Project Characteristics, Organizational Structure, and Managerial Incentives
41 Pages Posted: 19 Mar 2009 Last revised: 29 Jun 2013
Date Written: June 15, 2013
We develop a model to show how agency conflicts between shareholders and managers, information processing and learning about project quality, manager synergies and bargaining power interact to affect a firm's internal organizational structure and the incentive compensation structures of its managers. Our theory provides a novel explanation 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 the risk and profitability of a firm's pool of projects 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 with profitability. (iv) The optimal height and breadth decrease with managerial bargaining power. Broadly, our study contributes to the literature on the theory of the internal organization of firms by providing insights into the organization of managers or decision-makers within firms, and the design of their incentives.
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