Hierarchic Contracting

We analyze the contracting structure in a moral hazard setting with several agents whereoutput is produced jointly and is the only contractible variable. Since the salary of each agentis a function of all agents efforts, a positive externality arises between them. This externalityis not internalised by a centralised structure where the principal contracts directly with eachagent. Instead, we find that a hierarchic structure (i.e. the delegation of quot;contracting rightsquot;from the principal to the agents) internalises the externality by making agents quot;residualclaimantsquot;. Consequently, the second best situation can be improved upon just by changingthe contracting structure of the principal-agents relationship. The analysis is relevant to theliterature on decentralisation, outsourcing, subcontracting and intra-firm organization