A double moral hazard model of organization design

1. A double moral hazard model of organization design Elazar Berkovitch, IDC Herzliya Ronen Israel, IDC HerzliyaYossi Spiegel, GSB Tel Aviv University

2. Introduction • We develop a model in which the organization structure is chosen to mitigate MH problems in: • The selection of projects (managerial MH) • The implementation of projects (MH in teams) • We consider a firm with 2 agents, 2 projects, and 2 tasks • (Multi)divisional structure (M-form): each agent gets a full responsibility for one project and performs both tasks on this project • (Unitary) functional structure (U-form): each agent specializes in one task and performs it on both projects • The main idea: • DIV is more efficient ex post but also more susceptible to managerial MH problem in projects’ selection • The optimal organizational structure trades off ex post efficiency and managerial MH A double moral hazard model of organization design

3. The organizational structure Functional structure Divisional structure manager manager Division 1 Division 2 Department p Department m p1 m1 p2 m2 p1 p2 m1 m2 A double moral hazard model of organization design

4. Related literature • Chandler (1962): "Structure follows strategy:" as firms grow and adopted more diverse product lines, the difficulties in coordinating functions across different product lines induces a switch from U-form to the M-form • Williamson (1970, 1975): Diversified firms must follow the M-form to alleviate communication overload • Aghion and Tirole (EER, 1995): Under the U-form agents specialize, so the firm saves on training cost. However, the M-form enables agents to better signal their ability to the external job market and therefore strengthens their incentives to exert effort • Rotemberg (JEMS, 1999): Under the U-form agents who perform similar tasks are grouped together so the firm gains more info. about the optimal way to perform tasks. Under the M-form, agents who work on different tasks are grouped together so the firm can better coordinate different tasks with each other. A double moral hazard model of organization design

5. More related literature • Qian, Roland, and Xu (2006): The U-form allows coordination between tasks on a company-wide basis so there is a need for fewer managers to coordinate tasks. The M-form saves on costly cross-division communication • Maskin, Qian, and Xu (RES, 2000): The U-form exploits economies of scale by grouping similar tasks in the same division, but the M-form provides better incentives by promoting yardstick competition between different self-contained divisions • Besanko, Régibeau, and Rockett (2005): Under the U-form, compensation can be tied directly to the agents’ performance. Under the M-form, compensation is tied to additional profitability measures and hence it is more costly to motivate risk-averse agents. This result however may be reversed if there are asymmetries in the effect of tasks on profits, or significant positive externalities across tasks • Corts (2007): Under “individual accountability” (akin to the M-form) agents are compensated on the basis of (noisy) performance measures that depend only on their own efforts. Under “teams” (akin to the U-form), compensation is based on (noisy) performance measures which depend on the agents' joint effort. Hence, agents bear more risk under teams but on the other hand are rewarded on the basis of more performance measures • Harris and Raviv (2002): Under the U-form the firm hires 2 middle managers, each coordinates two similar tasks. Under the M-form, each middle manager coordinates two different tasks. Which is better depends on the likelihood of various cross task interactions and on the CEO’s opportunity cost of coordinating company-wide interactions. A double moral hazard model of organization design

6. The model • The firm has a three-level hierarchy: • A manager - screens projects and recommends them to the board of directors • Board of directors – approves/rejects the manager’s recommendations • Two agents (middle managers, business units, or simply employees) – implement projects • If the board rejects the manager's selection, the game ends and all agents get a payoff of 0 A double moral hazard model of organization design

7. Projects • All projects yield R if they succeed and 0 o/w • H-type projects can always be discovered and require an initial investment I < R • L-type projects are discovered with prob. a and require 0 investment • The manager can conceal L-type projects  When the manager recommends H-type projects the board does not know if he did or did not discover L-type projects • a measures the importance of managerial ability or the importance of managerial MH A double moral hazard model of organization design

8. Preferences • The board of directors is a perfect agent for outside investors and hence prefers L-type projects • The manager prefers H-type projects: • The manager likes to manage expensive projects (“empire building”) • H-type projects enhance the manager's general human capital whereas L-type projects only contribute to his firm-specific human capital • L-type projects are “traditional,” whereas H-type projects are more “innovative” and the manager likes “cutting edge” technologies • The manager is emotionally attached to H-type projects • Monetary incentive are insufficient to induce the manager to recommend L-type projects  the manager’s wage is a constant which we normalize to 0 • The manager will recommend 2 H-type projects if he expects that the board of directors will approve them. O/w he will recommend L-type projects (if he discovers them) A double moral hazard model of organization design

9. Projects' implementation • The 2 agents need to perform 2 tasks on each project to enhance their chances to succeed • For concreteness, we refer to the tasks as production (p) and marketing (m) • Each agent can perform at most 2 tasks  the firm can at most adopt 2 projects • The prob. that a project succeeds is A double moral hazard model of organization design

10. Divisional structure • Each project is assigned to one agent who performs both tasks on that project • The firm has 2 divisions, each is fully responsible for one project • Agent j's cost of implementing its project: • g ≥ 1, and ρ  (-1, 1) measures the complementarily between tasks p and m • 0 < ρ < 1 - the joint production of the two task exhibits economies of scope • -1 < ρ < 0 - there are diseconomies of scope A double moral hazard model of organization design

11. Functional structure • Each agent specializes in one task and performs it on both projects • The two agents are “production department” and “marketing department” • Agent i’s cost when performing task i on projects 1 and 2 • s (-1, 1) measures economies of scale • 0 < s < 1 - economies of scale • -1 < s < 0 - diseconomies of scale A double moral hazard model of organization design

12. The timing • The manager recommends 2 projects to the board of directors • The board accepts or rejects • If no projects are recommended, the game ends • If the board accepts the manager's recommendation, it signs incentive contracts with the two agents • The agents implement the selected projects and payoffs are realized A double moral hazard model of organization design

13. Contracting under the divisional structure A double moral hazard model of organization design

14. Contracting under the functional structure A double moral hazard model of organization design

15. Expected profits • Solving the contracting problems, the expected profits per project, gross of the cost of investment, are: • Divisional: • Functional: • pd > pf due to MH in teams A double moral hazard model of organization design

16. The optimal structure a 1 Functional L-type prob. a Divisional Divisional Divisional L-type prob. a H-type H-type I pf pd A double moral hazard model of organization design

17. Implications • Suppose that pf I pd. All else equal, the functional structure is optimal for a wider set of parameters as • I (H-type projects are more costly) - ex ante considerations are more important • R (firms operate in more competitive environment) – ex post considerations are less important • ρ (there are weaker economies of scope) • σ (there are stronger economics of scale) A double moral hazard model of organization design

18. Implications • Relative to firms with a functional structure, firms with a divisional structure: • have less restrictive standards for project evaluation (approve H-type projects even if pf I pd) • adopt more projects than firms (under the functional structure the prob. of adopting projects is a) • have projects that are more likely to succeed (qd > qf) • pay a higher expected compensation to their agents (qd wd > qfwf) A double moral hazard model of organization design

19. Implications • Suppose that for each firm, R is drawn from some distribution function h(R) • The functional structure is optimal iff pf I pd and a > (pd–I)/pf, or z0 ≤ R ≤ z1, where • Relative to firms with the functional structure, firms with a divisional structure: • may or may not have higher expected net returns than firms with a functional structure - consistent with Mahajan, Sharma, and Bettis (1988) • have projects with a smaller variance of gross returns A double moral hazard model of organization design

20. Discussion • The firm may wish to choose an ex post inefficient functional structure in order to mitigate the manager's incentive to recommend H-type projects • The idea that firms adopt ex post inefficient actions to provide incentives ex ante is not new: • Debt may lead to costly bankruptcy ex post but may mitigate managerial MH ex ante (e.g., Grossman and Hart, 1982) • Borrowing from 2 creditors may lead to inefficient monitoring activity and may prevent refinancing ex post but may improve projects' selection ex ante (Dewatripont and Maskin, 1995) • Can the firm achieve this goal by other means? • Threaten to fire the manager if he recommends H-type projects • Hire two managers to screen projects and use yardstick competition to induce them to recommend L-type projects • Distort the agents' compensation such that they will implement H-type projects inefficiently A double moral hazard model of organization design

21. Size effect • Suppose that each agent can complete 2n tasks, where n is a positive integer  the firm can adopt 2n projects • Divisional structure: the firm will assign n projects to each agent who will perform tasks p and m on these n projects • Functional structure: each agent will specialize in one task and will perform it on all 2n projects • With prob. a there are at least 2n L-type projects and with probability 1- a, there are no L-type projects • Since each agent needs to perform tasks p and m on n > 1 projects, Cd is affected by both econ. of scope and econ. of scale A double moral hazard model of organization design

22. a 1 Functional L-type prob. a Divisional Divisional Divisional L-type prob. a H-type H-type I pf pd Size effect - n (s > 0) • n means that econ. of scale are more significant A double moral hazard model of organization design

23. Complexity effect • Suppose that each project requires 2k tasks, where k is a positive integer • To ensure that the firm can adopt exactly two projects, we will also assume that there are 2k agents, who can perform two tasks each • To ensure that the prob. of success does not increase simply due to the increase in k • Under the divisional structure, the firm will establish two divisions and will assign each division the full responsibility over one project • Now there are k > 1 agents in each division, so there is MH in teams even under the divisional structure • Unlike the functional structure, here each agent performs two different tasks on the same project, whereas under the functional structure, each agent performs the same task on two different projects • Under the functional structure, each of the 2k agents specializes in a single task and performs it on the two projects A double moral hazard model of organization design

24. a 1 Functional L-type prob. a Divisional Divisional Divisional L-type prob. a H-type H-type I pf pd Complexity effect - k • k means that MH in teams is more severe A double moral hazard model of organization design

25. Cross-task asymmetries • Suppose that task m has a bigger influence on the likelihood of success than task p: • Divisional structure: h induces each agent to shift effort from task p to task m • Shifting effort from m to p has a first order effect on the prob. of success but second order effect on the cost of effort • Functional structure: since h > 1, it is more efficient to pay agent m an extra dollar at the expense of agent p; the firm will effectively shut down department p • The firm only operates the m department whose marginal productivity is increasing with h A double moral hazard model of organization design

26. a 1 Functional L-type prob. a Divisional Divisional Divisional L-type prob. a H-type H-type I pf pd Cross-task asymmetries h •  only if I is sufficiently large A double moral hazard model of organization design

27. Narrow business strategies (NBS) • Adopt a strategy that imposes a technological constraint that prevents the firm from implementing H-type projects • Advantage: the firm can mitigate managerial MH without adopting an ex post inefficient organizational structure • Disadvantage: the firm forgoes H-type projects even if they are profitable and even if there are no L-type projects around • Suppose that with prob. μ, H-type projects require an initial investment I1 and with prob. 1-μ they require an initial investment I2, where I1 < pf < I2 < pd • I = I1: managerial MH under both organizational structures • I = I2: managerial MH only under the divisional structure (the board of directors rejects H-type projects) A double moral hazard model of organization design

28. Expected payoffs under NBS • Under NBS, the firm focuses exclusively on L-type projects • The firm might as well adopt the ex post efficient divisional structure and implement L-type projects efficiently • L-type projects are available only with prob. a. • The expected per-project profit of the firm under NBS: A double moral hazard model of organization design

29. Expected payoffs without NBS • Under the divisional structure, the firm will always have H-type projects: • Under the functional structure, the firm will have H-type projects with prob. m and L-type projects with prob. (1-m)a: A double moral hazard model of organization design

30. When is NBS desirable? • I1=1, I2=8, R=3, g=0.5, r=0, s=0.4. a ON  with a Of with a Of-Od 1 ON-Od NBS ON-Of Funct. Divisional 1 m A double moral hazard model of organization design

31. When is NBS optimal? • a is high (info. MH is “important”) • mis small (H-type projects are not “that bad”) A double moral hazard model of organization design

32. Conclusion • The organizational structure of the firm is chosen by trading off ex post efficiency against mitigating managerial MH • The divisional structure is more efficient ex post but more susceptible to managerial MH • The functional structure may overcome managerial MH • Adopting NBS and focusing exclusively on L-type projects could be profitable only when managerial skills are important and the managerial MH problem is severe A double moral hazard model of organization design