjects incorporate outside options to define fairness. Based on this, we provide a theoretical model of how fairness concerns affect the formation of new firms.