On the Emergence of Hierarchies: Coordination Versus Incentives

Abstract

This paper studies internal organization of a multi-divisional firm using an incomplete contracting approach a la Grossman-Hart-Moore and Aghion-Tirole. Performance of each division depends on the level of human capital invested in it and there are externalities among divisional activities. We compare three types of organizational structures: centralization where the center retains decision-making authority for all divisions, decentralization where each division makes its own decision, and hierarchical delegation where authority is allocated in a hierarchical fashion. Centralization is optimal when externalities and the requisite coordination are the main issue. Decentralization is optimal if the investment in human capital is more important. Hierarchical delegation is optimal in the intermediate case. We also discuss the optimal pattern of hierarchical delegation as well as several directions extending the basic model.

Keywords: Delegation, Incomplete Contracts, Hierarchy

JEL Classification: C70, D23, L22