Incomplete contract, bargaining and optimal divisional structure

When complete contracting is not possible, allocating control structure becomes the second-best arrangement. This paper analyzes the design of optimal divisional structure within an organization where ex post bargaining between the potential divisional managers is possible. In much the same light as Aghion and Tirole (J Political Econ 105(1):1–29, <CitationRef CitationID="CR1">1997</CitationRef>), we study the control problem in the context of search for projects. Our model shows that when the managers cannot bargain with one another, internal integration is preferred to internal separation. Where bargaining is possible, formal divisional structure defines both the ex post bargaining position of the two managers and their incentive to search ex ante. When the managers tend to arrive at a more favorable project to the principal via bargaining, the general leader of a firm may want to choose separation instead to increase the probability of bargaining, as the symmetrical incentive requires both managers to search and get informed. Copyright The Author(s) 2012