Incomplete Contract and Divisional Structures

This paper analyzes the internal divisional structure within an organization in the framework of incomplete contract theory. We use the framework of Aghion and Tirole (1997) and define the managerial control structure as \sequence of search". A key feature of this paper which di erentiate it from other works in the literature is that we add an ex post bargaining phase in which the managers can agree on the project which maximize their joint private bene t. Our model shows the share of cooperative surplus the managers can get from bargaining and their default pay off plays a key role in determining their search effort. When there is no spill over effect between the agents' efort, internal separation is always dominated by internal integration with control right assigned to the agent (manager) with high interest congruence with the principal (head quarter). When there are dissonance effect during integration, the principal want to have separation to avoid it. But more importantly, the optimal divisional structure depends heavily on whether the bargaining is interest congruence enhancing (increase the interest congruence between agents and the principal) or destroying (decrease the interest congruence).