Organizational Design: Decision Rights and Incentive Contracts

Abstract:     
We explore the interaction between the allocation of decision rights over investment opportunities and the design of incentive contracts to induce unobservable effort in a multiagent, multitasking agency framework. These are linked in our model because the only available performance measures confound the two: the returns to investments are not directly observed by the principal, but instead affect the means of the signals on effort. In our model, the optimal effort-inducing incentives give very bad incentives for selecting investments, while providing incentives to make the right investment decisions is costly in terms of inducing effort. In this set-up, hierarchy can emerge endogenously, with one agent being given authority to decide about implementing projects developed by another. The agents then get very different incentive contracts. Other solutions may involve each agent being empowered to adopt projects he has developed or both having to agree before a project is accepted. Bringing in a third agent to make investment decisions may also be optimal.

JEL Classifications: L2, D2

Working Paper Series