Delegation to Encourage Communication of Problems

Abstract

We consider a principal-agent model where the agent is hired to take an action on behalf of the principal. The agent can exert costly effort to learn the true state of the world. If he fails to discover the state, he can end an inquiry to the principal who then can exert (additional) costly effort to learn the state of the world. If the true state is unknown, the principal's preferred action may be different from the agent's. In other words, the principal and the agent have different preferences over Type I and Type II errors. Knowing this, the agent, when uninformed, may decide not to report a problem if the principal is unlikely to select a correct action. The principal, in anticipation of the possibility of no inquiry, can provide an incentive for the agent to send an inquiry by allowing the agent to ignore the principal's recommendation. We label this organizational arrangement delegation. Alternatively, the principal can choose centralization - an arrangement where the principal's recommendation, if issued, is always binding. We demonstrate that the principal may choose centralization for two reasons: (i) to exercise better control over the agent's actions when the agent finds it optimal to send an inquiry, and (ii) to dissuade the agent from sending an inquiry altogether when, by doing so, she provides a stronger incentive for the agent to exert high effort. Delegation emerges in equilibrium only if the costs of effort for both the principal and the agent are sufficiently high and occurs less often as the principal's and agent's preferences become better aligned. Further, the agent's information acquisition effort under delegation is always lower than under centralization.

Keywords: delegation, communication

JEL Classification: D82, L20, M40, M46