Project Characteristics, Organizational Structure, and Managerial Incentives

Abstract:     
We develop a model to show how agency conflicts between shareholders and managers, manager synergies, and the threat of expropriation by managers interact to affect a firm's internal organizational structure and the incentives of its managers. Our theory provides a novel explanation based on agency considerations for two empirical regularities; firms typically have pyramidal organizational forms; and the pay-performance sensitivities of managers increase with their hierarchical level. We also derive a number of implications that relate characteristics of a firm's pool of projects -- their risk and profitability -- to its internal organization and the incentives of its managers. (i) The optimal breadth of a firm's organization increases with the risk of the firm's projects. (ii) The optimal height of the organization declines with risk and increases with profitability. (iii) The pay-performance sensitivities of top managers increase withprofitability. Our results explain recent empirical evidence that firms "flatten'' over time. Broadly, our study contributes to the literature on the theory of the firm by providing insights into sources of unobserved heterogeneity among firms, the organization of managers within firms, and the design of their incentives.

Number of Pages in PDF File: 40

working papers series