On the Optimality of Multi-tier Hierarchies: Coordination versus Motivation

We study internal organization of a firm that comprises a CEO and two division managers. The two key ingredients of our model are externalities among divisions' projects that may require coordination and effort incentives for the CEO and the two division managers. Depending on how decision authority over each project is allocated, we compare various organizational structures including centralization, different forms of partial and full delegation, and hierarchical delegation. We identify conditions under which different organizational structures can be Pareto ranked. We also discuss the optimal pattern of hierarchical delegation and offer various examples of organizational restructuring in large corporations that our theory can shed light on. The Author 2011. Published by Oxford University Press on behalf of Yale University. All rights reserved. For Permissions, please email: journals.permissions@oup.com, Oxford University Press.