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FORMAL AND REAL AUTHORITY IN ORGANIZATIONS
Philippe Aghion
Jean Tirole
March 1994
massachusetts
institute of
technology
50 memorial drive
Cambridge, mass. 02139
FORMAL AND REAL AUTHORITY IN ORGANIZATIONS
Philippe Aghion
Jean Tirole
94-13
March 1994
M.I.T.
JUL
LIBRARIES
1 2 1994
RECEIVED
Formal and Real Authority
in Organizations^
Philippe Aghion^
and
Jean Tirole^
March
^The authors are grateful
to Oliver Hart
Bolton, Leonardo FeUi, and especially Denis
a
first draft,
and
1994
and Martin Hellwig for helpful discussions, to Patrick
Gromb and David Martimort for helpful comments on
to the Centre National d'Etudes des
^Nuffield College, Oxford,
'institut
10,
and
EBRD,
Telecommunications
London.
d'Economie IndustrieUe, Toulouse, and Ceras,
Paris.
for financial support.
Abstract
The paper develops
cide)
and
a theory of the separation between formal authority (the right to de-
integrated structure can
is
accommodate various degrees
determined by the structure of information, which
formal authority.
a
and
real authority (the effective control over decisions),
An
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
loss of control for 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
allocation of formal authority.
in
an organization
is
shown
to
depend on the
Introduction
1
Over forty years ago, Herbert Simon defined authority
as the right to select actions affecting
part or the whole of an organization.^ As pointed out by Grossman-Hart (1986) and Hart-
Moore
may be
(1990), authority
conferred by 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.^
This formal authority however need not confer real authority, that
over decisions,
upon
its
holder. For example,
it is
commonplace
have hmited control over their board of directors, which
nation of the top executives,
who
in turn often
itself
an
is
effective control
to observe that shareholders
may be
subject to the domi-
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 between
formal authority and real authority,"' and illustrates
accommodate various degrees
Our approach
Weber notes that
follows
Max
officials,
how a
formally 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 knowledge. This is 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
'
[a
"We
will
say that the boss exercises authority over the worker
"behavior",
i.e.,
any element of the set of
the worker accepts authority
will
accept authority only
acceptance") of
in
all
if
when
his behavior
xq, the x chosen
the possible values. This
modern administrative theory" [Simon
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
specific actions that the
is
by the boss,
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
three types of authority, the other two being "traditional authority" and "charismatic authority".
^The
distinction between ownership
among
and control is reflected in the principal-agent literature, starting
with Mirrlees (1975), Holmstrom (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
authority, formal or real.
1
a product of the striving for power."
As
The
tion.
so
our analysis of formal vs real authority
to
is
asymmetric informa-
superior can always reverse her subordinate's decision, but will refrain from doing
the subordinate
if
We
Weber, the key
in
is
much
better informed and
formalize this idea in a straightforward way.
tiative) to suggest a project to the superior.
is
their objectives are not too antinomic.
The subordinate
exerts effort (shows
latter as well chooses
how much
Once informed, the subordinate recommends a
about the potential project.
sometimes
The
if
ini-
to learn
project that
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
decisions
is
much information
what creates
when the superior's
is
on
many suboptimal
projects.
very prospect of influencing
from the subordinate. The subordinate
behind the subordinate's shoulders", that
is
loses motivation
who performs and monitors
it,
is
endogenous;
him
to monitor very thoroughly.
thus a general trade-off between initiative and loss of control.
degree of separation of ownership and control
task,
The
time to monitor her
incentives (for instance, idleness, obsession or high competency) lead
to "stand constantly
There
initiative
also hurts the superior.
little
Furthermore, the
depends on the nature of the
it
and on the organizational
structure."*
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:^ The reallocation of formal authority to the
agent prevents the principal from overruHng 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
"•a
more
transfer of formal authority to the agent thus credibly increases the
the other hand, the principal has more incentives to become informed
straightforward application of this idea
likely to
is
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.
*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
also exert "real authority", in that he
may
bring information that influences
if
Firm boundaries and information
she has the right to reverse decisions.
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
his initiative, there are also
a number of factors that encourage initiative when the principal retains formal authority.
factor of initiative
and
loss of control
One
a wide span of control, which raises the principal's
is
We
marginal cost of monitoring each agent.
show that there
is
a sense in which optimal
organizations always function in a situation of overload. Another raise-the-monitoring-cost
way
of
committing not to
stifle initiative is to refrain
from imposing 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
difficult
its
among
benefits
several principals/owners;^ intervention can
by sphtting property rights among several superiors
of a matrix organization or of multiministry oversight)
(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 a
urgency of decision making, which
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.^ 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
mem-
from the traditional
to 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.
^This theme
a
number
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
is,
The moral hazard and property
blocks developed by other authors.
the two polar cases.
our knowledge, new,
to the best of
A seminar
it
makes use
rights literatures supplied
Riordan (1990), and Schmidt (1991) develop
may
MIT
given by Diego Rodriguez and Dimitri Vayanos at
1991 contained several seeds of the basic model described here.^ Papers by
information
of building
in different contexts
Cremer
in
(1992),
the idea that too
much
hurt a principal.^ Riordan (1990) argues that information allows principals
He provides a definition
to expropriate the agents' specific investments.
Cremer
based on information.
(in
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 between property rights
The paper
it:
first
It
is
organized as follows:
thority
it
Arrow (1975),
Riordan and Schmidt
posit (but do not formally
Section 2 presents the model.
Section 3 analyzes
and equilibrium payoffs
to the allocation of
then demonstrates a tight hnk between our incomplete contract/au-
methodology and a complete contract approach. Section 4 looks
the agent's initiative
accurate
and information structure.
relates the information structure
formal authority;
ability.
A more
when the
principal has formal authority (overload, lenient rules, urgency
of decision, reputation, better
implications for business
at factors favoring
performance measurement, multiple principals), and derives
management. Section 5 endogenizes communication, and
section 6
concludes.
2
A
The model
hierarchy
project.
project.
composed
The
of a principal (she)
and an agent (he) can implement one or zero
principal hires the agent to collect information about
Examples
of hierarchies
we have
in
mind are board
and implement the
of directors or trustees/mana-
gement. CEO/division manager, thesis advisor/student, foreman/worker, or supranational
authority/country.
• Projects:
The agent
behalf of the principal.
gain or profit
gross of any
Bk
screens
To each project k G
for the principal
3 potential
{1,
human
''Their 1993 discussion paper focuses
literature
on the ratchet
•
•
•
,n}
and a private benefit
monetary transfer between the two
perks on the job, acquisition of
^The
among n >
parties].
is
and a
priori identical projects
associated a verifiable monetary
b^ for
The
the agent. [These payoffs are
agent's private benefit includes
capital, the possibility of signaUing abihty, or (minus)
on different themes than the ones considered here.
emphasizes a cost for a principal from being well informed.
effect also
on
the disutility of implementing the project. ^°
private benefit are both equal to zero.
known
with
=
payoffs Bq
Only two
bo
=
If
no project
implemented, the
is
profit
"No project" can formally be treated
as project 0,
0.
n potential projects are actually "serious" or "relevant".
of the
and the
All other
Anticipating somewhat, this
projects yield "sufficiently negative" payoffs to both parties.
imply that an uninformed agent prefers to confess ignorance and to recommend inaction
will
recommend a
rather than to
specific project,
and that
similarly an
uninformed principal
would not choose by herself to undertake a project.
One
Similarly,
other
5 >
of the two relevant projects yields profit
one of the two relevant projects yields private benefit
ante probability that the same project
The ex
0.
and the other
to the principal
6
>
to the agent,
preferred by both
is
a G
is
0.
and the
[0, 1],
the
parameter of congruence. ^^
The
• Preferences:
and
w
The
agent's utility
principal
risk neutral
then u{w)
is
+
we
therefore does not respond to
his reservation
wage
where
6^.,
will
and has utihty
The agent
the wage paid to the agent.
is
For expositional simplicity
He
is
u(-)
is
is
li
project k
is
liability, so
chosen,
w >
assume that the agent
monetary incentives and
is
infinitely risk averse to
wage equal
receives a constant
may
income.
monetary
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
4.5
0.
increasing and concave.
noncontractible; the agent's wage
is
—w
protected by hmited
of zero. Alternatively, the agent
the principal's benefit
5^.
incentives. Profit sharing then lowers the principal's
and
to
raises the agent's utility
from picking a profitable project.]
Information:
•
The agent
acquires information in a binary form. At private cost (7A(e),
he perfectly learns the payoifs of
(1
—
candidate projects with probabihty
the agent learns nothing and
e),
'°For example, a
and
all
R&D
common
units put too
applications ("D").
complaint
in large
much emphasis on
The emphasis on
still
e.
With probabihty
views the projects as identical.
conglomerates
is
basic research ("R")
basic research stems
that
R&D
and too
from the
operations get out of control
little
on developing commercial
units' private benefit.
"This congruence parameter will be treated as exogenous in the following analysis. However, one could
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
think of various
[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
is
A
a
is
the possibility that other agents working for the principal are aff'ected
case in point
is
supplied by the difference in behavior of
less successful in keeping an arms-length relationship with
its
IBM
and Fujitsu
units than Fujitsu
The Economist (Management Focus. April 10, 199.3), one
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
reason
is
British subsidiary ICL. According to
that Fujitsu and
ICL
are not serious rivals
the higher the congruence.
A
systematic exploration of the various ways of endogenizing the congruence parameter
scope of this paper.
lies
beyond the
how much time
Similarly, the principal chooses
or effort to devote to learning payoffs.
At private cost gp{E), she becomes perfectly informed about the payoffs with probabihty
and learns nothing with probability
The
(1
—
E).
principal's acquisition of information can
else start after the
agent makes his report.
We
be contemporaneous with the agent's or
will refer to these
simultaneous and seqxLential models, respectively. Which variant
on the context. Sequential investigations usually are
who can already
build on an existing report.
On
less
is
two possibiUties as the
more
relevant depends
time consuming for the principal,
the other hand, the principal
to accept the agent's proposal by lack of time.^^
same
we
results,
may
not want
may be
to wait until the report accrues to start her investigation, as otherwise she
cases yield essentially the
E
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
rA(0)
•
=
0, (7;(0)
=
verified
=
0, <7:(l)
Communication:
or soft.
and
disutilities of effort (7^(-)
oo,
z
=
(jp[-)
are increasing
by the other party
information being
•
if
communicated by the party who
is
The
for a project choice.
its
and
is
collected
Soft information
it.
communication must be interpreted
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
In this case, the principal
fully
either hard
soft.
called the ''superior'\
and can
is
and instantaneously
project's payoffs can be costlessly
Authority: In the case of P-formal authority (which
gration"'
convex and satisfy
most of the paper we can assume that information
In
Hard information about a
pure suggestion
strictly
/l,P.
cannot be verified by the other party and therefore
as a
and
principal
may
informed and
if
always overrule the agent (the
the agent's recommendation
is
^''subordinate'").
not "congruent".
has both the formal and real authority over the choice of project
dispense with the agent's information and recommendation.
(optimally) rubber-stamps the agent's proposal.
We
will
Otherwise, she
then say that the agent has
real
authority.
Our
payoff structure implies that there
subordinate;
The standard
for,
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
'-For instance, directors of a
stamp the annual report
involved.
"exit option" for the
company
if
they are unhappy with their superiors'
model
in
which the principal's preferred
members of a thesis jury are usually forced to rubberthey have waited until receiving the documents to become
or external
or to accept the thesis
if
project
may impose
a substantial loss of utility for the agent.
Under A-formal authority (which we
dent agenf\
That
is,
agent
is
informed, picks his preferred project and cannot be overruled by the principal.
the agent
now has formal
authority. Note that this covers the situation in which the
an employee who contractually receives an irrevocable right to take
decision.
We
if
will occasionally label "delegation"), the ''''indepen-
will
assume that whoever has authority
zero, but benefits the other party to doing
two relevant projects yield
•
this particular
^'^
Contracts.
In
prefers choosing a project that gives
him
nothing (equivalently, we could assume that the
strictly positive payoffs to
both parties).
most of the analysis, 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 oi 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;^''
gather information about the n projects' payoffs;
(iii)
the party
the parties privately
(ii)
who
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
when
•
we
will point at the implications of contract
incompleteness
these circumstances do not obtain.
Payoffs under the two allocations of authority.
Under
P -formal
authority (integration).
''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 fight.
we assume that there is ex ante a competitive supply of potential agents, so that the allocation
authority between the two parties is the one that maximizes the principal's ex ante expected utility.
^''That
of
is,
the utilities are
up =
EB +
- E)eaB-gp{E)
{\
(1)
anc
= Eab+{l-E)eb-gA{e).
UA
That
is,
with probabiHty E, the principal
probability
—
(1
and suggests
E), the principal
is
informed and picks her preferred project. With
uninformed. With probability
The
his preferred project.
is
(2)
principal then 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. ^^
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
u'^P
=
ecxB
+ {l-e)EB -gp{E)
(3)
and
u''^
= 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 the
specific projects payoff structure, in particular
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
1,2
and
3.
n
Project 3 yields a strictly negative profit to the principal, whilst projects
2 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 ruhng out the negative-profit project having been
disclosed to her.
'^Note that the superior
is
always better
off,
the higher the agent's effort. This need not hold in a multi-
task extension of our model; for, the agent's effort on this task
(.'onsequently, the agent's initiative in one task
may
may
then crowd out his effort on other tasks,
not be positively valued by the principal.
8
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)
(5)
and
{l-E)b =
The
gM.
principal supervises more, the higher her stake
and the agent's
effort.
We
{E^eY^ [Such an assumption
acquires information only
The
if
initiative,
the higher his private benefit
interference.
assume that the two systems
stability condition
and the lower the congruence parameter
The agent demonstrates more
and the lower the principal's
(6)
is
of equations {(5), (6)} has a unique, stable intersection
not needed in the sequential case:
the agent makes a proposal,
E
is
Because the principal
independent of
e
and the
automatically satisfied. ^^]
is
fact that the agent's reaction curve (6)
of this (or any) delegation model.
sloping, the principal
In contrast,
would never want
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
downward
if
the
sloping.
Finally, 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 the
is,
is
that the principal can and has
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
gathered by the agent and modify the existing project. The principal's reaction
then hkely 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.]
^nha.t
is,
abB <
g'l,{E)g'J^{e).
^'For example, with soft information, the principal's payoff in the sequential case
up
= e[EB
4- (1
- E)aB -
gp{E)].
is:
The
3.2
basic tradeoff
Suppose that
effort of
priori
between
some "exogenous" reason
for
the principal
(i.e., g'p)
On
ambiguous.
increases.
and
loss of control
because of overload), the marginal cost of
(e.g.,
The
effect
on the principal's expected payoff
E
(5));
On
the principal thus
the other hand, the reduction in the principal's
encourages initiative from the subordinate (see equation
raises the principal's
a
control) over the choice of project, with a higher resulting risk of
(i.e.,
having to endorse suboptimal projects.
intervention
is
the one hand, ceteris paribus, the principal's probabihty of becoming
informed about the projects' payoffs (E) decreases (see equation
loses real authority
initiative
(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
question then arises as to
(optimal)
amount
This question
is
contract allocates formal authority to the principal.
how the
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
initial
One (extreme) way
in detail in section 4.
is
to relinquish her formal authority, a^
we
for the principal to
shall
now
see.
allocation of /orma/ 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:
(1
- e)B =
g'p{E)
(7)
and
{l-aE)b =
Assuming again that
that
gM.
(8)
{(7), (8)} yields a unique, stable equilibrium {E'^,e'^),^^
one can show
:
E>
Our model thus
explains
why
and
E"^
is
agent, she has less incentive to
is
understood as
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
e''.
often suggested in the literature (e.g., in Williamson
(1975,1985)), to an arms-length relationship.
is
<
the absence of integration (where "integration"
P-formal authority) corresponds, as
the agent
e
more
on the other hand,
is
a loss of control.
The agent
often.
'*The stability condition
is
the
same
as in the case of
10
P-formai authority.
takes suboptimal
Example: Let us compare the two governance structures
tion, in
=
which 54(e)
e^/2 and gp{E)
=
E^/2}^
g(l
-
c^b)
in the
quadratic cost specifica-
One has
^^
1
-abB
^
'
^
6(1
1
- B)
-abB'
and
,
^ ^(1-6)
- a6fi
^ b{\-aB)
1 - abB
,
'
1
'
Furthermore,
P-formal authority
is
optimal for low levels of congruence (a small), and A-formal authority
dominates when preferences almost coincide (a close to
a' E
such that P-formal authority
(0, 1)
if
Indeed, there
and only
if
a <
is
a cutoff value
a*.^°
Complete vs incomplete contracts
3.4
The purpose
One
optimal
is
1).
of this subsection
common
of the
is
to step back
and
on our methodological approach. ^^
reflect
motivations for using incomplete contracting models
is
that the standard
complete contract paradigms (moral hazard, adverse selection or Nash implementation)
and authority.
to account for notions such as ownership
We
fail
have adopted an incomplete
contracting approach to analyze authority and
its
delegation and found
conceptualize our intuitions and obtain others.
Yet, in view of the current lack of proper
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 an incomplete
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.
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
Second,
who
gets his
we assume
way when both
may
lead to the adoption
parties are informed?
The
second question hinges on the classic tradeoff between ex post efficiency of
this
'®This case does not satisfy the assumption that
as
First,
(7|(1)
=
00,
is still amenable to our analysis as long
do not become informed with probability
but
that, in the relevant range of parameters, the parties
1.
•^"To
prove
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
this,
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
primarily interested in the incomplete contracting approach.
11
may be skipped by
readers
who
are
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 that the
step,
first
only two parties (or that
B
is
noncontractible); as
we
principal
and the agent are the
shall see, this
assumption essentially
rules out the use of the sharing of the principal's profit with outsiders in order to
We
the agent's initiative.
The timing
assume limited habiUty
as follows:
is
The two
(i)
both
for
parties.^'^
parties sign a contract;
knows whether the other party has learned them
they possibly renegotiate the
new contract
is
either
(if
("I
initial contract; (v)
renegotiation has taken place)
as well);
(ii)
(iii)
A
implemented.
learned the payoffs
they send messages;
the initial contract
is
they privately gather
who has
information about the n projects' payoffs (for simphcity, a party
also
encourage
force) or the
(if still in
message
(iv)
rrii,
i
= A,P,
have not learned the payoffs"), or a pair of payoffs for the principal and the
agent for each project
fc
=
1,
•
•
•
,
n
("I
have learned the payoffs, and they
specifies probabilities^^ Pk{i^p,'m-A) of
implementing project
k,
A
are...").
contract
such that
n
k=l
There are three
therefore a project
£^(1
— e));
2:
states of the world in
is
to
be implemented:
congruent project
In state j
is
preferred project
is
E {1,2,3},
implemented
principal's preferred project
T
1:
is
if
let
only the principal learns the payoffs (probability
there indeed
•
•
,
T"
is
— E)e);
{l
Xj denote the
3:
both learn the payoffs
equiUbrium probability that the
congruence; in case of noncongruence, the
implemented with equihbrium probabihty
implemented with equilibrium probabihty
assume that the renegotiation process
•
one party learns the payoffs and
least
only the agent learns the payoffs (probabihty
(probability Ee).
We
= 1,
which at
is
with
Zj,
yj
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 Umited liability assumption.
^^Unlike in conventional mechanism design, there
is
no leeway
in using
incentives because there are only two parties, profits cannot be thrown
and one of the
parties, the agent, does not
away
respond to monetary incentives.
12
monetary transfers
(since renegotiation
is
to adjust
feasible),
that information
is
The argument can be extended with minor
hard.
modifications to soft
information.
The
=
possibihty of renegotiation^'' implies that x;
for all
1
compatibihty plus the possibihty of renegotiation imply that
is,
in case of
=
j/i
1
and
Z2
=
by disclosing only
1.
To
see this, note
first
that, because
when both announce they have
not learned
the payoffs, the initial contract yields status quo expected payoffs equal to zero
probability one no project
is
bargaining
game and suppose
project at the last subperiod T.
other party (alternatively
amount
(m,-
=
0,
z
=
A, P) at stage
Now
(iii).
Then, whoever makes the
we could assume
consider the stage
last offer necessarily
is
proposes
preferred by the
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 impHes that
when the information
investments
e
is
with
that the informed party has disclosed only his preferred
assuming that when indifferent a party chooses what
this project and,
(if
implemented) or negative (otherwise.) Second, suppose that
the informed party feigns ignorance
positive
That
because of
his preferred project, which,
then implemented with probability
is
irrelevant projects yield very negative payoifs,
(iv)
1.
asymmetric information and noncongruence, the informed party can guaran-
tee himself his preferred payoff
renegotiation,
Furthermore, incentive
i.
symmetric
(state 3)
2/3
+
23
=
Who
1.
gets his
own
own way
determined by the relative desirabiUty of the
is
and E.^^
To sum up,
the optimal contract is a
(random) authority scheme,
ex post conferred upon the principal with probability
1/3
in
which authority
is
and upon the agent with proba-
(note that the allocation of authority was shown in section 3.1 to be irrelevant in
bility 23
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
some contracting features that might emerge otherwise, such
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 releveint projects are proposed and would costlessly ensure truthful revelation. This
poUcy 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
of projects and therefore can claim that he is aware only of one relevant project.]
^''The possibility of renegotiation rules out
as throwing
^^That
is,
{y3,Z3,e,E) solves:
Tmix{B[E{\ -e)
+ e(l - E)a + eE{a +
{I
-
a)y3)]
- gp{E)}
s.t.
€ argmax{S[£'(l -
E
e
6 argmax
y3
+ 23=
{h[E{\
e) -H e(l
-
e)a
- E)a + eE{a +
+ e(l -
E)
1-
13
(1
+ eE{a +
(1
-
0)^3)]
-
0)23)]
-
9p{E)],
-
gA{e)},
(although they are usually not considered in the literature),
we conclude
that the incomplete
contracting approach cannot involve a loss of generaUty under these specific circumstances.
What about
•
third parties?
shareholders, headquarters) do exist in practice,
(e.g.,
function by sharing her profit.
A
B is contractible (call it a profit), such parties
Assuming that
contract
now
The presence
specifies probabihties
who
alter the principal's objective
of third parties
{pi(mp,m^)}
expands the contract space.
of implementing projects as well as
monetary rewards {Bp{mp,TnA),B — jBp(mp,m^)} to the principal and the third parties
when
profit
some
fraction in
We
is
leave
it
We
B.
[0, 1]
assume that
to the reader to check that the optimal complete contract in the presence of
absence of third parties)
receives a fraction in
[0, 1]
cum
if
a linear profit sharing
the principal has too
we conclude
is
scheme
therefore the
much
which the principal
in
new instrument, and
incentives to monitor. ^^ Because
that the incomplete contracting approach cannot involve
a loss of generality in the model of section
We
(random) authority relationship
specifies a
schemes involving third parties are perfectly consistent with the incomplete
contracting approach,
•
It
of the profit B. Profit sharing
serves to encourage initiative
profit sharing
by the renegotiation.
of the increase in profit brought about
third parties takes the following simple form:
(as in the
with the agent, the principal gets
in case of renegotiation
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
than by implementing the project he prefers,
for bringing information to the fore rather
which
is
impossible in the standard incomplete contracting approach followed here.
abihty 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
The
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.
Factors favoring initiative
formal authority
4
4.1
It is
Span of
and
control, overload
when the
principal has
initiative
often argued that the planning and allocation process of the large conglomerates that
were formed in the '60s became bureaucratized, and that the headquarters were responsible
^®The third
the shares.
parties'
ex post expected profit
The reason why
(1982)'s terminology)
is
is
received ex ante by the principal through an auction of
the third parties act as a "sink" rather than a "source" (to use Holmstrom
that from the principal's viewpoint, the principal's effort
the principal receives the
full profit
B, but
may be
excessive in that
14
it
is
never suboptimal when
reduces the agent's initiative.
for too
many
units,
whose strategy they could not understand or
a refocus on "core businesses"
.
The purpose
of this subsection
is
influence. This called for
to introduce the superior's
m
span of control and overload into the analysis. Suppose that a superior has authority over
Each subordinate
identical subordinates.
i
screens in a set of tasks as described in section 2
and learns the corresponding payoff structure with probability
5p(E,£',) where Ei
of efforts
is
activity.
The
is:
up
=
Each agent's reaction curve
£,[£.B
is still
+
assume that the equilibrium
is
(1
- Ei)t,aB -
/]
is
-
a fixed cost
/ per
i's
subordinate.^'^
gpilliEi).
(9)
given by
(1
We
principal's disutihty
the principal's probabihty of learning the payoffs of agent
is
subordinates' tasks are independent. There
So, the principal's payoff
The
e,.
-
E.)b
=
g\{ei).
(10)
symmetric''* and stable. ^^
{I
- ae)B =
g'p{mE),
(11)
and
{\-E)h^g'^{e).
(12)
Let {£'(m),e(m)} denote the solution of the system of equations {(11), (12)}.
notation,
Abusing
let
up{m)
= mR{E{m), e(m)) — gp{mE{m)),
where
R{E{Tn), 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
^
am
The
=
is
obtained from
[R{E{m), e(m))
expression in brackets in (13)
the span of control.
An
is
- E{m)g'pimE{m))] +
=
m^-^
oe am
0.
(13)
the marginal profit associated with a unit increase in
extra agent brings revenue
^^The superior would choose to have an
(or, equivalently,
m as a real number,
infinite
i?,
but requires attention
number of subordinates
of a positive reservation wage of the subordinates.)
A
E
which
raises
in the absence of a fixed cost
finite size is
obtained when /
>
^*There also exist asymmetric equilibria in which the principal devotes all her attention to a subset of
agents, who therefore lack initiative, and none to the others. To eliminate asymmetric equilibria, one can
assume that the probabihties {Ei} are
sufficiently nonsubstitutable in the principal's disutility of eff'ort
function.
^^In the quadratic csise (see the
example
in
subsection 3.3), this amounts to
15
abB < m.
The second term,
the cost of supervision by Eg'p, the "overload cost".
"initiative effect",
and measures the increase
|^^ >
in
in the agents' effort associated
the
0, is
with a reduction
in oversight.
We
will say that a firm
in
is
a situation of overload
employee, keeping employee behavior constant,
is
if
the marginal profit of an extra
negative. Equation (13) shows that
it
is
always optimal for the firm to he in a situation of overload so as to credibly commit to reward
initiative.'^''
Remark
The
1:
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,
new subordinates
hiring
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
managers or
CEOs
B
generally, the extent
more agents subject
to the
more overload.
in subsection 3.4,
the principal to share B, provided
More
is
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
consists in refraining
subsection.)
A
is
one way of raising the marginal cost of monitoring. Another way
from investing
case in point
is
in the
monitoring structure (on
the relationship between Fujitsu and
this, see also
its
the next
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
fact that only
two Japanese managers are resident
^"Because the margincil profit
is
respect."'^
in
Of
particular interest
London. [Fujitsu also wants
is
the
to fioat
negative, the principal would be better off committing herself, say, to
The problem with this is that playing golf is not a credible
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.
playing golf rather than reaching overload.
commitment
(recall that the gp{-) function
^'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
hterature. Here,
concretely,
we
to provide a link
is
The concept
rules.
but not
A'^,
will
two
and the lack of
choose by himself,
is
only one respect:
must screen
under which the agent
namely the one that
An
by a
assume that the two candidate research
The
principal ha^ less expertise on research strategy
is
is
that a rule
is
independent agent
come up with a
likely to
is
and
expertise in
A'^
A'^,
than
in
We
A'^.
more
likely to he
A'^
N
and
N
differ in
than on
then ask,
is
A'^
and
a rule
imposed when the principal has formal
not threatened by the principal's being well informed,
Actually, in the simultaneous
by choosing research strategy
A'^,
N
model studied
because the principal
in order to protect himself against interference
Whether the superior should allow her subordinate
of initiative
strategy
N
strategies
is
useful idea. In contrast, in the absence of rule, a subordinate
well choose research strategy
his superior.
would
within an organization rather than across organizations, for the following
here, the agent even strictly gains
may
free to pick his screening strategy.
rule.
because the principal cannot overrule him.
more
"the agent must screen
in N''\
will
result
authority, that
reason.
is
possibilities for a given
be imposed when the principal has formal authority?
to
Our main
will screen projects either in
forces the agent to pick the subset he
therefore has a higher cost of monitoring projects in
more hkely
on the agent's action space?'^
and N. The agent
rules ("the agent
in the
can be screened by the agent
set of projects that
A'^
meanings
rights
equivalent to the lack of rule. So, there are really two choices: constrain
or not constrain the agent
we
between the distribution of decision
There are therefore three contractual
rule,
Naturally, one of the rules,
Concretely,
3 above.]
of "rule" has been given several
assume that the
in both.
allocation of authority:
in A'^"),
remark
will define a rule as a contractual constraint
can ex ante be divided into two subsets
A^ or in
this, see
stake and
lenient rules
and the existence of
More
On
its
loss of control
is
and congruence
is
the
to
K the
more important concern.
from
do so hinges on which
superior has very
little
low, the superior wants to force the agent to adopt research
A'^.
So, let us
assume that the
g'p{E),
higher than that of investigating recommendations in
is
agent searches in
^^As we
N or N
will predict,
is
principal's marginal cost of investigating
contractible. In each research line
(
A'^,
recommendations
g'p{E).
in
Whether the
N or N), there are as earlier
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
laboratory.
17
restrict the research
Una to be pursued by the
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.
reaction curve.
The equihbrium
efforts therefore satisfy:
E{N) < E{N)
and
when the
or
A'^.
Furthermore, the agent,
of intervention, at least
On
if
is
thus to
is
and the principal has
One way
for the principal to
commit
A'^
A'^
order to limit the threat
in
low.^^
the other hand, a lack of congruence makes initiative
less relevant
nate most often recommends projects that are useless to the superior.
prefers to
less
the agent choose whether to screen within
given the freedom, chooses
congruence
if
let
e{N).
initiative
superior has a higher monitoring cost.
to a lower degree of intervention
>
e(yV)
As expected, the subordinate demonstrates more
control
N in-
curve downwards without affecting the subordinate's
shifts the superior's reaction
A'^
Having the subordinate screen within
impose a rule when the congruence parameter
The
small {up{N)
is
An independent
Consider now the case of A-formal authority.
because the subordi-
agent
superior therefore
>
is
up{N)).^'^
not threatened
by the principal's being well informed, because the principal cannot overrule him. Actually,
in
the simultaneous model studied here, the agent even strictly gains by choosing research
strategy
A'^,
because the principal
more
is
upon an independent
therefore are therefore never imposed
^^In the absence of a rule, the subordinate
if
congruence
is
high.
It
may
come up with a
likely to
may
not want to
agent.
useful idea."'^
high monitoring costs on the superior
inflict
turn out that he benefits from the superior's being well informed.
subordinate definitely prefers research strategy
N
if
Rules
"'^
the congruence parameter
a
is
low.
To
But the
see this, let
K 6 [0, i\,hp{E, K), with hp{E,0)
and h'p{E, K) decreasing with K. Then, by the envelope theorem:
us index the principal's disutility-of-effort function by a parameter
gp{E),hp{E,
1)
= gp{E)
which is unambiguously negative
^^As in the previous footnote,
for
let
a
close to zero since
(
/ip(0, A')
for all
K
and
Umo_oe =
ff^'[(l
—
g'p^{B))b]
>
0.
us index the principal's disutility-of-effort function by a parameter K,
gp{E), and both hp{E,K) and h'p{E,K) decreasing with K
and h'p{E, K) decreasing in K imply that hp{E, K) is eJso decreasing in K). The
hp{E,K), with hp(E,0) = gp{E),hp(E,l)
=
^>
=
=
envelope theorem implies that:
^
dK
Thus,
for
a
=
(l_^)aB|i_^M|^>0
oK
for
oK
a
close to zero.
close to zero:
up{N) = up{K =
1)
> up{K =
^^More formally, since E'^{N) > E''{N) and since for any
we have ui{N) = max^ u^(£;''(Af), e) > max. u^(£;''(iV),e)
^^Rules could arise under j4-formal authority for instance
to monitor them, but in the payoffs.
18
0)
e the
=
if
=
up{fl).
function
E i-> u^{E,e)
is
increasing in E,
u'j^{N)._
N and N
differed not in the principal's ability
Urgency and delegation
4.3
It is
sometimes observed
tliat
the need to adapt quickly to customer requirements has forced
firms to decentrahze decision-making.
some
insights
^'^
The purpose
of this subsection
two-fold:
is
It offers
on how delegation might be affected by the urgency of the decision and
We
illustrates the sequential case.
will formalize
it
the urgency of the decision by the length
of a product Hfe cycle, but several alternative interpretations are possible.
Suppose that the
superior can investigate only once the project proposal has been made.
Let
horizon, that
A
Abusing terminology, we
A
>
t
and date T,
him
yields
The
to start production even
more time
first
time
in case of
in this
us
it
in choosing a stopping
some date
in
r,
F{t),
is
paper,
is
it
makes a
trivial
difference
it
—
F(r)]
whether information
and uninteresting.
from the agent and implements
is
If
the project
immediately (5
=
0);
is
is
T] at which
Waiting
There are
decreasing.
hard or
soft.
congruent, the
is
on the other hand,
always some hope that she will discover her preferred one {S
B
soft.
is
aB
between S and
T
and
t
if
rS p-rt
up =
B
r
Jo
is
_
[-
is
T).^ So
T
if
she learns payoffs
a,t
t
<
S,
and has
she has not learned payoifs by date
thus rubber-stamps the agent's project at date S.
agent's having proposed a project,
=
For a given stopping rule 5, the principal obtains
between the date of learning
expected flow profit
r
[0,
increasing, with density /(t).
monitoring, so the hazard rate /(t)/[1
assume that information
flow profit
where
S €
time
noncongruence, the superior never implements the subordinate's preferred project,
because there
let
and T; the other relevant project
her investigations have not been successful by then.
case of hard information
principal learns
t
for monitoring; namely, the probability that the principal learns
however decreasing returns
The
problem consists
if
the payoffs herself before
For the
Similarly, the subordinate's preferred project
profit.
benefit.
principal's decision
longer gives her
stand for the product hfe
per unit of time between the starting date for
private benefit b per unit of time, between
no private
T
will let
which time a superior substitute arrives on the market.
at
noncongruent project generates no
gives
B
congruent project yields profit
production
denote the
the time elapsed between the proposal (date 0) and the date at which the
is
product becomes obsolete.
cycle.
T
The
principal's utility, conditional
S and
on the
therefore:"'^
g-rS
p-rT
—]mdt
+ aB[l -
_
-tT
F{S)][
],
r
the principal's rate of time preference. This objective function
is
quasi-concave,
Wyman-Gordon and WalMart in Continental Bank (1993).
the subordinate's preferred project yielded a strictly positive profit to the
^^See, e.g., the discussions of
''*This
would not be so
if
superior.
^^In this formulation, the principal's cost of investigating
duction of the product.
The
is
simply forgone profit due to delayed intromore standard disutiUty of the
sequential model can also be formulated with a
principal's effort: See footnote 17.
19
and the optimal stopping time either
is
zero
if
principal rubber-stamps without even checking), or
fi^\
The
left-hand side of (14)
(divided by B);
is
1
^IpL)
^
(for
\
decreases with
-£-'•(^-•5)
is
equal to the conditional density of discovering the
strictly positive increases
if
a {dS/da <
0), as
we would
S and T
with
T
Our main
expect.
That
horizon, the principal conducts a cursory investigation.
to
large enough, the
given by the first-order condition:
is
payoffs times the value of overruling the agent's choice between
The optimal stopping time
a
the marginal cost of delaying the introduction of the product
right-hand side
its
'
j^ >
{\
(divided by B).
> dS/dT >
result
is
that for a short
the principal is
is,
and
0)
more
likely
rubber-stamp, the more urgent the decision.'^°
Last,
we have been
silent
about the agent's behavior
that his search time (which could be
in that
we have
random) was exogenously
implicitly
assumed
given. 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
of acquisition of information by the agent)
whether the agent would ever want to delay a proposal.
is
the date of adoption (recall that
overruled (because
dS/dT >
0).
dS/dT <
1),
Delaying the proposal delays
but also reduces the probability of being
Clearly, an agent with a congruent project
to delay the proposal, but an agent with a noncongruent project might.
late proposal could signal a
principal (since
dS/da <
of positive correlation
would not want
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,"*^ 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 lines.
We
justified".
it is
For conciseness, we
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 likely to be centralized. However the
notion of centralization and the set of issues studied there are quite different from the ones analyzed here.
our terminology, Bolton and Farrell's "centralization vs decentralization" refers more to the allocation
Bolton and Farrell analyze a
multi-agent investment problem and contrast the duplication-and-delay inefficiency of decentralization with
In
of formal authority than to the degree of the subordinate's real authority.
the incompetence of a bumbling central decision maker.
"•'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
the principal but reduces initiative too
optimal
A
in section 3.3).
much
to
be worth
it
is
if
if
the noncongruent
ex post optimal for
(A-formal authority would be
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 a
in matters
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 generaUze
our theory to allow the agent to respond to monetary incentives. The profit
u{w)
the agent's utihty for project k
is
of generality, the agent receives
w>
The
+
bk
(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
0,
is
u"
<
is
verifiable
and
0).
Without
loss
B, and
otherwise.
B = B — w.
6 = 6 + au{w)
The
for
agent's
u{w)
<
b,
the agent always picks his preferred
wage w. The case u{w) >
b
can be labelled
agent's monetary incentives are powerful enough that he forgoes
and always recommends the
principal's preferred decision.
Note that
it
never optimal for the principal to set a wage just below u~^{b), because she can obtain
congruent decision-making by raising the wage
The
first-order conditions (5)
and
(6)
slightly.
under
{l-ae)B =
P -formal
authority become:
g'p{E),
(15)
gM.
(16)
and
{l-E)b =
The main
conclusion of this section can be drawn from these two equations.
wage increases
makes
it
more
real authority
likely that
for two reasons:
First,
the 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 {E{w), e{w)} denote the solution of {(15), (16)}, the derivative of the principal's
profit
with respect to
w
is:
^
aw
The
first
term on the
=
{I
- E)a{B -
hand
right
reflects the increase in the
not ahgned)
is
Remark
1:
Chandler
if
(in
a
E)ea].
is
wage
bill.
The optimal wage (when
is
effective in
incentives are
mature industries while the corporate
which new product development
application of this idea within a firm yields the so-called dual top
in
is
office
The
critical.
management approach^
"applying decentrahzed financial controls to mature businesses and a more
He
centralized form of "strategic" control to capital-intensive, high-tech businesses".
serves that at (generally
deemed
successful)
GE
from the corporate
office,
and were run instead through
and budget-based bonuses). The corporate
ob-
during the '80s, the managers of the "core"
businesses - the long-estabHshed, mature businesses - received
gets
The
small, but can be positive in general.
closely involved in industries in
which consists
(17)
Continental Bank, 1993, p54-58) argues that decentralization
combined with financial controls
must be
-
side of (17) corresponds to the increase in initiative.
second term
equal to zero
- [E + (l
w)^
aw
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.)
management approach.
The 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
w
b
and that the agent has learned the payoffs while the principal has
>
u{w).
Suppose further that the agent's information
noncongruence, the principal must raise the wage to w*
will
be willing to do so
commit
to
wage w' ex
if
=
is
Suppose that
hard information."*^ In case
w* < B. While renegotiation occurs, the principal may not want
ante, because she can get
away with a lower wage when she
is
to that developed in the absence of renegotiation.
equally straightforward to study the case of soft information.
22
of
u~^{b) in order to get a profit. She
informed or when the projects are congruent. The analysis
"•^It is
not.
wage
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
of useful observations. There are two dimensions to the deconcen-
and authority.
tration of ownership: returns
The
a) Splitting returns.
lies
benefit B, provided
principals. Consider for instance the case of
to receive
B/n
want
all
maximize
to
principal's
whole
set of principals as a
monetary, can be
it is
n equal partners
in case of success of the project.
The
principals.
While
is
We
split
profit, the allocation of authority
cost function for
any of them
if
several
(or "co-owners"), each entitled
assume the same
informed
among
among them
is.
is
all
Because they
Each
irrelevant.
and the agent's reaction curves are respectively given by
{I
- Er-\l - ea)- =
n
g'piE)
(5')
and
{l-Erb =
(6')
g'Ae).
Spreading monetary benefits among several principals has two
principal's cost function
In this case,
control.
On
is
an increase
not too convex, as
number
in the
is
of principals raises initiative
and
cost.''"'
results in a loss of
the other hand, with a very convex cost function, the multiplication of monitors
We
1:
tiplying the
initiative. First,
the case for instance for a quadratic
substantially improves the monitoring structure, which
Remark
on
This effect dominates when the
generates free riding and therefore reduces monitoring.
it
effects
may reduce
initiative."*^
have assumed that the principals have similar monitoring
number
of monitors
may
increase monitoring
if
abilities.
Mul-
the principals' talents are
complementary.'**
''^To
show
rewrite (5') and (6') in terms of the probabiUty
this,
S
that the principals be informed; Let
E{£, n) be defined by
(!-£')"
The
= 1-f.
first-order conditions are then:
(1
-
£){l
- ea)B =
n(l
- E{£,n))g'p{E{S,n))
(5")
and
{l-S)b^g'^{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 < £'o, and = oo
demonstrated with the following functions: gp{E) =
is given by 1 - f = (1 - Eq)"''^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
''''This
for
E>
point
Eo-
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).
systematic analysis of complex organizations however
SpHtting authority
b) Splitting authority:
consequence
thority
is
among
benefits are then spread
lies
among
beyond the scope of
among
often spUt
manufacturing divisions
several principals obviously hcis no
matrix organization, multiple ministries, chambers
in a
hinges on the matrix of congruence parameters
the governance
mechanism
(for
among
Who
principals
and agent,
conflict of interest
It
may
among
may be enhanced
principals
may
may be
on
On
Depending on these
or reduced by the split of authority.
increase the probability of veto by one of them.
also raise each principal's incentive to
recommendations.
as well as
example, each principal can have veto power, or there can
considerations, the agent's initiative
A
in congress,
has real authority then
be majority voting with or without the participation of the agent.)
agent
But au-
ahgned objectives (marketing and
principals with imperfectly
partners in a joint venture, creditors in a bankruptcy process).
principals'
this paper.
the principals' objectives are aligned as in the previous example.
if
A
several (upper) layers.
become informed and not
the other hand, for
more
to rely
on the other
coUegial decision processes, the
able to "play" his multiple principals against each other and thereby get his
way."*^
5
Authority and communication
This section extends the basic framework by introducing the possibility that the agent com-
municates some prior information he
question then
is
privately hold about the projects.
whether the allocation of formal authority
(relevant) information
We
may
assume that
E >
0.
at the beginning the agent can
A'^i
of
A'^
communicating information
g'p
to g'p such that g'p{E)
know
and decide whether to reveal
to the principal
is
Then the two
A^i to
the principal.]
The timing
communicate
parties choose noncooperatively
to invest in learning the projects' payoffs.
>
g'p{E) for
that the two relevant projects
noncontractible.
section 2 except that the agent first chooses whether to
to the principal.
communication of
communicate information that reduces
[For example, the agent might privately
belong to a subset
natural
by the agent.
the principal's marginal cost of investigation from
all
affects the
A
is
The
action of
as described in
his private information
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 {gp{-) or gp{-))^See Davis-Lawrence (1977) for a description of such behaviors.
24
Communication
curve up (regardless of the allocation of
shifts the principal's reaction
formal authority) and has no effect on the agent's reaction curve.
E
effort
to
thus increases in a stable equiHbrium.
communicate information
principal's marginal disutility function
=
g'piE), h'p{E, 1)
=
principal's monitoring
question of whether the agent wants
down
to the principal thus boils
Without
from the principal's being better informed.
with h'p{E,0)
The
The
to
whether the agent gains
loss of generality let us
by a communication parameter
g'p{E) for aU
E
£
[0,1],
and h'p{E,K) decreasing
E{K) and
noted that the principal's equiHbrium efforts
K
in
index the
h'p{E,K)
K.
E'^{K) increase with K. Using the
envelope theorem, the impact of communication on the agent's utility (see equations
(4))
(2)
and
given by:
is
duA
and
_
An independent
.,dE
,
=
(l_e)a6—
(19)
.
agent always benefits from the principal's being better informed. In contrast,
a subordinate wants to communicate information
his
if
expected gain from the superior
becoming informed, a6, exceeds the expected benefit from having
a >
We just
e.
When
congruence
low,
is
his information. In case of
a <
e,"*^
so the agent
low congruence there
real authority, e6, or
better off not communicating
is
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^
is
is
longer derives a benefit from the principal's being ex ante well informed
well informed
indeed close to
(e''
1,
close to 1).
If
the agent's private benefit
is
high enough so
the independent agent does not bother incurring the cost of
communicating ex ante information. In contrast,
with quadratic payoffs) that, provided
a
is
it
may be
the case (this can be checked
high enough,
^>^:^0.
dK
dl<
To summarize
centives to
(20)
^
'
this discussion, the allocation of formal authority affects the agent's in-
communicate
of formal authority
prior information to the principal.
of the allocation
in par-
congruence between the principal's and the agent's objectives. More
communication may take place under F-formal authority
e
The impact
on communication depends upon the parameters of the model,
ticular the degree of
4^0ne has lim„-,o
if
= ^^^(l - gp\B))]b >
0.
25
if
these objectives are sufficiently
congruent,
conrimunication will take place
less
if
they are too dissonant.
We
conclude
this
section with two remarks:
Remark
1
:
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)
thereby also affect the amount of communication within the same organization.
the equilibrium
amount
of
initiative left to the agent
mentioned
in section 4
Remark
2:
(
will'
Whether
communication varies "comonotonically" with the amount of
by the principal through various commitment devices of the kind
span of control, multiple principals,
The above
analysis shows that
etc.),
is left
for future research.
communication can never be detrimental
an independent agent. Such a strong conclusion, however,
is
to
unhkely 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
in
two
parties' preferences are congruent
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
amount
are endogenous and
of
points. In
an organization, the structure and the distribution
communication among members, and the existence of
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
Relatedly,
activity.
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
delegation. There are
many
first
step toward a
members.
A
more general theory
desirable extensions. For instance,
with a single decision right. Organizations
their
factors, the investigation of
for future research.
This paper aims only at being a
its
moderate interventionism, performance mea-
fascinating question
is
in
of authority
we have been concerned
general allocate multiple decision rights
whether there
26
and
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
That
is
Monitoring (which consists
the principal, but by a supervisor
who
is
most congruent with
in learning
(real)
his preferences
authority over
delegated to the agent whose
the principal's. This point
well
is
The
as described in the two-tier model.
is
6^ and his wage in case of success
the payoffs with probability E)
is
lo^.
is
not performed by
enjoys no private benefit and receives wage
principal in case of success. In this model, the supervisor clearly should
because
about
to their superior (the principal).
that authority
is
kind of questions
collect information
which agent has
is,
private benefit attached to his preferred project
illustrate the
an organization
in
by the following hierarchy: The agent
illustrated
To
recommendations
advice will the principal follow?
the other agent?
and to study the
to allow for multi-layered hierarchies,
is
ws from
the
be given authority,
with respect to project choice (maximize the probabihty of success)
perfectly coincide with the principal's, even though his preferences over his monitoring effort
differ
from the
principal's.
The
issue contingent.
principal decides
whose objective
of the one
Note that, more generally, whether the supervisor gets
is less
among
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."**
Another question directly related to authority and
hierarchies,
project.
and
The
relates to a negative externaUty exerted
existing legal literature
situations of two-sided moral hazard
upon both a
its
principal's
on "vicarious"
delegation
is
that of liability in
on a third party by the choice of
liability rules essentially
argues that
in
where the externahties exerted by a hierarchy depend
and an agent's
damages
efforts, responsibility for
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
principal can monitor
and control the agent's
him
entirely hable
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
''*For
example, a principal
may
arbitrate in favor of the agent
when he
to a prejudice against the agent, collusion with a rival agent, supervisor's
feels the
own
supervisor
is
biased (due
private benefit, and so forth).
Along the same hues, one can wonder whether the principed necessarily gains from choosing a "protege"
is someone with high congruence with her. It might be the case that the principal be
as a supervisor, that
better off with a supervisor sharing the
cover-ups.
The
Our focus on
"protege" might
same
culture (congruent) with the agent even
if
this entails
some
stifle initiative.
private benefits does not preclude the existence of other factors influencing the allocation
of authority such as the relative
competency of the two
parties.
Who
gets his
way may
also
depend on the
indispensability /bargaining power of the various parties, or on the desire of the organization to keep key
personnel
in
the long run (Rotemberg (1993,1994)).
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 habihty imposed
upon a
liable
if
(i)
in
First,
companies or creditors should
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
an extensive account of the courts' views
thus provide support for liability rules that can be
accommodate various organizational
our analysis suggests that
in 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 responsibihty 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.''^ There
is
thus a trade-off between responsabihzing
the owners or managers in integrated firms and at the
same time avoiding
inefficiencies in
the allocation of formal authority.
The
tion
analysis of these
and of other exciting questions related to authority and
its
delega-
must await future research.
''^Such
phenomena appear
to have occurred in the
US
Uability rules (see Ringleb- Wiggins (1990)).
28
following the introduction of the
new environmental
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