Authority and Incentives in Organizations

• Published date: 01 April 2017
• Author: Matthias Kräkel
• DOI: http://doi.org/10.1111/sjoe.12172
• Date: 01 April 2017

Scand. J. of Economics 119(2), 295–311, 2017

DOI: 10.1111/sjoe.12172

Authority and Incentives in Organizations∗

Matthias Kr¨

akel

University of Bonn, DE-53113 Bonn, Germany

Abstract

I consider a corporation that consists of an owner, a manager, and two divisions. There

exist externalities between the divisions: if a division behaves cooperatively, its success

will increase the performance of the other division. The owner creates monetary effort

incentives and allocates decision authority over the divisions. I characterize how externalities

and benefits of control determine the corporation’s optimal organization. The introduction

of endogenous incentives changes the major findings of the existing literature, because then

concentrated delegation of authority over both divisions to one of the division heads will be

optimal if cooperation is important and divisions are difficult to incentivize.

Keywords: Centralization; contracts; decentralization; moral hazard

JEL classification:D21; D23; D86; L22

I. Introduction

Large corporations are usually organized as hierarchies and controlled by a

top manager (e.g., the CEO), who determines the strategy and exerts effort

that influences the performance of all organizational units at the lower

hierarchy levels. The major question then is how shall authority rights be

allocated between the manager and the organizational units to create the

best organizational structure? In this paper, I answer the question from an

incentive perspective.

In practice, strong cooperation between the different organizational units

is often crucial for the success of corporations.1For example, at the former

General Electric Co. small electric motors were produced by one organiza-

tional unit and transferred to other units that used the motors to produce

home appliances. Nowadays, General Electric is a conglomerate with inde-

pendent divisions, on the one hand, but also complementarities within single

divisions, on the other. Hewlett Packard consists of several largely indepen-

dent divisions, but because of strong technological interdependences among

its products it has to coordinate production and R&D activities. Likewise,

∗I would like to thank two anonymous referees, and the participants of the XIV Annual

Conference of the German Economic Association of Business Administration (GEABA), in

particular Christian Lukas, for helpful comments.

1The following examples refer to US corporations. However, similar observations also hold

for large corporations outside the US.

CThe editors of The Scandinavian Journal of Economics 2015.

296 Authority and incentives in organizations

Argyres (1995) refers to General Motors and IBM as prominent examples

of corporations that apply systems technologies, that is, technologies “for

which modification in one component requires significant adjustment in

other components, so that design coordination is necessary for innovation

at the systems level” (Argyres, 1995, p. 338).

The examples indicate that the divisions’ activities have to be coordi-

nated via the allocation of formal authority rights because otherwise the

whole organization runs the risk of a breakdown. There exists a wide spec-

trum of possible allocations of authority between the two polar cases of

decentralization and centralization. Under decentralization, each division

head receives authority over their own division, whereas under central-

ization the manager at the highest hierarchy level has authority over all

divisions. Prominent examples for these polar cases and their respective

success or failure are reported by Argyres (1995). He compares IBM and

General Motors, both facing coordination problems due to strong techno-

logical interdependences between their divisions. Argyres points out that

IBM successfully adopted a centralized organizational structure, although

this strategy led to distorted incentives. General Motors, on the contrary,

chose decentralization and failed. These findings are quite intuitive. They

show that decentralization might be beneficial for incentive reasons be-

cause divisions can be separately managed as profit centers, but for the

coordination of a firm’s activities, centralization is more appropriate.2

The design of organizational structure via allocation of authority typi-

cally triggers the behavior of the authorized decision maker (i.e., toward

either more selfish or more cooperative actions). In the case of decen-

tralization, each division head tends to selfishly focus on own division

profits. In the case of centralization, however, the manager at the top of

the hierarchy naturally cares greatly about cooperation between the divi-

sions. Decentralized General Motors and centralized IBM again offer good

examples for these behavioral patterns. As Argyres (1995) reports, no co-

operation took place between the division heads at General Motors, who

ignored possible synergies and made their procurement and applications

engineering decisions independently to minimize own costs. At IBM, how-

ever, potential intervention of corporate management made the divisions

behave cooperatively. For example, the Personal Systems Division volun-

tarily invested considerable time to achieve compatibility of its software

projects with other IBM projects, although this investment led to a delay

in completing own projects.

In this paper, I consider a stylized hierarchy with four players: the owner

of the corporation, who chooses optimal incentive contracts for the three

2See also the cases of Eastman Kodak and McKinsey, considered by Brickley et al. (2014,

chapter 9).

CThe editors of The Scandinavian Journal of Economics 2015.