Optimal Organization in a Sequential Investment Problem with the Principal's Cancellation Option

Abstract

This paper considers a two-stage sequential investment problem where the principal wishes to cancel the project if it fails in the first stage. Suppose that only the first-stage agent can observe the outcome in the first stage. There are two organizational forms to choose from: integration, where a single agent is in charge of investments in two stages; and separation, where two different agents are in charge of the two stages. Integration gives rise to a smaller wage cost of inducing high effort in both stages; however, in order to obtain the correct information to cancel the project, separation may have some advantage in terms of saving the information rent. We show that when the effort cost in the first stage is sufficiently small, the principal prefers separation because the first-stage agent has less incentive to lie about the outcome.

Keywords: Optimal organization, sequential investment, cancellation option

JEL Classification: D23, L23, O32