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working paper
department
of economics
FORMAL AND REAL AUTHORITY
IN
ORGANIZATIONS
Philippe Aghion
Jean Tirole
95-8
June, 1994
massachusetts
institute of
technology
50 memorial drive
Cambridge, mass. 02139
FORMAL AND REAL AUTHORITY
IN
ORGANIZATIONS
Philippe Aghion
Jean Tirole
June, 1994
95-8
MASSAC? !US£TTS
INSTI i"U'f£
OF TECHNOLOGY
MAR 2
9 1995
USRARiES
Formal and Real Authority
in
Organizations*
Philippe Aghiont and
June
"The authors
1994
and Martin Hellwig for helpful discussions, to
and especially Denis Gromb and David Martimort for helpand to the Centre National d'Etudes des Telecommunications
are grateful to Oliver Hart
Patrick Bolton, Leonardo
ful
1,
Jean Tirole*
comments on a first
Felli,
draft,
for financial support.
'Nuffield College, Oxford
tlDEI, Toulouse, France;
and EBRD, London
CERAS, Paris; and MIT, Cambridge,
MA USA
Abstract
The paper develops a theory
cide)
and
real authority (the effective control over decisions),
integrated structure can
is
accommodate various degrees
determined by the structure of information, which
formal authority.
a
of the separation between formal authority (the right to de-
An
loss of control for
and
illustrates
how a
formally
of "real" integration. Real authority
in turn
depends on the allocation of
increase in an agent's real authority promotes initiative but results in
the principal.
After showing that firm boundaries and information structures are intertwined, the paper
examines a number of factors that increase the subordinates' real authority
in
an integrated
structure: overload, lenient rules, urgency of decision, reputation, performance
measurement,
and multiplicity of superiors.
Lastly,
the
amount
of communication in an organization
allocation of formal authority.
is
shown
to
depend on the
Introduction
1
Over forty years ago, Herbert Simon defined authority
part or the whole of an organization.
Moore
( 1
1
As pointed out by Grossman-Hart (1986) and Hart-
may be conferred by
990), authority
as the right to select actions affecting
the ownership of an asset, which gives the owner
may more
the right to take decisions concerning the use of this asset. Authority
result
to a
from an
member
members
of the organization.
2
This formal authority however need not confer real authority, that
over decisions,
upon
its
holder. For example,
it is
commonplace
have limited control over their board of directors, which
nation of the top executives,
who
in
itself
an
is
effective control
to observe that shareholders
may be
subject to the domi-
turn often rubber-stamp the divisions' projects, and so
Similarly, the president of a country really controls only a small
forth.
on specified matters
explicit or implicit contract allocating the right to decide
or group of
generally
number
of the deci-
sions taken by the executive branch. This paper develops a theory of the separation
formal authority and real authority,
accommodate various degrees
Our approach
Weber notes that
follows
Max
officials,
3
and
illustrates
how a formally
between
integrated structure can
of "real" integration.
Weber's (1968) description of "rational" or "legal" authority.
employees, and workers attached to the administrative staff of a
bureaucracy do not themselves own the non-human means of production and administration,
yet they
may
exert substantial control over the bureaucratic machinery (p217-225).
example, he observes that
For
:
"Bureaucratic administration means fundamentally domination through knowlis the feature of it which makes it specifically rational. This consists
on the one hand in technical knowledge which, by itself, is sufficient to ensure
it a position of extraordinary power. But in addition to this, bureaucratic organizations, or the holders of power who make use of them, have the tendency to
increase their power still further by the knowledge growing out of experience in
the service. For they acquire through the conduct of office a special knowledge of
facts and have available a store of documentary material peculiar to themselves.
While not peculiar to bureaucratic organizations, the concept of "official secrets"
is certainly typical of them. It stands in relation to technical knowledge in somewhat the same position as commercial secrets do to technological training. It is
edge. This
1
[a
"We
will
say that the boss exercises authority over the worker
"behavior",
i.e.,
any element of the
the worker accepts authority
will
accept authority only
acceptance") of
in
all
if
when
Xq, tne
his
if
the worker permits the boss to select x
worker performs on the job]. That is,
determined by the boss's decision. In general, the worker
set of specific actions that the
behavior
is
x chosen by the boss,
the possible values. This
modern administrative theory" [Simon
(
is
is
restricted to
some subset
the definition of authority that
is
(the worker's "area of
most generally employed
1951 ,p294)].
This corresponds to Weber's (1968) notion of "rational" or "legal" authority. Weber distinguishes among
three types of authority, the other two being "traditional authority" and "charismatic authority".
2
3
and control is reflected in the principal-agent literature, starting
Holmstrom
with Mirrlees (1975),
(1979) and Shavell (1979). This literature studies the structuring of
compensation and rewards, assuming full control by the agent, and does not investigate the allocation of
The
distinction between ownership
authority, formal or real.
1
a product of the striving for power."
As
The
tion.
so
real authority
is
asymmetric informa-
superior can always reverse her subordinate's decision, but will refrain from doing
the subordinate
if
We
Weber, the key to our analysis of formal vs
in
is
much
better informed and
formalize this idea in a straightforward way.
The
tiative) to suggest a project to the superior.
is
The subordinate
exerts effort (shows
latter as well chooses
how much
ini-
to learn
Once informed, the subordinate recommends a project that
about the potential project.
sometimes
their objectives are not too antinomic.
if
not optimal for the superior, because from the point of view of the agent this
project creates a higher private benefit, yields better career opportunities, or requires less
effort to
superior
may
be implemented than the optimal project.
is
Formal authority prevails when the
informed, since the superior then chooses her preferred project (which
may
or
not coincide with the subordinate's proposal). In contrast, a poorly informed superior
optimally rubber-stamps the subordinate's proposal by fear of picking a worse alternative.
The subordinate then has
A
superior
who
real,
although no formal authority.
for instance
is
overloaded and therefore has
subordinates' decisions loses control and involuntarily endorses
Conversely, too
much
what
The
information also hurts the superior.
creates initiative from the subordinate.
little
time to monitor her
many suboptimal
projects.
very prospect of influencing
The subordinate
loses motivation
decisions
is
when the
superior's incentives (for instance, idleness, obsession or high competency) lead
to "stand constantly
There
is
behind the subordinate's shoulders", that
to monitor very thoroughly.
thus a general trade-off between initiative and loss of control.
degree of separation of ownership and control
task,
is
on who performs and monitors
it,
is
endogenous;
him
Furthermore, the
depends on the nature of the
it
and on the organizational structure. 4
This new approach to ownership and control based on the distinction between formal
and
real authority delivers a
First,
it
number
of interesting conclusions.
provides a logical relationship between the information structure and the alloca-
tion of decision rights within an organization:
5
The
reallocation of formal authority to the
agent prevents the principal from overruling the agent in those situations (a la Grossman-
Hart (1986)) where both parties have acquired the relevant information about the potential
projects' payoffs.
The
agent's initiative.
On
4
A
more
transfer of formal authority to the agent thus credibly increases the
the other hand, the principal has
straightforward application of this idea
likely to
is
more
incentives to
become informed
the prediction that the delegation of day-to-day activities
be observed than the delegation of key investments. This
of day-to-day activities, but rather to the fact that they are very
is
is
not due to a relative irrelevance
numerous and therefore more
costly to
monitor.
3
Note also that an agent who
contract with the principal,
decision making.
may
is
"outside the organization" in the sense of not having signed an initial
may bring information that influences
also exert "real authority", in that he
Firm boundaries and information
she has the right to reverse decisions.
if
thus intertwined,
and the
size of a firm
structures are
ultimately determined by the above trade-off be-
is
tween the subordinate's initiative and the principal's cost of losing control over the choice
of projects.
Second, whilst conferring decision rights on the agent increases
a
number
of factors that encourage initiative
factor of initiative
and
loss of control
when
his initiative, there are also
the principal retains formal authority.
One
a wide span of control, which raises the principal's
is
We
marginal cost of monitoring each agent.
show that there
a sense in which optimal
is
organizations always function in a situation of overload. Another raise-the-monitoring-cost
way
of committing not to
from imposing
stifle initiative is to refrain
rules that constrain the
agent within a set of easily monitorable activities. Alternatively, the gain from intervention
can be reduced by spreading
also
be made more
its
among
benefits
several principals/owners;
by splitting property rights
difficult
among
of a matrix organization or of multiministry oversight)
6
intervention can
several superiors (as in the case
and by requiring that intervention be
unanimously agreed upon.
Other factors that encourage
does not give the superior
initiative include the
much time
for
urgency of decision making, which
a thorough investigation; repeated interaction,
which allows the superior to develop a reputation for not intervening
fairly
in
matters that are
inconsequential to her and for intervening only in important matters; and improved
performance measurement.
Third, our approach enables us to provide a modest, but
of "'collective
bounded
plications of imperfect
rationality"'
and
incentives.
A
first,
step toward the integration
recent literature has studied the im-
communication on the functioning of an organization. 7 This research
has taken the imperfection of communication as given and in general has assumed that
bers of the organization pursue the
same
objective.
endogenizing the limits to communication.
team theoretic framework of the
The communication
because the agent
is
is
would
basic idea
literature to allow
of information
ship. In particular, less
The
We
is
like to
go one step beyond by
to depart
members
to
mem-
from the traditional
have dissonant objectives.
then strategic and depends on the authority relation-
communication may take place
if
the principal has formal authority
concerned that the principal might abuse her authority once she
informed. This will typically be the case
if
sufficiently dissonant. In the opposite case
is
well
the principal's and subordinate's objectives are
where these objectives are
we show that communication may instead be encouraged by the
sufficiently
congruent
agent's subordination to
the principal.
6
a
This theme
number
7
is
developed
in
a corporate finance framework by Burkart,
Gromb and Panunzi
(1994), with
of interesting implications.
See, e.g.,
Marschak-Radner (1992). Sah-Stiglitz (1986), Bolton- Dewatripont (1992) and Radner (1992).
Although our analysis
The moral hazard and property
blocks developed by other authors.
A
the two polar cases.
our knowledge, new,
to the best of
is,
Riordan (1990), and Schmidt (1991) develop
may
hurt a principal.
9
rights literatures supplied
Cremer
8
MIT
in
Papers by Cremer (1992),
in different contexts the idea that too
much
Riordan (1990) argues that information allows principals
to expropriate the agents' specific investments.
based on information.
makes use of building
seminar given by Diego Rodriguez and Dimitri Vayanos at
1991 contained several seeds of the basic model described here.
information
it
(in
He provides a definition of vertical
integration
the context of a corporation) and Schmidt (in a paper
on privatization) show that poor information allows principals to avoid (ex ante costly)
renegotiation of long term contracts with agents. In Cremer's paper, the principal publicly
chooses the accuracy of a technology used to monitor the agent's type.
technology reduces the agent's incentive to work to signal high
discuss property rights and, in the tradition of
establish) a link
The paper
it:
first
It
Arrow (1975),
accurate
Riordan and Schmidt
posit (but do not formally
between property rights and information structure.
is
organized as follows:
Section 2 presents the model.
relates the information structure
formal authority;
thority
ability.
A more
Section 3 analyzes
and equilibrium payoffs to the allocation
then demonstrates a tight link between our incomplete contract/au-
it
methodology and a complete contract approach. Section 4 looks
the agent's initiative
of
when the
at factors favoring
principal has formal authority (overload, lenient rules, urgency
of decision, reputation, better performance
measurement, multiple principals), and derives
implications for business management. Section 5 endogenizes communication, and section 6
concludes.
2
A
The model
hierarchy composed of a principal (she) and an agent (he) can implement one or zero
project.
project.
The
principal hires the agent to collect information about
Examples of
hierarchies
we have
in
mind
and implement the
are board of directors or trustees/mana-
gement, CEO/division manager, thesis advisor/student, foreman/worker, or supranational
authority/country.
• Projects:
The
agent screens
among n >
3 potential
behalf of the principal. To each project k 6 {1,
gain or profit
gross of any
Bk
for the principal
monetary
•
,n}
and a private benefit
transfer between the two parties].
perks on the job, acquisition of
human
and a
priori identical projects
on
is
associated a verifiable monetary
&<,
for the agent. [These payoffs are
The
agent's private benefit includes
capital, the possibility of signalling ability, or (minus)
"Their 1993 discussion paper focuses on different themes than the ones considered here.
3
The literature on the ratchet effect also emphasizes a cost for a principal from being well informed.
the disutility of implementing the project.
private benefit are both equal to zero.
with known payoffs
B =
=
b
10
If
no project
is
implemented, the
profit
"No project" can formally be treated
and the
as project 0,
0.
Only two of the n potential projects are actually "serious" or "relevant".
projects yield "sufficiently negative" payoffs to both parties.
All other
Anticipating somewhat, this
imply that an uninformed agent prefers to confess ignorance and to recommend inaction
will
recommend a
rather than to
specific project,
and that
an uninformed principal
similarly
would not choose by herself to undertake a project.
One
Similarly,
other
B >
of the two relevant projects yields profit
one of the two relevant projects yields private benefit
The ex ante
0.
to the principal
probability that the
same
project
is
b
>
and the other
to the agent,
preferred by both
is
a6
0.
and the
[0, 1],
the
parameter of congruence. 11
The
• Preferences:
and
w
The
agent's utility
is
the
principal
wage paid
risk neutral
to the agent.
then u(w)
is
is
+
6t,
and has
The agent
where
u(-)
is
is
utility
wage
4.5
is
project k
is
liability,
so
chosen,
w >
0.
increasing and concave.
of zero. Alternatively, the agent
the principal's benefit
if
is
infinitely risk averse to income.
monetary incentives and receives a constant wage equal
therefore does not respond to
his reservation
—w
protected by limited
For expositional simplicity we will assume that the agent
He
Bk
noncontractible; the agent's
may
wage
to
not be infinitely risk averse, but
is
then again a constant. [Section
shows that the model can be straightforwardly extended to allow the agent to respond to
monetary incentives.
Profit sharing then lowers the principal's
and
raises the agent's utility
from picking a profitable project.]
•
Information:
The agent
acquires information in a binary form. At private cost ^(e),
he perfectly learns the payoffs of
(1
—
10
and
all
candidate projects with probability
the agent learns nothing and
e),
For example, a
R&D
common
units put too
applications ("D").
complaint
in large
much emphasis on
The emphasis on
still
e.
With
probability
views the projects as identical.
conglomerates
is
basic research ("R")
basic research stems
that
R&D
and too
operations get out of control
little
from the units' private
on developing commercial
benefit.
"This congruence parameter will be treated as exogenous in the following analysis. However, one could
think of various methods whereby the principal might affect congruence with her subordinates: for example, investments in the recruiting and training of new employees, design of career profiles, enforcement of
[contractual] rules restricting the subordinates' set of possible actions.
An
interesting determinant of
by the activity of this agent.
vis-a-vis their units.
IBM
A
is less
a
is
the possibility that other agents working for the principal are affected
is supplied by the difference in behavior of IBM and Fujitsu
case in point
successful in keeping an arms-length relationship with
its
units than Fujitsu
According to The Economist (Management Focus. April 10, 1993), one
reason is that Fujitsu and ICL are not serious rivals anywhere while IBM's units are often competitors.
Under the plausible hypothesis that the existence of externalities on other units reduces the congruence
parameter, this view is consistent with our theory, which predicts that the subordinate has more discretion,
with
its
British subsidiary ICL.
the higher the congruence.
A
systematic exploration of the various ways of endogenizing the congruence parameter
scope of this paper.
lies
beyond the
Similarly, the principal chooses
how much time
or effort to devote to learning payoffs.
At private cost gp{E), she becomes perfectly informed about the payoffs with probability
and learns nothing with probability
The
(1
—
E).
be contemporaneous with the agent's or
principal's acquisition of information can
else start after the
agent makes his report.
We
will refer to these
simultaneous and sequential models, respectively. Which variant
on the context. Sequential investigations usually are
who can already
build on an existing report.
On
is
two
possibilities as the
more
relevant depends
time consuming for the principal,
less
the other hand, the principal
to wait until the report accrues to start her investigation, as otherwise she
to accept the agent's proposal by lack of time.
same
cases yield essentially the
results,
E
we
12
may
not want
may be
forced
Because the simultaneous and sequential
will focus
on the simultaneous case and content
ourselves with illustrating the sequential case in section 4.3.
We
leave the endogenization of
the timing (simultaneous vs sequential) for future research.
The
gi {0)
•
=
Q,g' (Q)
i
=
verified
=
0,g'i (\)
Communication:
or soft.
and gp(-) are increasing and
disutilities of effort fiu(-)
oo,i
most of the paper we can assume that information
In
by the other party
if
communicated by the party who
The
as a pure suggestion for a project choice.
and
is
it.
Soft information
specific results of section 4.3 rely
on the
we
will occasionally label "inte-
the main focus of this paper), the principal has the formal authority and
She indeed does so
if
.
she
The
is
principal
may always
informed and
In this case, the principal has
fully
collected
soft.
called the '''superior''
and can
either hard
communication must be interpreted
Authority: In the case of P-formal authority (which
gration''
is
its
is
be costlessly and instantaneously
project's payoffs can
cannot be verified by the other party and therefore
•
convex and satisfy
= A,P.
Hard information about a
information being
strictly
if
overrule the agent (the "subordinate").
the agent's recommendation
both the formal and
is
not "congruent".
real authority over the choice of project
dispense with the agent's information and recommendation. Otherwise, she
(optimally) rubber-stamps the agent's proposal.
We
will
then say that the agent has real
authority.
Our payoff structure
subordinate;
The standard
for,
implies that there
is
no need to include an
the superior always takes a decision that yields nonnegative utility to both.
institution of letting subordinates quit
decisions emerges naturally in the variant of our
12
For instance, directors of a
stamp the annual report or
involved.
"exit option" for the
company
or external
to accept the thesis
if
if
they are unhappy with their superiors'
model
members
in
which the principal's preferred
of a thesis jury are usually forced to rubber-
they have waited until receiving the documents to become
may impose
project
a substantial loss of utility for the agent.
Under A-formal authority (which we
dent agenf
That
is,
agent
is
the agent
now has formal
Note that
authority.
this covers the situation in
which the
this particular
13
will
assume that whoever has authority
zero, but benefits the other party to doing
two relevant projects yield
•
the "indepen-
informed, picks his preferred project and cannot be overruled by the principal.
an employee who contractually receives an irrevocable right to take
decision.
We
if
,
will occasionally label "delegation"),
Contracts.
In
prefers choosing a project that gives
nothing (equivalently, we could assume that the
strictly positive payoffs to
most of the
analysis,
him
both parties).
we adopt the incomplete contracting approach
(Grossman-Hart (1986)) by positing that projects cannot be described and contracted upon
ex ante.
to
The
initial
one of the two
The timing
is
contract only specifies an allocation of formal authority (control rights)
parties.
as follows:
(i)
The
principal proposes a contract that allocates formal
authority to her or the agent over the future choice of projects; 14
gather information about the n projects' payoffs;
(iii)
the party
(ii)
who
the parties privately
does not have formal
authority communicates a subset of the relevant projects' payoffs he has learned to the
controlling party; given that there are only two relevant projects, this subset
zero,
one or two project payoffs descriptions;
(iv)
may comprise
the controlling party picks a project (or
none) on the basis of his information and the information communicated by the other party.
To put the incomplete contracting approach somewhat
in perspective, section 3.4 explores
the polar assumption that projects can be described and contracted
though
their payoffs are ex ante
unknown
to
both parties.
We
upon ex
will see that
ante, even
under
specific
circumstances, the optimal complete contract corresponds exactly to a (possibly random)
authority allocation scheme, and we will point at the implications of contract incompleteness
when these circumstances do not
• Payoffs
obtain.
under the two allocations of authority. Under
P -formal
authority (integration),
13
The allocation of authority must therefore be thought of as issue specific. For instance, the chairperson of
a department can pick the salary or the teaching load of a professor but has no right to choose the professor's
research agenda. Another case in point is that of Du Pont in 1921, in which "headquarters did not have
the [formal] authority to step in and interfere with divisional decisions unless something was clearly going
wrong" (Chandler, in Continental Bank (1993), p56, bracket added). Our model has a single project/issue,
but we find its extension to multiple decision rights and clusters of authority potentially fascinating.
Note also that the delegation of formal authority is sometimes partial in that the principal may be able
to regain authority at a large cost: An official may be impeached, or a board of directors overruled by
shareholders through a takeover or a proxy
l4
fight.
we assume that there is ex ante a competitive supply of potential agents, so that the allocation
of authority between the two parties is the one that maximizes the principal's ex ante expected utility
That
is,
the
utilities
are
= EB +
uP
{1
-E)eaB-gp(E)
(1)
and
= Eab + {l-E)eb-gA (e).
uA
That
is,
with probability E, the principal
probability (1
and suggests
—
E), the principal
is
is
informed and picks her preferred project. With
uninformed. With probability
The principal then
his preferred project.
(2)
either learns
the payoffs attached to this project (hard information) or
is still
e,
the agent
from
his
is
informed
recommendation
uncertain about whether the
agent proposes her preferred project (soft information). Either way, the principal optimally
rubber-stamps the agent's proposal. 15
Under A-formal authority (delegation) when informed, the agent simply chooses
ferred project.
When
the agent
is
uninformed, and the principal
suggests her preferred project, which
is
is
his pre-
informed, the principal
then implemented by the agent. So, using the su-
perscript "d" for "delegation", preferences are
= eaB +
up
{\
-e)EB-gp(E)
(3)
and
d
uA
=eb+{l-e)Eab-gA (e).
(4)
Note that the agent's lack of responsiveness to monetary incentives precludes any renegotiation of the exercise of authority.
Remark: That the
principal
is
principal's formal authority
uninformed follows from the
becomes
entirely ineffective
when
specific projects payoff structure, in particular
the
from
the principal's weakly preferring a (relevant) noncongruent project to no project at
all.
To
>
4),
say
see this, consider the following example: there are three relevant projects (thus
k
=
1
and 2
1,2
and
3.
n
Project 3 yields a strictly negative profit to the principal, whilst projects
yield (as above) a nonnegative profit.
whenever uninformed can
still
Then,
if
information
use her formal authority in order to
project 3 vs projects {1,2} from the agent.
The
is
elicit
hard, the principal
information about
principal will then rubber-stamp the agent's
decision only conditionally on information ruling out the negative-profit project having been
disclosed to her.
13
Note that the superior
is
always better
off,
the higher the agent's effort. This need not hold in a multi-
may then crowd out his effort on other
one task may not be positively valued by the principal.
task extension of our model; for, the agent's effort on this task
Consequently, the agent's initiative
in
tasks.
Analysis
3
The
3.1
The
reaction curves under P- formal authority
first-order conditions
when
the principal has formal authority are:
- ea)B = g'P (E)
(1
(5)
and
-
(I
The
= g'A (e).
principal supervises more, the higher her stake
and the agent's
and
E)b
effort.
(6)
and the lower the congruence parameter
The agent demonstrates more
initiative,
the higher his private benefit
the lower the principal's interference.
We
assume that the two systems
(E.e) 16 [Such an assumption
acquires information only
stability condition
The
is
if
is
of equations {(5), (6)} has a unique, stable intersection
not needed in the sequential case:
the agent makes a proposal,
automatically satisfied.
sloping, the principal
independent of e and the
]
In contrast,
would never want
is
17
fact that the agent's reaction curve (6)
of this (or any) delegation model.
E
Because the principal
is
if
downward sloping
is
a crucial feature
the agent's reaction curve were upward
to reduce her degree of interference
E
for strategic
reasons. This latter case might correspond either to a situation of strategic complementarity
if
the principal's reaction curve were also upward sloping or to a supervision situation
principal's reaction curve were
Finally,
downward
if
the
sloping.
note the first-order condition (5) implies that the principal's reaction to the
agent's effort
is
also
downward
sloping.
an incentive to substitute for the agent
that the agent
is
indispensable.
That
The
interpretation
in case
is,
is
that the principal can and has
the agent does not work. Suppose in contrast
the principal cannot invent a project
if
the agent
does not come up with a proper suggestion; on the other hand, the principal can carefully
read any
curve
is
file
then
gathered by the agent and modify the existing project. The principal's reaction
likely to
slope up. [The comparative statics results obtained in this paper carry
over to this case for shifts in the principal's reaction function, but not for shifts in the agent's
reaction function.!
16
That is, abB < y P (E)g^{e).
'"For example, with soft information, the principal's payoff in the sequential case
up
= e[EB +
(1
- E)aB - g P (E)].
is:
The
3.2
basic tradeoff between loss of control
Suppose that
some "exogenous" reason
(e.g.,
initiative
because of overload), the marginal cost of
P ) increases. The effect on the principal's expected payoff is a
ambiguous. On the one hand, ceteris paribus, the principal's probability of becoming
effort of
priori
for
and
the principal
(i.e., g'
informed about the projects' payoffs (E) decreases (see equation
loses real authority (i.e., control) over the choice of project,
having to endorse suboptimal projects.
intervention
E
On
with a higher resulting
risk of
the other hand, the reduction in the principal's
encourages initiative from the subordinate (see equation
raises the principal's
the principal thus
(5));
(6)),
which
in
turn
expected (monetary) benefit.
This basic tradeoff between loss of control and initiative determines the optimal allocation
of real authority
when the
initial
how the
question then arises as to
amount
(optimal)
This question
is
principal can actually
commit
The
herself to delegate an
of real authority to her subordinate while retaining formal authority.
taken up
foster the agent's initiative
The optimal
3.3
contract allocates formal authority to the principal.
One (extreme) way
in detail in section 4.
is
to relinquish her
for the principal to
formal authority, as we shall now
see.
allocation of formal authority
Whether formal authority should optimally be allocated
to the principal or to the agent
hinges on the tradeoff between loss of control and initiative.
More
formally,
when the agent
has formal authority, the first-order conditions are:
(l-e)B = g'P (E)
(7)
and
(l-aE)b =
Assuming again that
that
{(7), (8)} yields
(8)
18
one can show
a unique, stable equilibrium (E^e*),
:
E > Ed
Our model
thus explains
why
and
is
agent, she has less incentive to
is
The
e
d
.
(e.g., in
Williamson
Because the principal cannot overrule the
become informed and thus giving the formal authority
to
a credible way for the principal to commit not to intervene. The cost of leaving
initiative to the agent,
decisions
<
often suggested in the literature
(1975,1985)), to an arms-length relationship.
the agent
e
the absence of integration (where "integration" is understood as
P-formal authority) corresponds, as
ls
g' (e).
A
more
on the other hand,
is
a loss of control.
The agent
often.
stability condition
is
the
same
as in the case of P-formal authority.
10
takes suboptimal
Example: Let us compare the two governance structures
tion, in
One
which gA (e)
=
e
2
=£
/2 and gP (E)
2
in
the quadratic cost specifica-
/2.
19
has
B{\-ab)
E_
1
6(1
- abB
'
1
- B)
- abB
'
and
d
=
B(l-b)
I
b(l-aB)
d
\-abB
-abB'
'
Furthermore,
UP ~
P -formal
authority
is
^ = o'-ai"^
optimal for low
" I (1 +
11
levels of
Q)
" a(1 " a6B)1
congruence (a small), and A-formal authority
dominates when preferences almost coincide (a close to
a" 6
3.4
such that P-formal authority
(0, 1)
optimal
if
1).
Indeed, there
and only
if
a <
a*.
is
a cutoff value
20
Complete vs incomplete contracts
The purpose
One
is
'
of this subsection
common
of the
is
to step back
and
reflect
on our methodological approach. 21
motivations for using incomplete contracting models
is
that the standard
complete contract paradigms (moral hazard, adverse selection or Nash implementation)
to account for notions such as ownership
and authority.
We
fail
have adopted an incomplete
contracting approach to analyze authority and
its
conceptualize our intuitions and obtain others.
Yet, in view of the current lack of proper
delegation and found
it
very useful to
foundations for the incomplete contracting methodology, an investigation of what could be
achieved with complete contracts will bring us a deeper perspective.
Interestingly, while the notion of authority finds its natural habitat in
contracting framework,
it
does not rely on such an interpretation. As we have seen, choosing
who should decide amounts
A
to answering two subsidiary questions. First,
who
is
informed?
party with private information can manipulate decision making by revealing a coarser
information structure than his structure.
More
concretely, he will typically disclose his
preferred project and abstain from revealing information that
of projects he likes less.
answer to
19
as
an incomplete
this
Second,
who
gets his
second question hinges on the
way when both
classic tradeoff
may
lead to the adoption
parties are informed?
between ex post
The
efficiency of
This case does not satisfy the assumption that g'i(l) = oc, but is still amenable to our analysis as long
that, in the relevant range of parameters, the parties do not become informed with probability
we assume
1.
20
To prove
this,
one uses the fact that the probabilities e and E must be less than one. One can also show
when congruence is low, but may prefer not to have formal
that the agent prefers having formal authority
authority in specific circumstances (high congruence, private benefit small relative to the principal's payoff.)
-'This section is not required reading for the rest of the paper, and may be skipped by readers who are
primarily interested in the incomplete contracting approach.
11
making and ex ante
decision
as well in a world of
These two questions surface
incentives to acquire information.
We now
complete contracting with multiple moral hazard.
state the
circumstances under which the outcome can alternatively be interpreted as resulting from
an optimal complete contract.
a
• In
we maintain our assumption
step,
first
only two parties (or that
B
is
that the principal and the agent are the
noncontractible); as
we
rules out the use of the sharing of the principal's profit
the agent's initiative.
The timing
We
assume limited
as follows:
is
liability for
The two
(i)
with outsiders
both parties.
parties sign a contract;
information about the n projects' payoffs (for simplicity, a party
also
knows whether the other party has learned them
they possibly renegotiate the
new contract
is
either
(if
("I
the
initial contract; (v)
renegotiation has taken place)
is
assumption essentially
shall see, this
as well);
initial
in order to
(ii)
they privately gather
who has
(iii)
learned the payoffs
they send messages;
contract
implemented.
encourage
22
A
(if still in
message
(iv)
force) or the
m,-,
i
=
A, P,
have not learned the payoffs"), or a pair of payoffs for the principal and the
agent for each project k
specifies probabilities
23
=
1,
•
•
•
,n ("I have learned the payoffs, and they
pk(mp,m A
)
are...").
A
contract
of implementing project k, such that
n
Y^,Pk(™p,m A ) <
1.
k=i
There are three states of the world
therefore a project
£(1
— e));
2:
is
to be
implemented:
congruent project
In state j
is
preferred project
=
1,
is
£ {1,2,3},
implemented
principal's preferred project
r
which at
1:
is
if
let
•
,
T
one party learns the payoffs and
only the principal learns the payoffs (probability
(1
— E)e);
3:
both learn the payoffs
Xj denote the equilibrium probability that the
there indeed
is
congruence; in case of noncongruence, the
implemented with equilibrium probability
implemented with equilibrium probability
assume that the renegotiation process
•
least
only the agent learns the payoffs (probability
(probability Ee).
We
in
is
Zj,
with
y_,
yj
and the agent's
+ Zj <
1.
a finite bargaining game. In each subperiod
of this process, one of the parties suggests a project or doing nothing (or
more
generally, a probability distribution over these decisions); the other party accepts or turns
down the
offer.
In the latter case, bargaining proceeds to the next subperiod.
specified by the initial contract for the messages sent at stage
agreement
is
(iii)
is
The
decision
implemented
if
no
reached by subperiod T. Furthermore an informed party can disclose payoffs
about particular projects
at the start of each subperiod.
For concreteness we
"Alternatively, the two parties might be infinitely risk averse under zero income.
An
will
assume
arbitrarily small
probability of error would then endogenize the limited liability assumption.
23
no leeway in using monetary transfers to adjust
thrown away (since renegotiation is feasible),
the agent, does not respond to monetary incentives.
t'nlike in conventional
mechanism
design, there
is
incentives because there are only two parties, profits cannot be
and one of the
parties,
12
g
that information
is
The argument can be extended with minor
hard.
modifications to soft
information.
The
possibility of renegotiation
24
implies that ij
=
for all
1
compatibility plus the possibility of renegotiation imply that y t
is,
in case of
Furthermore, incentive
i.
=
1
and z2
=
renegotiation,
is
then implemented with probability
irrelevant projects yield very negative payoffs,
1.
To
see this, note
first
because of
that, because
when both announce they have not
the payoffs, the initial contract yields status quo expected payoffs equal to zero
probability one no project
is
bargaining
game and suppose
and, assuming that
amount
positive
=
0,
=
i
A, P) at stage
(if
(Hi).
Now
consider the stage
when
last offer necessarily
indifferent a party chooses
we could assume
what
proposes
preferred by the
is
that each relevant project yields at least a small
Backward induction then shows
to each party), the other party accepts.
that by disclosing only his preferred project, the informed party necessarily gets his
way. Last, the possibility of renegotiation implies that y3
when
the information
investments
e
is
with
that the informed party has disclosed only his preferred
Then, whoever makes the
project at the last subperiod T.
other party (alternatively
learned
implemented) or negative (otherwise.) Second, suppose that
the informed party feigns ignorance (m<
this project
That
asymmetric information and noncongruence, the informed party can guaran-
tee himself his preferred payoff by disclosing only his preferred project, which,
(iv)
1.
symmetric (state
3)
+
z3
=
1.
Who
gets his
own
own way
determined by the relative desirability of the
is
and E. 25
To sum up,
the optimal contract is a
(random) authority scheme,
in
which authority
is
ex post conferred upon the principal with probability y3 and upon the agent with proba(note that the allocation of authority was shown in section 3.1 to be irrelevant in
bility z3
states of
asymmetric information,
in
which the informed party always gets
his
own way).
Because random authority mechanisms are allowed by the incomplete contracting approach
24
The possibility of renegotiation rules out some contracting features that might emerge otherwise, such
throwing away profit or not implementing profitable projects. The absence of renegotiation would also
prevent parties from concealing information; for, the optimal contract would specify that no project is
implemented unless two relevant projects are proposed and would costlessly ensure truthful revelation. This
policy eliminates asymmetries of information. [To reintroduce real asymmetries of information in the absence
of renegotiation, one may assume that each party observes with some probability the payoffs of only a subset
as
of projects
25
That
and therefore can claim that he
is,
is
aware only of one relevant project.]
{y 3 ,z 3 ,e,E) solves:
max{fl[£(l
-
e)
+ e(l - E)a + eE{a + (1 -
a)y3 )}
- g P {E)}
s.t.
E 6 argmaxlfl^l -e) + e(l - E)a+ eE{a +
e€ argmax
+ -3 = I.
{b[E{[
-
e)a
+
e(l
-
E)
J/3
13
+ eE(a +
(1
(I
- a)y3 )] - gp(E)},
-
a)z 3 )]- A (e)},
(although they are usually not considered
in
the literature),
we conclude
that the incomplete
contracting approach cannot involve a loss of generality under these specific circumstances.
What about
•
third parties?
B is contractible (call it a profit), such parties
who
shareholders, headquarters) do exist in practice,
(e.g.,
function by sharing her profit.
A
Assuming that
contract
now
The presence
specifies probabilities
monetary rewards {Bp(mp,mA),B
when
profit
some
fraction in
We
leave
We
B.
is
it
assume that
of third parties
— Bp(mp,m,A)}
to the principal
third parties
by the renegotiation.
to the reader to check that the optimal complete contract in the presence of
(random) authority relationship
absence of third parties) cum a linear profit sharing scheme
receives a fraction in
[0, 1]
of the profit B. Profit sharing
serves to encourage initiative
profit sharing
and the
with the agent, the principal gets
in case of renegotiation
third parties takes the following simple form: It specifies a
(as in the
expands the contract space.
{pfc(mp,m /i)} of implementing projects as well as
of the increase in profit brought about
[0, 1]
alter the principal's objective
if
the principal has too
is
in
therefore the
much
which the principal
new instrument, and
incentives to monitor. 26 Because
schemes involving third parties are perfectly consistent with the incomplete
contracting approach, we conclude that the incomplete contracting approach cannot involve
a loss of generality in the model of section
•
We
2.
by no means want to argue that optimal complete contracts always boil down to
simple authority relationships (possibly augmented by profit sharing schemes). In particular,
if
the agent responded to monetary incentives as in section 4.5, he could be rewarded simply
for bringing information to the fore rather
which
is
impossible
in
than by implementing the project he prefers,
the standard incomplete contracting approach followed here.
ability to contract ex ante
on projects then considerably
alters the picture
because
it
a disconnection between rewards for information acquisition and project choice. But
it
allows
we
find
comforting that authority can under some circumstances be given the complete contracting
interpretation of
who
gets his
way
in case of
discordant announcements.
when the
Factors favoring initiative
formal authority
4
Span of
4.1
It
The
is
and
initiative
often argued that the planning and allocation process of the large conglomerates that
were formed
26
control, overload
principal has
The
in the "60s
became bureaucratized, and
third parties' ex post expected profit
the shares.
The
reason
why the
is
that the headquarters were responsible
received ex ante by the principal through an auction of
third parties act as a "sink" rather than a "source" (to use
Holmstrom
when
that from the principal's viewpoint, the principal's effort is never suboptimal
the principal receives the full profit B, but may be excessive in that it reduces the agent's initiative.
(1982)'s terminology)
is
14
for too
many
units,
whose strategy they could not understand or
The purpose
a refocus on "core businesses".
of this subsection
is
influence. This called for
to introduce the superior's
span of control and overload into the analysis. Suppose that a superior has authority over
identical subordinates.
Each subordinate
screens in a set of tasks as described in section 2
i
and learns the corresponding payoff structure with probability
gp(EiEi) where
of efforts
is
activity.
The
£,- is
is:
up
=
E,[£,-fl
Each agent's reaction curve
is still
+
(1
-
Ei)tiaB
principal's disutility
is
z's
a fixed cost / per subordinate. 27
is
(9)
given by
i
assume that the equilibrium
The
-/}- gp(EiEi).
(l-E )b = g'A (e
We
e,-.
the principal's probability of learning the payoffs of agent
subordinates' tasks are independent. There
So, the principal's payoff
m
symmetric 28 and
(1
(10)
i ).
stable.
29
- ae)B = g'P (mE),
(11)
and
(1
Let
{E(m),e(m)} denote the
notation,
- E)b =
g' (e).
A
(12)
solution of the system of equations {(11), (12)}.
Abusing
let
up(m)
= mR(E(m),e(m)) — gp(mE(m)),
where
R{E(m), e(m))
is
= E{m)B +
[1
- E{m)]e(m)aB - f
the revenue per subordinate. Using the envelope theorem and treating
the optimal span of control
^
The
The
[R(E(m), e(m))
There
agents,
An
is
- E(m)g P (mE(m))} +
0.
extra agent brings revenue R, but requires attention
number of subordinates
of a positive reservation wage of the subordinates.)
also exist
who
m^^- =
asymmetric equilibria
in
A
in the
all
In the quadratic case (see the
which
raises
obtained when /
>
her attention to a subset of
To eliminate asymmetric
equilibria,
one can
sufficiently nonsubstitutable in the principal's disutility of effort
function.
29
E
absence of a fixed cost
finite size is
which the principal devotes
therefore lack initiative, and none to the others.
assume that the probabilities {£,} are
(13)
the marginal profit associated with a unit increase in
superior would choose to have an infinite
(or, equivalently,
28
obtained from
expression in brackets in (13)
the span of control.
27
=
is
m as a real number,
example
in
subsection 3.3), this amounts to
15
abB < m.
the cost of supervision by Eg'P
"initiative effect",
the "overload cost".
,
and measures the increase
The second term,
in
ff j
in the agents' effort associated
5-
>
0,
is
the
with a reduction
in oversight.
We
will say that
a firm
is
in a situation of overload
employee, keeping employee behavior constant,
always optimal for the firm
initiative.
to be in a situation
is
if
the marginal profit of an extra
negative. Equation (13) shows that
it is
of overload so as to credibly commit to reward
30
Remark
1:
The
analysis in this subsection has an interesting
dynamic
application: Sup-
pose that the implementation of projects takes place continuously over time, and that at each
point in time the principal can freely adjust the span of control by hiring or firing subordinates.
Assume furthermore
time passes by (there
is
that the principal acquires experience about her subordinates as
learning-by-doing in monitoring). Then, the above trade-off between
overload costs and initiative has the following dynamic equivalent: Letting the firm grow fast
(that
is,
hiring
new subordinates
at a high speed) involves high overload costs
a loss of control for the principal; on the other hand, a slow growth policy
stifle
is
and therefore
more
likely to
the subordinates' initiative as the principal acquires experience on monitoring them.
Remark
2:
We have assumed
that
all
agents are subordinates.
of "partial integration" determines the level of overload, with
principal's authority corresponding to
Remark
3:
As noted
in subsection 3.4,
the principal to share B, provided
CEOs
managers or
more
B
is
More
generally, the extent
more agents subject
to the
overload.
another credible way to promoting initiative
verifiable,
is
for
with a third party. [Recall that division
are not residual claimants in practice.]
While
it
has the drawback of
reducing the principal's incentives on other tasks as well, profit sharing
may
reduce the
desirability of overload.
Remark
4:
Overload
is
one way of raising the marginal cost of monitoring. Another way
consists in refraining from investing in the monitoring structure (on this, see also the next
subsection.)
A
case in point
is
the relationship between Fujitsu and
its
British subsidiary
ICL. Fujitsu wanted to commit to preserve ICL's independence and initiative after acquiring
it
in
1990 and seems to have been successful in this respect.
fact that only
two Japanese managers are resident
in
30
31
Of
particular interest
is
London. [Fujitsu also wants to
the
float
Because the marginal profit is negative, the principal would be better off committing herself, say, to
playing golf rather than reaching overload. The problem with this is that playing golf is not a credible
commitment (recall that the g P () function summarizes the principal's disutility of supervision and therefore
already includes the cost of forgone opportunities). Overload is a credible commitment not to stifle initiative.
31
See The Economist (Management Focus. April
10, 1993).
16
shares of
ICL
1995 while retaining a majority holding, in order to reduce
in
further guarantee ICL's independence.
More
4.2
The purpose
of this subsection
we
literature. Here,
we
concretely,
rules.
to provide a link
is
The concept
will define a rule as
N, but
in
will
A "),
r
between the distribution of decision
rights
of "rule" has been given several meanings in the
assume that the
can be screened by the agent
set of projects that
N
and N. The agent
will screen projects either in
not in both. There are therefore three contractual possibilities for a given
two rules ("the agent must screen
allocation of authority:
in
remark 3 above.]
a contractual constraint on the agent's action space. 32
can ex ante be divided into two subsets
N or
this, see
stake and
lenient rules
and the existence of
More
On
its
and the
under which the agent
lack of rule,
Naturally, one of the rules,
choose by himself,
is
namely the one that
is
in JV"
"the agent must screen
,
free to pick his screening strategy.
forces the agent to pick the subset he
would
equivalent to the lack of rule. So, there are really two choices: constrain
or not constrain the agent by a rule.
Concretely,
we
only one respect:
will
assume that the two candidate research strategies
The
principal has less expertise on research strategy
therefore has a higher cost of monitoring projects in
more
result
authority, that
An
reason.
is
is
that a rule
is
more
likely to be
independent agent
is
here, the agent even strictly gains
may
likely to
come up with a
and
loss of control
is
expertise in
N and congruence
is
N,
We
then ask,
is
a rule
imposed when the principal has formal
not threatened by the principal's being well informed,
Actually, in the simultaneous
model studied
by choosing research strategy N, because the principal
N
in order to protect himself against interference
Whether the superior should
of initiative
strategy
N.
is
useful idea. In contrast, in the absence of rule, a subordinate
well choose research strategy
his superior.
in
within an organization rather than across organizations, for the following
because the principal cannot overrule him.
more
than
be imposed when the principal has formal authority?
likely to
Our main
N
N and N differ in
N than on N and
from
allow her subordinate to do so hinges on which
the more important concern.
If
the superior has very
little
low, the superior wants to force the agent to adopt research
N.
So, let us
assume that the
g'
higher than that of investigating recommendations in
P {E),
is
agent searches in
N or N
is
principal's marginal cost of investigating
contractible. In each research line
(
N,
recommendations
g'p(E).
in
Whether the
N or N), there are as earlier
As we will predict, such contractual restrictions are mainly enforced within organizations, even though
they are sometimes observed across organizations, for example in research contracts between independent
laboratories and product manufacturers, which sometimes restrict the research line to be pursued by the
32
laboratory.
17
two relevant projects and a bunch of negative value projects. The agent can investigate only
one research
Consider
stead of
line.
first
the case of P-formal authority. Having the subordinate screen within
N shifts the superior's reaction curve downwards without affecting the subordinate's
reaction curve.
The
equilibrium efforts therefore satisfy:
E(N) < E{N)
and
e(N)
As expected, the subordinate demonstrates more
control
when
N. Furthermore, the
of intervention, at least
On
agent,
thus to
is
if
e(N).
One way
the other hand, a lack of congruence makes initiative
for the principal to
N in order
less relevant
nate most often recommends projects that are useless to the superior.
prefers to
impose a
rule
when
principal has less
commit
N
to limit the threat
33
low.
is
and the
the agent choose whether to screen within
let
given the freedom, chooses
congruence
if
>
initiative
the superior has a higher monitoring cost.
to a lower degree of intervention
or
N in-
the congruence parameter
is
The
small (up(N)
An independent
Consider now the case of A-formal authority.
because the subordi-
agent
superior therefore
>
is
up(N)). 34
not threatened
by the principal's being well informed, because the principal cannot overrule him. Actually,
simultaneous model studied here, the agent even strictly gains by choosing research
in the
strategy
N, because the principal
more
is
33
In the
absence of a
congruence
is
high.
rule, the
It
may
subordinate
may
not want to
inflict
N
= gp(E)
h'P (E,K)
and
decreasing with
34
is
As in the previous footnote,
(
h P {Q,
K) =
for all
K
=
6
[0,
is
low.
To
But the
see this,
l],hp(E, K), with hp(E,
0)
let
=
dE
a close to zero since j^ > and lim<,_o e = 9a~ [(1 — d'p [B))b] > 0.
us index the principal's disutility-of-effort function by a parameter K,
g P (E),h P (E,l) = gp(E), and both h P {E,K) and h'P (E,K) decreasing with
unambiguously negative
h P {EJ<), withAp(£,0)
K
a
K. Then, by the envelope theorem:
du A
which
Rules
high monitoring costs on the superior
the congruence parameter
if
us index the principal's disutility-of-effort function by a parameter
1)
35
turn out that he benefits from the superior's being well informed.
subordinate definitely prefers research strategy
<jp(E),hp(E,
useful idea.
upon an independent agent. 36
therefore are therefore never imposed
if
come up with a
likely to
for
let
K
and
K)
P {E,
li'
decreasing in
K
imply that h P (E,
K)
is
also decreasing in
K). The
envelope theorem implies that:
dup
—
- =
,,
(1
- E)aBn
,-,>
i//\
Thus,
for
a
.More formally, since
we have
36
to
dh P (E,K)
oK
-
>
for
a
,
close to zero.
close to zero:
u P (N)
35
Q— —
de
dl<
u^N) =
=
u P (K
E d (N) > E d (N)
d
=
and since
max, u%(E (N),e) > max e
>
1)
u P (K
any
u A (E (N),e)
d
for
d
Rules could arise under .4-forrnal authority for instance
monitor them, but
in
the payoffs.
IS
=
e
=
if
0)
= u P (N).
the function
E >->
u dA (E,e)
is
increasing in E,
d
u A (N)._
N
and
JV differed not in the principal's ability
Urgency and delegation
4.3
It is
sometimes observed that the need to adapt quickly to customer requirements has forced
firms to decentralize decision-making.
some
insights
The purpose
of this subsection
is
We
superior can investigate only once the project proposal has been made.
A
Abusing terminology, we
A
>
t
and date T,
him
yields
to start production even
more time
The
time
in
t
life
and T; the other relevant project
in this
it
in
S€
choosing a stopping time
[0,
T] at which
her investigations have not been successful by then.
some date
r,
paper,
F(t),
is
makes a
it
trivial
Waiting
namely, the probability that the principal learns
is
in monitoring, so the
case of hard information
principal learns
stand for the product
Similarly, the subordinate's preferred project
profit.
for monitoring;
however decreasing returns
first
denote the
per unit of time between the starting date for
problem consists
if
the payoffs herself before
For the
T
Let
benefit.
principal's decision
longer gives her
T
will let
private benefit b per unit of time, between
no private
The
Suppose that the
which time a superior substitute arrives on the market.
at
noncongruent project generates no
gives
B
congruent project yields profit
production
it
the time elapsed between the proposal (date 0) and the date at which the
is
product becomes obsolete.
cycle.
It offers
urgency of the decision by the length
will formalize the
cycle, but several alternative interpretations are possible.
life
horizon, that
two-fold:
on how delegation might be affected by the urgency of the decision and
illustrates the sequential case.
of a product
37
hazard rate /(t)/[1
and uninteresting.
it
—
F(r)]
whether information
difference
from the agent and implements
There are
increasing, with density /(r).
If
the project
immediately (S
=
0);
is
is
is
decreasing.
hard or
soft.
congruent, the
on the other hand,
case of noncongruence, the superior never implements the subordinate's preferred project,
because there
let
us
is
always some hope that she
assume that information
flow profit
B
soft.
is
aB
between S and
T
and
t
if
uP
rS e -rt
= B
7'
is
e
therefore:
T
she learns payoffs at
if
The
g-rS
-rT
}f(t)dt
37
See, e.g., the discussions of
This would not be so
if
<
t
S,
38
So
and has
principal's utility, conditional
+ aB[l -
_
S and
on the
-rT
F(S)}[
],
r
the principal's rate of time preference. This objective function
38
T).
39
r
Jo
where
_
[-
is
=
she has not learned payoffs by date
thus rubber-stamps the agent's project at date S.
agent's having proposed a project,
her preferred one (S
For a given stopping rule 5, the principal obtains
between the date of learning
expected flow profit
will discover
Wyman-Gordon and WalMart
in
is
quasi-concave,
Continental Bank (1993).
the subordinate's preferred project yielded a strictly positive profit to the
superior.
39
In this formulation, the principal's cost of investigating
duction of the product.
The
is
simply forgone profit due to delayed intromore standard disutility of the
sequential model can also be formulated with a
principal's effort: See footnote 17.
19
and the optimal stopping time either
zero
is
principal rubber-stamps without even checking), or
f(S)
The
left-hand side of (14)
(divided by B);
its
is
'
^~ >
if
i
*
a
(^or
%
i-f(o)
^
ar g e enough, the
is
given by the first-order condition:
-
e
- r ( T - 5)
the marginal cost of delaying the introduction of the product
right-hand side
is
equal to the conditional density of discovering the
S and T (divided
T (1 > dS/dT >
payoffs times the value of overruling the agent's choice between
by B).
The optimal stopping time
0)
decreases with
a (dS/da <
strictly positive increases
if
0), as
we would
Our main
expect.
That
horizon, the principal conducts a cursory investigation.
to rubber-stamp, the
Last,
more urgent the
we have been
silent
decision.
result
is
that for a short
the principal
is,
and
is
more
likely
40
about the agent's behavior
that his search time (which could be
with
in that
we have
random) was exogenously given.
implicitly
assumed
In general this time
could depend on the urgency of the decision due to altered incentives of the agent. Another
interesting question (in a world of
random time
whether the agent would ever want
is
the date of adoption (recall that
overruled (because
dS/dT >
of acquisition of information
to delay a proposal.
dS/dT <
0). Clearly,
1),
Delaying the proposal delays
but also reduces the probability of being
an agent with a congruent project would not want
to delay the proposal, but an agent with a noncongruent project might.
late proposal could signal a
principal (since
dS/da <
of positive correlation
by the agent)
In this case, a
noncongruent project and be given substantial attention by the
0).
We
conjecture that this would not reverse our main insight
between urgency and rubber-stamping, 41 but a formal treatment
lies
outside the scope of this paper.
4.4
As
is
Reputation and random delegation
usual, an alternative to contracting or authority allocation
is
reputation. In practice,
superiors try to develop reputations for "not intervening too often", or in a context with
a larger project diversity, for "intervening only
when
not develop a formal model of reputation building, but
the familiar
40
lines.
We
justified".
it is
In our terminology, Bolton
will
straightforward to do so along
can sketch the broader idea of "intervening only when justified".
Bolton and Farrell (1990) find that urgent decisions are more
notion of centralization and
For conciseness, we
likely to
the set of issues studied there are quite different
and
be centralized. However the
from the ones analyzed here.
Farrell's "centralization vs decentralization" refers
more
to the allocation
of formal authority than to the degree of the subordinate's real authority. Bolton and Farrell analyze a
multi-agent investment problem and contrast the duplication-and-delay inefficiency of decentralization with
the incompetence of a bumbling central decision maker.
4
'No
type'' of
agent would choose to delay the proposal
investigation.
20
if
this also increased the principal's length of
Suppose that the superior faces a sequence of agents. For each agent, the payoff structure
is
as described
above except that with some probability a noncongruent project imposes a
nonnegligible loss on the principal instead of yielding profit zero. For incentives purposes,
may then be optimal for the superior to commit
to overrule the agent only
project yields a negative profit, in that overruling in the other case
much
the principal but reduces initiative too
optimal in section
A
3.3).
to be
worth
is
if
if
the noncongruent
ex post optimal
for
(A-formal authority would be
it
patient superior facing enough subordinates
a reputation for overruling agents only
it
may
then develop
the noncongruent project yields a negative profit.
So, the superior uses her authority to overrule the subordinate "in important matters", but
voluntarily relinquishes this authority (which
is
that are less important to her. This behavior
would not be credible
in
from rubber-stamping)
different
which the superior would systematically overrule
if
in matters
in a one-shot situation,
informed.
Performance measurement and subordinate's responsiveness
to monetary incentives
4.5
The economics
literature has
emphasized the
effect of the allocation of control
on incentives.
This subsection shows that incentives feed back on control. To this purpose, we generalize
The
profit
>
u"
our theory to allow the agent to respond to monetary incentives.
u(w)
the agent's utility for project k
is
of generality, the agent receives
w>
The
+
6jt
(where u(0)
when the
=
0, u'
principal's profit
principal's net profit in her preferred project
is
now
average gain from being informed and having real authority
and
b
=
decision;
u(w)
+
ab
u(w)
>
b:
when congruent, the agent
"aligned incentives".
his private benefit
is
for
The
When
u(w) <
also receives
b,
is
is
congruent decision-making by raising the wage
first-order conditions (5)
and
(6)
and
0).
Without
loss
B, and
otherwise.
B = B — w.
6 = b + au(w)
wage w. The case u(w) >
agent's monetary incentives are powerful
and always recommends the
<
verifiable
The
for
agent's
u(w)
<
6,
the agent always picks his preferred
b
can be labelled
enough that he forgoes
principal's preferred decision.
never optimal for the principal to set a wage just below u
The
0,
is
-1
(6),
Note that
it
because she can obtain
slightly.
under P-formal authority become:
(l-ae)B =
g' (E),
P
(15)
and
(1
The main
it
more
(16)
conclusion of this section can be drawn from these two equations.
wage increases
makes
- E)b = g'A (e).
real authority
likely that the
for two reasons:
First,
agent will be able to
21
A
higher
by raising the agent's incentives,
recommend a
project. Second,
it
it
reduces
the principal's incentive to monitor and therefore the probability that the principal overrules
the agent.
Letting
profit
{E{w) e(w)} denote the
1
with respect to
w
is:
=
^f
The
term on the
first
second term
not aligned)
Remark
(1
- E)a(B - w)^- -
hand
right
is
1:
a
wage
bill.
if
Chandler
Continental Bank,
financial controls
+ (1 -
E)ea\.
is
is
effective in
closely involved in industries in
The optimal wage (when
1993.,
in
incentives are
mature industries while the corporate
which new product development
office
The
is critical.
management approach,
"applying decentralized financial controls to mature businesses and a more
centralized form of "strategic" control to capital-intensive, high-tech businesses".
serves that at (generally
deemed
successful)
GE
from the corporate
office,
He
ob-
during the '80s, the managers of the "core"
businesses - the long-established, mature businesses - received
gets
The
p54-58) argues that decentralization
application of this idea within a firm yields the so-called dual top
which consists
(17)
small, but can be positive in general.
equal to zero
(in
[E
side of (17) corresponds to the increase in initiative.
reflects the increase in the
combined with
must be
solution of {(15), (16)}, the derivative of the principal's
and were run instead through
and budget-based bonuses). The corporate
strict
little
planning or attention
monetary incentives (bud-
office in contrast
was very involved
in
the
high-tech businesses (aerospace, aircraft engines, medical equipment), for which monetary
incentives are harder to design (due to the uncertainty
Our argument
that better performance measurement raises an agent's real authority offers
a rationale for the dual top
Remark
2:
and the novelty of the products.)
The
management approach.
equilibrium described above
may
not be
immune
to the possibility of
renegotiation. For, suppose that the principal and the agent have ex ante agreed on a
wage
w and that the agent has learned the payoffs while the principal has not. Suppose that
42
In case of
b > u(w). Suppose further that the agent's information is hard information.
noncongruence, the principal must raise the wage to w* = u~ (b) in order to get a profit. She
l
will
be willing to do so
commit
to
wage w" ex
if
w~ < B. While renegotiation occurs, the principal may not want
ante, because she can get
away with a lower wage when she
informed or when the projects are congruent. The analysis
to that
42
It is
developed
in the
is
absence of renegotiation.
equally straightforward to study the case of soft information.
22
herself
to
is
otherwise qualitatively similar
Multiple principals
4.6
Having multiple principals
providing a
generally believed to impact on an agent's behavior.
is
treatment of this topic
full
already yields a
number
out of the scope of this paper, a short discussion
and authority.
The
benefit B, provided
principals. Consider for instance the case of
to receive
B/n
want to maximize
all
whole
set of principals as a
profit,
it is
monetary, can be
n equal partners
in case of success of the project.
The
principals.
There are two dimensions to the deconcen-
of useful observations.
tration of ownership: returns
a) Splitting returns.
lies
While
is
We
among
split
several
(or "co-owners"), each entitled
assume the same cost function
informed
the allocation of authority
if
any of them
among them
Because they
is.
is
for all
Each
irrelevant.
and the agent's reaction curves are respectively given by
principal's
(1
- Er-/(l- ea)- = g'p (E)
(5')
-E) n b = g'A (e).
(6')
n
and
(1
Spreading monetary benefits among several principals has two
it
effects
on
initiative. First,
generates free riding and therefore reduces monitoring. This effect dominates
principal's cost function
In this case,
On
control.
an increase
not too convex, as
is
in
the
number
is
the case for instance for a quadratic cost. 43
results in a loss of
the other hand, with a very convex cost function, the multiplication of monitors
1:
tiplying the
and
of principals raises initiative
substantially improves the monitoring structure, which
Remark
when the
We
may reduce
initiative.
have assumed that the principals have similar monitoring
number
of monitors
may
increase monitoring
if
44
abilities.
Mul-
the principals' talents are
complementary. 45
43
To show
and
this, rewrite (5')
(6') in
terms of the probability £ that the principals be informed: Let
E(£, n) be defined by
(1
The
-E) n = \-£.
first-order conditions are then:
(1
-£)(1 - ea)B = n(l - E(£,n))g'P (E(£,n))
(5")
and
(l-£)b = g'A (e).
In the {£ e) space,
,
hand side of
(5")-
an increase
We
leave
it
in
n
(6")
shifts only the principals' reaction curve,
to the reader to check that for a quadratic
gp
through a change
in the right-
function, the right-hand side of
(5") increases with n.
for E < Eq, and = oo
demonstrated with the following functions: gp(E) =
n
is given by 1 — £ = (1 — E )
Consider a project that yields a strictly positive profit only if both its marketing and manufacturing
sides are satisfactory. The use of two experts in the two fields increases the efficiency of the monitoring
44
This point
E>E
for
45
.
is
Then
most
easily
the probability that the principals are informed, £,
process.
23
.
Remark
The
2:
insights of this subsection should also apply to multi-layers hierarchies
where, for instance, downstream agents are monitored by both a principal and a supervisor
The monetary
(middle-man).
benefits are then spread
systematic analysis of complex organizations however
Splitting authority
b) Splitting authority:
consequence
thority
is
if
lies
among
among
beyond the scope
of this paper.
several principals obviously has
among
manufacturing divisions
in
no
But au-
the principals' objectives are aligned as in the previous example.
often split
A
several (upper) layers.
principals with imperfectly aligned objectives (marketing
and
a matrix organization, multiple ministries, chambers in congress,
Who
partners in a joint venture, creditors in a bankruptcy process).
hinges on the matrix of congruence parameters
among
principals
has real authority then
and agent,
as well as
on
the governance mechanism (for example, each principal can have veto power, or there can
be majority voting with or without the participation of the agent.)
considerations, the agent's initiative
A
conflict of interest
It
may
way.
principals
may
recommendations.
may be
On
or reduced
by the
split of authority.
increase the probability of veto by one of them.
also raise each principal's incentive to
principals'
agent
among
may be enhanced
Depending on these
become informed and not
on the other
to rely
the other hand, for more collegial decision processes, the
able to ''play" his multiple principals against each other and thereby get his
46
Authority and communication
5
This section extends the basic framework by introducing the possibility that the agent com-
municates some prior information he
question then
is
may
privately hold about the projects.
whether the allocation of formal authority
affects the
A
natural
communication of
(relevant) information by the agent.
We
assume that
at the beginning the agent can
the principal's marginal cost of investigation from
all
E >
0.
communicate information that reduces
g'
P to
[For example, the agent might privately
P such that g'p(E)
g'
know that the two
to the principal
section 2 except that the agent
to the principal.
Then
first
is
noncontractible.
The timing
P {E)
g'
for
relevant projects
belong to a subset N^ of vV and decide whether to reveal Ni to the principal.]
communicating information
>
is
The
action of
as described in
chooses whether to communicate his private information
the two parties choose noncooperatively
to invest in learning the projects' payoffs.
how much
effort
(E and
e)
Depending on the allocation of formal authority
the equilibrium efforts are given by the first-order conditions (5) through (8) for the relevant
marginal-disutility-of-effort function for the principal (g'P {-) or g'P (-))lS
See Davis-Lawrence (1977) for a description of such behaviors.
24
Communication
curve up (regardless of the allocation of
shifts the principal's reaction
The
formal authority) and has no effect on the agent's reaction curve.
E
effort
to
communicate information
principal's marginal disutility function
h'P (E,0)
=
question of whether the agent wants
down
to the principal thus boils
Without
from the principal's being better informed.
with
The
thus increases in a stable equilibrium.
g'p(E), h'P {E,l)
=
to
whether the agent gains
loss of generality let us
by a communication parameter
P (E)
g'
noted that the principal's equilibrium
principal's monitoring
for all
E
and
E(K) and
efforts
h'P (E,K)
E
d
K€
index the
P (E, K)
[0, 1], h'
decreasing in K.
(K) increase with K. Using the
envelope theorem, the impact of communication on the agent's utility (see equations
(4))
is
We just
and
(2)
given by:
du A
,
7K=
{Q
.,dE
- e)b
(18)
dK
and
§
An independent
M
(>-*<<.
=
agent always benefits from the principal's being better informed. In contrast,
communicate information
a subordinate wants to
if
his
expected gain from the superior
becoming informed, ab, exceeds the expected benefit from having
a >
e.
When
congruence
his information.
low,
is
a <
e,
47
so the agent
In case of low congruence there
is
real authority, eb, or
better off not communicating
more communication by an independent
is
agent.
In this
framework, there
formal authority. This
is
may no
actually always at least as
longer be the case
if
much communication under A-
congruence
is
high and the agent incurs
a direct (fixed) cost of communicating the information, as can be seen from equation (19).
The agent no
he himself
that e
d
is
is
longer derives a benefit from the principal's being ex ante well informed
well informed (e
indeed close to
1,
d
close to 1).
If
the agent's private benefit
In contrast,
with quadratic payoffs) that, provided
a
is
it
may be
the case (this can be checked
high enough,
**>*£~0.
dl<
centives to
'
formal authority affects the agent's
prior information to the principal.
of formal authority on communication depends
ticular the degree of
0ne
has lim a _
e
=
The impact
upon the parameters
in-
of the allocation
of the model, in par-
congruence between the principal's and the agent's objectives. More
communication may take place under P-formal authority
47
(20)
K
dl<
this discussion, the allocation of
communicate
high enough so
the independent agent does not bother incurring the cost of
communicating ex ante information.
To summarize
is
if
g'^
l
[{l
-
l
g'p
(B))]b
>
0.
25
if
these objectives are sufficiently
congruent,
communication
less
take place
will
if
they are too dissonant.
We
conclude
this
section with two remarks:
Remark
J:
The
discussion above has focused on the effects of the allocation of formal
authority on communication.
One can reasonably
conjecture that the organizational factors
that affect the distribution of real authority under P-formal authority (see section 4) will
thereby also affect the amount of communication within the same organization.
amount
the equilibrium
of
in section 4
Remark
2:
(
communication varies "comonotonically" with the amount of
by the principal through various commitment devices of the kind
initiative left to the agent
mentioned
Whether
span of control, multiple principals,
The above
analysis shows that
etc.), is left for
future research.
communication can never be detrimental to
an independent agent. Such a strong conclusion, however,
is
unlikely to be robust to various
extensions of our basic model, in particular to the introduction of the agent's responsiveness
to
monetary
incentives.
For example, one could imagine that an independent agent might
prefer not to help the principal find out that the two parties' preferences are congruent
in
order to credibly blackmail the principal ex post and thereby obtain a higher monetary
compensation.
Summary and
6
Let us
first
extensions
summarize our main
of information, the
are endogenous
amount
of
points. In
an organization, the structure and the distribution
communication among members, and the existence of
and depend on the allocation of decision
raises one's incentives to
become informed; consequently
improves the principal's information about the agent's
agent's initiative.
It
may
rights.
also (although
it
Having the
right to decide
vertical integration
activity.
Relatedly,
rules all
endogenously
it
reduces the
need not) jeopardize communication by making
the agent concerned about being overruled. Similarly, rules are more likely to be imposed
within an organization than across organizations because integration makes the agent fearful
of being overruled
We
and therefore
less
also identified factors that
trustworthy.
may
increase a subordinate's real authority: large span of
control, lenient rules, urgency, reputation for
surement and multiple principals.
which we leave
There doubtless are other
factors, the investigation of
for future research.
This paper aims only at being a
its
moderate interventionism, performance mea-
delegation. There are
many
first
step toward a
more general theory
desirable extensions. For instance,
of authority and
we have been concerned
with a single decision right. Organizations in general allocate multiple decision rights
their
members.
A
fascinating question
is
whether there
26
among
exist forces that lead to the clustering
of certain types of decision rights in a single hand.
Another crucial extension
complex webs of authority relationships
to
in organizations.
be answered here, suppose two subordinates
potential projects and
Whose
make
different
The obvious answer
(possibly endogenous) preferences are
illustrated
That
is
in learning
who
is
is
(real) authority over
delegated to the agent whose
principal's. This point
b^ and his
wage
in case of success
the payoffs with probability E)
is
his preferences
well
is
as described in the two-tier model.
The
is
w^.
not performed by
enjoys no private benefit and receives wage
principal in case of success. In this model, the supervisor clearly should
because
about
their superior (the principal).
most congruent with the
is
collect information
which agent has
that authority
private benefit attached to his preferred project
the principal, but by a supervisor
is,
to study the
kind of questions
illustrate the
an organization
in
by the following hierarchy: The agent
Monitoring (which consists
To
recommendations to
advice will the principal follow?
the other agent?
and
to allow for multi-layered hierarchies,
is
ws from
the
be given authority,
with respect to project choice (maximize the probability of success)
perfectly coincide with the principal's, even though his preferences over his monitoring effort
from the
differ
principal's.
issue contingent.
of the
The
Note
that,
more
principal decides
one whose objective
is
less
generally,
among
whether the supervisor gets
who
the parties
his
way
is
collect information, in favor
biased by private benefits or can be most easily aligned
with the principal's through formal incentives. 48
Another question
hierarchies,
project.
and
The
directly related to authority
its
relates to a negative externality exerted
delegation
is
that of liability in
on a third party by the choice
of
existing legal literature on "vicarious" liability rules essentially argues that in
situations of two-sided moral hazard
upon both a
and
principal's
where the externalities exerted by a hierarchy depend
and an agent's
efforts, responsibility for
damages
to a third party
should be shared between the two contracting parties. Even in situations where the agent
alone can directly affect the third party, making him entirely liable
principal can monitor
and control the agent's
level of care (that
agent only has a limited ability to pay for damages. Thus,
if
is,
is
suboptimal
if
the
has authority) and the
the principal has a direct power
of intervention, she should be held responsible as well (see Shavell (1987, chapter 7) for a
statement of the argument). While providing some support for this basic principle (which has
4S
For example, a principal may arbitrate in favor of the agent when he feels the supervisor is biased (due
a prejudice against the agent, collusion with a rival agent, supervisor's own private benefit, and so forth).
Along the same lines, one can wonder whether the principal necessarily gains from choosing a "protege"
as a supervisor, that is someone with high congruence with her. It might be the case that the principal be
better off with a supervisor sharing the same culture (congruent) with the agent even if this entails some
to
The "protege' might stifle initiative.
focus on private benefits does not preclude the existence of other factors influencing the allocation
cover-ups.
Our
competency of the two parties. Who gets his way may also depend on the
power
of the various parties, or on the desire of the organization to keep key
indispensability/bargaining
personnel in the long run (Rotemberg (1993,1994)).
of authority such as the relative
27
been applied,
e.g., to
the
new environmental
liability rules
("CERCLA")
1980), our analysis suggests at least two further considerations for
the degree of liability imposed
upon a
liable
if
First,
companies or creditors should
an extensive account of the courts' views
thus provide support for liability rules that can be
accommodate various organizational
our analysis suggests that
in
(i)
in
they are more directly involved in supervising the agent's activities
(see Strasser-Rodosevich (1993) for
We
enforcement:
US
principal in an integrated firm should vary with her
ability to exert real authority: In particular, directors, parent
be held more
its
enacted in the
integrated structures
sufficiently flexible in order to
characteristics that affect real authority,
liability rules
may have
made
in this respect).
(ii)
Second,
which allocate much responsibility to principals
undesirable consequences "ex ante"
an endogenous choice of the authority structure.
Such
liability rules
when we
may
allow for
indeed induce
excessive divestiture in situations where coordination considerations would naturally favor
the emergence of integrated structures.
49
There
is
thus a trade-off between responsabilizing
the owners or managers in integrated firms and at the
same time avoiding
inefficiencies in
the allocation of formal authority.
The
tion
49
analysis of these and of other exciting questions related to authority and
its
delega-
must await future research.
Such phenomena appear
liability rules (see
to have occurred in the
US
Ringleb-Wiggins (1990)).
28
following the introduction of the
new environmental
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