“Delegated Contracting and Corporate Hierarchies Corporate Hierarchies” by Chongwoo CHOE
University of New South Wales
University of Pittsburgh
In a typical corporate hierarchy, the manager is delegated the authority to make decisions that set directions for the organization, employ subordinates and contract with external suppliers. This paper explains when such delegation of authority is optimal, using a model of a firm with three parties: the principal, the manager and the worker. In centralization with two two-tier hierarchies, the principal designs contracts for both agents. In delegation with a three-tier hierarchy, the principal directly contracts with a delegated agent who, in turn, contracts with the other agent. We identify an environment where the principal can benefit from delegating authority to the manager, but not to the worker. Beneficial delegation arises endogenously when delegation motivates the manager to acquire valuable information, which is used for better decisions-making and more efficient incentive provision to the worker. We also show how total surplus is distributed in delegation vis-a-vis centralization, document comparative statics when delegation is more likely to dominate centralization.