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Organizational design and private information

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This paper analyzes the role of private information, one agent has about another, on organizational design. The authors compare a two-tier hierarchy where the principal contracts directly with two agents and allocates production centrally, to a three-tier one where the principal exclusively contracts with one agent (prime contractor), and delegates production allocation to this prime contractor, who in turn contracts with the other agent (sub-contractor). Myerson (1982) establishes, under costless communication and contracting, direct revelation mechanism is optimal, which implies the two-tier form dominates the three-tier one. The latter leads to a "control loss" because the prime contractor's incentives and those of the principal differ. The authors show that when the prime contractor has better information (than the principal) about the other agent's production process, the principal's welfare improves. In the limit, when the prime contractor has perfect information about the sub-contractor, the principal is as well off as under a two-tier form. This paper adds to the existing literature studying the tradeoffs between centralization and decentralization.

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