Technical Change, Moral Hazard, and the Decentralization Penalty

We consider two modes of organizing a firm and we compare them with regard tosocial welfare. In the Centralized mode, worker-control techniques, together with adequate compensation, insure that the worker chooses a welfare-maximizing effort. In the Decentralized mode the worker is not controlled. Instead a profit-driven Principal contracts with a self-interested Agent (worker) who freely chooses an effort and bears its cost. The Principal rewards the Agent once she sees the revenue generated by the Agent's hidden choice. The loss of surplus when the Principal induces her favorite effort is called the Decentralization Penalty. For certain common contract types, we study the behavior of the Penalty in response to changes in production technology. We find that as production technology improves, the Penalty oscillates. It follows a continuous-rise-sudden-change cycle. Under reasonable assumptions on costs and expected revenues, the sudden change must be a drop. While advances in worker-control technology always strengthen the social-welfare case for the Centralized mode, advances in production technology may do the opposite