| This paper analyzes the formation of optimal organizational structures. Using mechanism design and contract theory framework, we compare two types of organizational structures: hierarchical and divisional, both of which consist of one principal and two agents. In the hierarchical structure, the two agents are given roles---one is the leader and the other is the subordinate. The leader can monitor effort of the subordinate, but only at a cost. The leader makes a contract with the principal and decides the effort levels of both himself and his subordinate. The hierarchical structure benefits from this mutual monitoring among agents. Conversely, in the divisional structure, both agents contract individually with the principal and decide their own effort levels. The divisional structure can avoid collusive strategies among agents. While both structures are unique, the optimal structure and contract are found by solving this model analytically and numerically with Matlab.;The model has an important state variable, the agent's current utility. This variable is related to outcome in previous periods. The model suggests that when one agent has a higher current utility than another agent, the agent with higher utility level will become the leader if a hierarchical structure is chosen. The thought is that only the leader has a problem of incentive in the hierarchical structure, and the agent with the higher utility level has a less severe incentive problem so he should be made leader. Hierarchical structure is likely to dominate the divisional structure when there is a high level of inequality among the two agents. In a hierarchical structure with high monitoring costs, consumption and the promised utility of the leader will depend on the outcome of the subordinate because the leader will not exert a high monitoring effort if he is not compensated for better outcome of the subordinate. Switching regime is also possible, as the current utility levels of agents change over time. |
