|
Article Excerpt
This article analyzes the relation between authority and incentives. It extends the standard principal-agent model by a project selection stage in which the principal can either delegate the choice of project to the agent or keep the authority. The agent's subsequent choice of effort depends both on monetary incentives and the selected project. We find that the consideration of effort incentives makes the principal less likely to delegate the authority over projects to the agent. In fact, if the agent is protected by limited liability, delegation is never optimal.
1. Introduction
* How are decision rights and effort incentives related in the design of an organization? By specifying a structure of authority, an organization determines which of its members have the right to select certain decisions. Its overall efficiency depends on how closely the individual decision makers' interests are aligned with the organization's objective. The structure of authority, however, also determines to what extent the organization's members are affected by decisions that are taken by other members (see Simon, 1951). This in turn influences their incentives to provide effort for the organization's success. The optimal allocation of authority and the provision of effort incentives are therefore interdependent. (1)
As an example, consider investment decisions within a firm. If the management derives private benefits from "empire building," it favors projects that increase the firm's size. It tends to undertake inefficiently large investments, but it is also willing to invest more effort on such projects as they generate larger private benefits. In contrast, when the firm owners take investment decisions, they are concerned with maximizing the firm's market value rather than its size. Yet, they have to take into account that the management may show little enthusiasm to spend much effort on projects that prevent it from empire building.
Of course, the relation between incentive effects and decisions rights is relevant not only at the level of owners and management but at all layers of hierarchy within a firm. For instance, it is not atypical for middle managers to have goals which are different from general management goals. As Guth and MacMillan (1986) note, this implies that "the level of effort that an individual middle manager will apply to the implementation of a particular strategy depends on his/her [...] perception of the likelihood that successful performance will lead to an outcome he/she desires." Therefore, when general management selects a strategy, it has to consider also the objectives of middle managers.
To study the interaction between authority and effort incentives, we extend the standard principal-agent environment (see Holmstrom, 1979; Grossman and Hart, 1983; Sappington, 1983), in which the principal provides the agent with monetary incentives to exert a non-observable effort on a joint project. (2) The agent's effort determines the likelihood that the project succeeds. Whereas in the standard model the project is taken as given, we add a project selection stage where one out of a number of feasible projects is chosen. Projects generate private benefits, and the parties' preferences over projects diverge. To create a role for decision rights, we follow the emerging literature on contractible control by assuming that only the authority over project selection is contractible, because the selection of a particular project is neither ex ante nor ex post verifiable (e.g., Aghion and Tirole, 1997; Aghion, Dewatripont, and Rey, 2002; Hart and Holmstrom, 2002). (3) Thus, in addition to a wage schedule that is contingent on the project's outcome, the contract between the principal and the agent specifies which party has the right to select a project. The principal can either maintain the decision right over project selection or he can delegate this right to the agent. Because the agent's private benefits vary with the type of project, his effort incentives are determined jointly by the wage schedule and the allocation of authority.
Our main finding is that the consideration of effort incentives makes the principal less likely to delegate the authority over projects to the agent. We obtain this conclusion for two types of environments: first, we assume that there are no restrictions on monetary transfers between the principal and the agent. In this case, the agent is not protected by limited liability and the principal can extract the entire surplus from the relation. In the second environment, we assume that limited liability precludes negative wages so that the principal has to give the agent a rent to induce effort. For both environments, we compare the optimal allocation of authority with the hypothetical situation in which the agent's effort is publicly observable and contracted upon. This benchmark allows us to isolate the extent to which incentive considerations affect control rights when effort is not contractible. We find that both with and without limited liability, the range of parameter constellations where delegation is optimal shrinks relative to our benchmark. The driving force behind this observation is that when the principal keeps authority, he will take into account that the agent's subsequent choice of effort is positively related to the private benefits he derives from the selected project. Rather than resorting to delegation for incentive reasons, it turns out to be more efficient to exploit the fact that also the principal's project selection generates effort incentives. Indeed, this effect is most drastic under limited liability: if in this environment delegation were optimal for incentive reasons, then it would also be optimal for the principal to select the same project as the agent. Thus, by keeping authority, the principal can always ensure himself at least the same payoff as by delegation. Actually, we can show that he can even do better than selecting the agent's favorite project, which implies that delegation is never optimal under limited liability.
Our analysis contributes to the above-mentioned literature on contractible control. A standard result from this literature is that the decision right should be given to the party whose preferences over decisions are most closely aligned with the organization's objectives (see Hart and Holmstrom, 2002; Bester, 2005). This minimizes the inefficiencies that arise because the party endowed with authority will opportunistically select a decision in its own interest. A main insight of our article is that this argument needs to be modified when effort considerations are relevant. This is so because the principal will not always implement his ideal decision. As explained above, he will take into account that his choice affects the agent's effort incentives. Therefore, he may bias his decision making in favor of the agent to induce him to exert more effort. Leaving the control right with the principal has the key advantage that effort considerations induce him to act less opportunistically.
Our finding that incentive effects lead to less delegation might appear surprising in light of the incentive view of delegation in Aghion and Tirole (1997), where delegation of responsibility motivates the agent to acquire information about the benefits of different projects. In line with the incentive view, also in our model the agent can be induced to provide more effort by transferring decision rights to him. For a given bonus scheme, his effort incentives are maximized by empowering him to select his favorite project. However, unlike in Aghion and Tirole (1997), there are two reasons for why the principal refrains from using delegation as an incentive device: first, whereas in Aghion and Tirole (1997) the principal cannot use monetary incentives, in our model he is able to use bonus payments as an alternative incentive device. (4) The second important difference is that in our model the agent's effort choice occurs after a project has been determined; the agent's task thus consists of completing a project. In contrast, in Aghion and Tirole (1997), the agent invests effort before the selection stage to acquire information about potential projects. This difference in timing has an important consequence for the selection of projects if the principal maintains the decision right over projects. Whereas in Aghion and Tirole (1997) effort is sunk at the project selection stage, in our model the principal anticipates that--for a given bonus system--effort incentives increase with the agent's private benefits from the project. Therefore, the agent's preferences affect the choice of project even when the principal keeps authority. Because the principal's choice already takes into account that the agent is motivated by his private benefits, delegating authority for incentive reasons becomes less attractive. The comparison of Aghion and Tirole's (1997) and our analysis suggests that the effectiveness of delegation may depend critically on the nature and the sequencing of tasks that an organization faces. Delegation of decisions is likely to be an effective instrument to motivate subordinates to invest pre-decisional effort (such as information acquisition) but might be a suboptimal way to induce post-decisional effort (such as working on the project).
The literature on agency provides several insights into the relation between incentives and organizational design that are related to our analysis. For example, as shown by Holmstrom and Milgrom (1991), in a multitasking environment the number of tasks that an agent optimally performs depends on the reliability of performance measures. In our model, under delegation, the agent faces the dual task of selecting a project and devoting effort on its completion. Even in the absence of limited liability restrictions, the principal cannot design a payment schedule that induces the agent to perform both tasks efficiently. Yet, this does not imply that delegation is always inferior. Indeed, if the principal keeps authority, he becomes involved in a kind of two-sided moral hazard problem (see, e.g., Cooper and Ross, 1985; Dybvig and Lutz, 1993); Bhattacharyya and Lafontaine, 1995) because he selects the project and the agent the effort.
In our analysis, the only available performance measure of the agent's effort is the project outcome. This differs from Prendergast (2002), where the principal's delegation decision depends on the choice between monitoring inputs or outputs. If he monitors the agent's effort input, he restricts the set of activities that the agent is allowed to engage in. Alternatively, the principal can monitor the agent's output and delegate the choice of action to the agent. The comparison between these alternatives shows that the principal will delegate decision-making power more in uncertain environments.
Several authors investigate the relation between private information and the allocation of authority (see Riordan and Sappington, 1987; Athey and Roberts, 2001; Dessein, 2002). This literature argues that delegation leads to a loss of control but helps to exploit decentralized information which might be hard to elicit if the principal keeps authority. To focus on the relation between effort incentives and authority, our analysis abstracts from private information. Yet, as we point out in the concluding remarks, it may be interesting to extend our model to situations in which both incentives for information revelation and effort incentives play a role.
From a different perspective, Melumad and Reichelstein (1987) and...
|
