Organizational Design, Project Selection, and Incentives

This paper compares benefits and costs related to hierarchical and decentralized organizations in an agency framework. We show that the relative efficiency of hierarchy diminishes in contexts with asymmetric information. When effort is not observable, performance-related pay is required in order to encourage the agent to work hard. With risk-averse agents the use of this incentive system is more costly under hierarchy rather than under decentralization, in that a higher wage is necessary to elicit effort. From the efficiency comparison of hierarchy and delegation, a trade-off emerges between the advantages deriving from the principal's screening activity and the higher agency costs that this induces.