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A double moral hazard model of organization design
Elazar Berkovitch, IDC Herzliya
Ronen Israel, IDC Herzliya
Yossi Spiegel, GSB Tel Aviv University
A double moral hazard model of organization design
2
Introduction We develop a model in which the organization structure is
chosen to mitigate MH problems in: The selection of projects (managerial MH) The implementation of projects (MH in teams)
We consider a firm with 2 agents, 2 projects, and 2 tasks (Multi)divisional structure (M-form): each agent gets a full
responsibility for one project and performs both tasks on this project
(Unitary) functional structure (U-form): each agent specializes in one task and performs it on both projects
The main idea: DIV is more efficient ex post but also more susceptible to
managerial MH problem in projects’ selection The optimal organizational structure trades off ex post
efficiency and managerial MH
A double moral hazard model of organization design
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The organizational structure
manager
Division 1 Division 2
p2 m2p1 m1
manager
Departmentp
m1 m2p1 p2
Departmentm
Divisional structure Functional structure
A double moral hazard model of organization design
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Related literature Chandler (1962): "Structure follows strategy:" as firms grow and
adopted more diverse product lines, the difficulties in coordinating functions across different product lines induces a switch from U-form to the M-form
Williamson (1970, 1975): Diversified firms must follow the M-form to alleviate communication overload
Aghion and Tirole (EER, 1995): Under the U-form agents specialize, so the firm saves on training cost. However, the M-form enables agents to better signal their ability to the external job market and therefore strengthens their incentives to exert effort
Rotemberg (JEMS, 1999): Under the U-form agents who perform similar tasks are grouped together so the firm gains more info. about the optimal way to perform tasks. Under the M-form, agents who work on different tasks are grouped together so the firm can better coordinate different tasks with each other.
A double moral hazard model of organization design
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More related literature Qian, Roland, and Xu (2006): The U-form allows coordination between tasks on a company-
wide basis so there is a need for fewer managers to coordinate tasks. The M-form saves on costly cross-division communication
Maskin, Qian, and Xu (RES, 2000): The U-form exploits economies of scale by grouping similar tasks in the same division, but the M-form provides better incentives by promoting yardstick competition between different self-contained divisions
Besanko, Régibeau, and Rockett (2005): Under the U-form, compensation can be tied directly to the agents’ performance. Under the M-form, compensation is tied to additional profitability measures and hence it is more costly to motivate risk-averse agents. This result however may be reversed if there are asymmetries in the effect of tasks on profits, or significant positive externalities across tasks
Corts (2007): Under “individual accountability” (akin to the M-form) agents are compensated on the basis of (noisy) performance measures that depend only on their own efforts. Under “teams” (akin to the U-form), compensation is based on (noisy) performance measures which depend on the agents' joint effort. Hence, agents bear more risk under teams but on the other hand are rewarded on the basis of more performance measures
Harris and Raviv (2002): Under the U-form the firm hires 2 middle managers, each coordinates two similar tasks. Under the M-form, each middle manager coordinates two different tasks. Which is better depends on the likelihood of various cross task interactions and on the CEO’s opportunity cost of coordinating company-wide interactions.
A double moral hazard model of organization design
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The model The firm has a three-level hierarchy:
A manager - screens projects and recommends them to the board of directors
Board of directors – approves/rejects the manager’s recommendations
Two agents (middle managers, business units, or simply employees) – implement projects
If the board rejects the manager's selection, the game ends and all agents get a payoff of 0
A double moral hazard model of organization design
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Projects
All projects yield R if they succeed and 0 o/w H-type projects can always be discovered and require
an initial investment I < R L-type projects are discovered with prob. and
require 0 investment
The manager can conceal L-type projects When the manager recommends H-type projects the board does not know if he did or did not discover L-type projects
measures the importance of managerial ability or the importance of managerial MH
A double moral hazard model of organization design
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Preferences The board of directors is a perfect agent for outside investors and
hence prefers L-type projects
The manager prefers H-type projects: The manager likes to manage expensive projects (“empire building”) H-type projects enhance the manager's general human capital whereas
L-type projects only contribute to his firm-specific human capital L-type projects are “traditional,” whereas H-type projects are more
“innovative” and the manager likes “cutting edge” technologies The manager is emotionally attached to H-type projects
Monetary incentive are insufficient to induce the manager to recommend L-type projects the manager’s wage is a constant which we normalize to 0
The manager will recommend 2 H-type projects if he expects that the board of directors will approve them. O/w he will recommend L-type projects (if he discovers them)
A double moral hazard model of organization design
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Projects' implementation The 2 agents need to perform 2 tasks on each project to
enhance their chances to succeed
For concreteness, we refer to the tasks as production (p) and marketing (m)
Each agent can perform at most 2 tasks the firm can at most adopt 2 projects
The prob. that a project succeeds is
mpmp eeeeq ,
A double moral hazard model of organization design
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Divisional structure Each project is assigned to one agent who performs
both tasks on that project The firm has 2 divisions, each is fully responsible for
one project Agent j's cost of implementing its project:
≥ 1, and ρ (-1, 1) measures the complementarily between tasks p and m 0 < ρ < 1 - the joint production of the two task
exhibits economies of scope -1 < ρ < 0 - there are diseconomies of scope
,ee
eeeeCmjpj
mjpjmjpjd
2, 22
A double moral hazard model of organization design
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Functional structure Each agent specializes in one task and performs it on
both projects The two agents are “production department” and
“marketing department” Agent i’s cost when performing task i on projects 1 and 2
(-1, 1) measures economies of scale 0 < < 1 - economies of scale -1 < < 0 - diseconomies of scale
,ee
e+eeeC iiiiii
f
2, 212
22121
A double moral hazard model of organization design
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The timing
The manager recommends 2 projects to the board of directors
The board accepts or rejects If no projects are recommended, the
game ends If the board accepts the manager's
recommendation, it signs incentive contracts with the two agents
The agents implement the selected projects and payoffs are realized
A double moral hazard model of organization design
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Expected profits
Solving the contracting problems, the expected profits per project, gross of the cost of investment, are:
Divisional:
Functional:
d > f due to MH in teams
4
2Rd
42
2Rf
A double moral hazard model of organization design
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The optimal structure
I
f d
Divisional
Functional
H-typeL-typeprob. H-type
L-typeprob.
DivisionalDivisional
A double moral hazard model of organization design
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Implications Suppose that f I d. All else equal,
the functional structure is optimal for a wider set of parameters as
I (H-type projects are more costly) - ex ante considerations are more important
R (firms operate in more competitive environment) – ex post considerations are less important
ρ (there are weaker economies of scope) σ (there are stronger economics of scale)
A double moral hazard model of organization design
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Implications
Relative to firms with a functional structure, firms with a divisional structure:
have less restrictive standards for project evaluation (approve H-type projects even if f I d)
adopt more projects than firms (under the functional structure the prob. of adopting projects is )
have projects that are more likely to succeed (qd > qf) pay a higher expected compensation to their agents
(qd wd > qfwf)
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Suppose that for each firm, R is drawn from some distribution function h(R)
The functional structure is optimal iff f I d and > (d–I)/f, or z0 ≤ R ≤ z1, where
Relative to firms with the functional structure, firms with a divisional structure: may or may not have higher expected net returns than firms with a
functional structure - consistent with Mahajan, Sharma, and Bettis (1988)
have projects with a smaller variance of gross returns
Implications
I
I
I=zI=z
42,
4241
min4 10
A double moral hazard model of organization design
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Discussion The firm may wish to choose an ex post inefficient functional
structure in order to mitigate the manager's incentive to recommend H-type projects
The idea that firms adopt ex post inefficient actions to provide incentives ex ante is not new: Debt may lead to costly bankruptcy ex post but may mitigate
managerial MH ex ante (e.g., Grossman and Hart, 1982) Borrowing from 2 creditors may lead to inefficient monitoring activity
and may prevent refinancing ex post but may improve projects' selection ex ante (Dewatripont and Maskin, 1995)
Can the firm achieve this goal by other means? Threaten to fire the manager if he recommends H-type projects Hire two managers to screen projects and use yardstick competition to induce
them to recommend L-type projects Distort the agents' compensation such that they will implement H-type projects
inefficiently
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Size effect Suppose that each agent can complete 2n tasks,
where n is a positive integer the firm can adopt 2n projects Divisional structure: the firm will assign n projects to
each agent who will perform tasks p and m on these n projects
Functional structure: each agent will specialize in one task and will perform it on all 2n projects
With prob. there are at least 2n L-type projects and with probability 1- , there are no L-type projects
Since each agent needs to perform tasks p and m on n > 1 projects, Cd is affected by both econ. of scope and econ. of scale
A double moral hazard model of organization design
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Size effect - n ( > 0)
I
f d
Divisional
Functional
H-typeL-typeprob. H-type
L-typeprob.
DivisionalDivisional
n means that econ. of scale are more significant
A double moral hazard model of organization design
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Complexity effect Suppose that each project requires 2k tasks, where k is a positive
integer To ensure that the firm can adopt exactly two projects, we will also
assume that there are 2k agents, who can perform two tasks each To ensure that the prob. of success does not increase simply due
to the increase in k
Under the divisional structure, the firm will establish two divisions and will assign each division the full responsibility over one project Now there are k > 1 agents in each division, so there is MH in teams
even under the divisional structure Unlike the functional structure, here each agent performs two different
tasks on the same project, whereas under the functional structure, each agent performs the same task on two different projects
Under the functional structure, each of the 2k agents specializes in a single task and performs it on the two projects
k
ijk e
keeq
2
121
1,,
A double moral hazard model of organization design
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Complexity effect - k
I
f d
Divisional
Functional
H-typeL-typeprob. H-type
L-typeprob.
DivisionalDivisional
k means that MH in teams is more severe
A double moral hazard model of organization design
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Cross-task asymmetries Suppose that task m has a bigger influence on the likelihood
of success than task p:
Divisional structure: h induces each agent to shift effort from task p to task m Shifting effort from m to p has a first order effect on the prob.
of success but second order effect on the cost of effort
Functional structure: since h > 1, it is more efficient to pay agent m an extra dollar at the expense of agent p; the firm will effectively shut down department p The firm only operates the m department whose marginal
productivity is increasing with h
1
1
2,
hh
heeeeq mpmp
A double moral hazard model of organization design
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Cross-task asymmetries h
I
f d
Divisional
Functional
H-typeL-typeprob. H-type
L-typeprob.
DivisionalDivisional
only if I is sufficiently large
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Narrow business strategies (NBS) Adopt a strategy that imposes a technological constraint
that prevents the firm from implementing H-type projects Advantage: the firm can mitigate managerial MH without
adopting an ex post inefficient organizational structure Disadvantage: the firm forgoes H-type projects even if they are
profitable and even if there are no L-type projects around
Suppose that with prob. μ, H-type projects require an initial investment I1 and with prob. 1-μ they require an initial investment I2, where I1 < f < I2 < d
I = I1: managerial MH under both organizational structures I = I2: managerial MH only under the divisional structure (the
board of directors rejects H-type projects)
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Expected payoffs under NBS Under NBS, the firm focuses exclusively on L-type
projects
The firm might as well adopt the ex post efficient divisional structure and implement L-type projects efficiently
L-type projects are available only with prob. .
The expected per-project profit of the firm under NBS:
dN =O
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Expected payoffs without NBS Under the divisional structure, the firm will
always have H-type projects:
Under the functional structure, the firm will have H-type projects with prob. and L-type projects with prob. (1-):
21 1 II=O dd
fff I=O 11
A double moral hazard model of organization design
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When is NBS desirable?
I1=1, I2=8, R=3, =0.5, =0, =0.4.
ON-Od
ON-Of
Of-Od ON with Of with
NBS
Funct.
Divisional
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When is NBS optimal?
is high (info. MH is “important”)
is small (H-type projects are not “that bad”)
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Conclusion The organizational structure of the firm is chosen by
trading off ex post efficiency against mitigating managerial MH
The divisional structure is more efficient ex post but more susceptible to managerial MH
The functional structure may overcome managerial MH
Adopting NBS and focusing exclusively on L-type projects could be profitable only when managerial skills are important and the managerial MH problem is severe