Decentralization, Hierarchies and Incentives: A Mechanism Design Perspective

In summary, the most important lacuna of existing theoretical incentive-based literature is that it focuses on costs rather than the benefits of delegation. The latter are difficult to incorporate into traditional contract theory. Perhaps the most important benefit of delegation is the distribution of information processing tasks, but no progress has occurred in theories that marry information processing costs with incentives. Some progress has been possible with communication costs and simple measures of contract complexity, but these need better foundations. What have we learnt from the existing literature? It identifies a number of potential costs of delegation: moral hazard for intermediaries owing to non-coincidence of their own objectives with the principal’s, and their monopsony power over subordinates. These can result in production distortions (insufficient sourcing from subordinates), cascading of information rents across vertical layers, and problems of coordinating different horizontal branches. If agents do not collude, these agency costs of delegation can be avoided if (and only if) the principal can monitor subcontract costs or quantities, if contracts flow down the hierarchy, and agents are risk-neutral. If any one of these conditions do not hold then agency costs cannot be avoided. The only significant problem pertains to vertical control loss; if they can be avoided (i.e., under the above mentioned conditions) then incentive considerations do not complicate horizontal coordination across branches of the hierarchy: ‘group’-based incentive contracts can be designed to costlessly internalize these horizontal externalities. On the other hand, managerial risk aversion or limited capacity for principals to monitor local conditions or agent decisions can cause significant control losses from delegation, that grow with the size and complexity of the organization. This provides an explanation of organizational diseconomies of scale, i.e, why larger firms tend to be more ‘bureaucratic’ and less able to control costs. If agents collude, centralization is also subject to unobserved side contracting among agents, limiting the ability of the principal to moderate ‘control loss’. However, centralization potentially allows greater control over side contracting outcomes by the principal offering outside options to subordinates that limit monopsony power of intermediaries. Depending on the precise distortions engendered, this added dimension of control may or may not be valuable. Overall, the presence of collusion among agents enlarges the range of circumstances where delegation implements optimal allocations. There are numerous open questions and fruitful avenues for future research. I conclude by listing some of these. First, a better understanding of effects of collusion is still needed. The few papers on this topic emerge with different results the intuitive basis for which is not very clear. One hopes a more unified perspective will emerge in due course. There is a need to explore implications of different formulations of side-contracting, e.g., more general assignment of bargaining power within coalitions, or alternative timing assumptions. Baron-Besanko (1999) provide an intriguing model in which agents themselves decide ex ante whether to consolidate themselves into a single entity, a decision which the principal observes and takes into account before offering a contract. In the models we described, the principal can anticipate a particular pattern of side contracting, but cannot observe whether or not the agents actually do side-contract. In contexts with more agents and vertical layers, the possibility of collusion-within-collusion further complicates the analysis. Second, more effort needs to be devoted to explaining the potential benefits of delegation. Models integrating information processing or communication costs with incentive considerations are needed to provide a full-blown theory of the trade-off between centralization and decentralization. This would render the theory useful in applied work assessing the effectiveness of innovative human resource management practices and their complementarity with new information technology. A third possible avenue would consider applications and extensions to contexts involving more productive agents and a richer specification of the production technology. Questions concerning the optimal shape of hierarchies can then be addressed, e.g., tradeoffs between span of control and number of vertical layers, how to group agents within departments, organizational diseconomies of scale, and the advantages of non-hierarchical organizations. One hopes that both theory and empirical datasets regarding these organizational attributes can be developed interactively, permitting better understanding of their productivity implications, and how they respond to changes in market competition or information technology.