Firms in the same industry exhibit systematic differences in the organization of production and the structure of employment. Entrepreneurial ability is the specific scarce input that limits the size of a firm. This input must be allocated to two activities, coordinating production and monitoring workers. Able entrepreneurs can convert calendar time into larger supplies of coordinating effort that enable them to assemble large firms. Greater ability implies a higher shadow price of time which increases the implicit costs of monitoring. A dispersion of entrepreneurial abilities generates an equilibrium size distribution of firms. Differences in monitoring costs affect the choice of worker productivities, the design of products, and the organization of production. The monitoring cost hypothesis advanced in this paper goes a long way in explaining the equilibrium of an industry containing heterogeneous firms that differ in size and behavior.
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