Technical Change, Moral Hazard, and the Decentralization Penalty

We compare two modes of organizing a firm with regard to social welfare. In the centralized mode, worker-control techniques, together with adequate compensation, ensure that the worker chooses a surplus-maximizing effort. In the decentralized mode, a profit-driven principal contracts with a self-interested agent who freely chooses an effort and bears its cost. The resulting loss of surplus is called the decentralization penalty. For certain common contract types, we study how the penalty responds to changes in production technology. As production technology improves, the penalty oscillates in a continuous-rise-sudden-drop cycle. While advances in worker-control technology always strengthen the socialwelfare case for centralization, advances in production technology may do the opposite.