On the Use of Hierarchies to Complete Contracts When Players Have Limited Abilities

34 Pages Posted: 28 Feb 2006  

M. Martin Boyer

HEC Montreal - Department of Finance

Date Written: August 2004

Abstract

Why do larger corporations have more layers in their hierarchy? My contention in this paper is that hierarchies arise because economic agents have limited ability to anticipate and ascertain every possible contingency they are faced with. As a result, the complete contract may become too complex (or too costly) to devise and manage directly. My contention in this paper is that hierarchies may help a limited-ability principal (the organization's president) collect all pertinent information about the productive elements in the organization so that the complete is again possible. The contributions of the paper are six-fold: 1) it suggests a reason why hierarchies exist; 2) it develops a measure of the quantity of information that needs to be processed at each level of the organization; 3) it measures endogenously the optimal number of layers in a hierarchy given the players' ability to process information; 4) it provides a rationale for having the most talented individuals at the top of the hierarchy; 5) it offers an explanation for the existence of an unique president in an organization; and 6) it explains how the number of layers and of managers may vary over time as the company grows and/or the players' ability changes.

Keywords: Hierarchies, Contract Theory, Complexity, Correlated Information

JEL Classification: L22, D83

Suggested Citation

Boyer, M. Martin, On the Use of Hierarchies to Complete Contracts When Players Have Limited Abilities (August 2004). Available at SSRN: https://ssrn.com/abstract=886501 or http://dx.doi.org/10.2139/ssrn.886501

M. Martin Boyer (Contact Author)

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

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