ECOS3003 Tutorial 4 1
Hierarchies, incentives and firm structure ECOS3003
Tutorial 4
1. Describe ways a boss can credibly make a commitment not to meddle too much in the
decision making of a worker. Why would a boss ever want to make such a commitment?
Why? – to encourage an agent to put in effort (by relinquishing real authority a P encourages investment by
A but there is a loss of control)
Ways to credibly commit?
Many agents
Many principals
Repeated game
Too busy/limited time
2. A principal can either legally make a decision herself (P-formal authority) or can decide to assign
the formal right to make a decision to her subordinate (delegation). In each case the party that has
the formal right to decide can make a decision on a new project. If that party is uninformed they will
defer the decision to the other party who will decide if they are informed. The principal’s effort level
of finding a new project is denoted by E; e denotes the subordinate’s effort level. E and e represent
the probability that both the principal and the agent discover a new project. The following table
provides the effort levels of both parties under P-formal authority and delegation.
P-formal authority Delegation
Principal E = 0.7 E = 0.4
Agent e = 0.3 e = 0.8
If the principal’s preferred project is chosen, the principal gets a revenue/benefit of $100. Finally, the
probability that the agent’s preferred project is also preferred by the principal is α = 0.9.
Considering the above example, which statement is true?
a. Delegation of authority maximises the expected revenue of the principal (not considering any costs
of ex ante effort)
b. P-formal authority maximises the expected revenue of the principal (not considering any costs of
ex ante effort)
c. The principal is less likely to delegate authority as α increases.
d. The decision will be decentralised until MB = MC.
e. None of the above
UpF = 0.7(100) + 0.3(0.3)(0.9)100 = 78.1
UpD = 0.2(0.4)(100) + 0.8(0.9)100 = 80
UpF > UpD, hence (a) is the answer
4. Following Aghion and Tirole (or the lecture), write the equations for the principal and the agent
when for P-formal authority. Solve the equations for E and e. Now write down the equations for the
utility functions for each party respectively when the agent has formal authority. Explain how you
get these equations and solve. When is the principal’s effort level higher? What is the intuition for
this result? Under what authority regime does the agent put in more effort and why?
Formal authority
ECOS3003 Tutorial 4 2
(1 ) ( )p PU EB E e B g Eα= + − −
(1 ) ( )A AU Eb E eb g Eβ= + − −
Thus:
d
d
E E
e e
>
<
'(1 ) ( )PB e g E Eα− =  '(1 ) ( )PB e g E Eα− = 
'(1 ) ( )AE b g e e− = 
Delegation
(1 ) ( )dP PU e B e EB g Eα= + − −
(1 ) ( )dA AU eb e E b g Eβ= + − −
Thus
'(1 ) ( ) dPe B g E E− = 
'(1 ) ( ) dAE b g e eβ− = 
Hence dE E> , as being informed is more valuable when have formal authority; further, in equilibrium E
and e are substitutes
Likewise, de e<
5. Aghion and Tirole (1997) argue that the more subordinates a principal has the more real authority
the agents will have or, in other words, the more likely it is that decision making will be delegated.
Meagher and Wait (2004) have found that decision-making rights are more likely to be centralised to
a higher level of management when there is an increase in the number of workplace units
undertaking the same activity. Can the two findings be reconciled? What does this say for the theory
of Aghion and Tirole?
In A&T tasks are independent, meaning that P has less incentive to get involved in any particular agent’s
project. In the data the tasks are not independent. (As the tasks are related, becoming informed in any one
project also helps the P become informed about other projects, effectively increasing the incentive for P to
become informed – thus increasing the real authority of P.)
But this raises a limitation of the model of A&T – when designing an organisation, a P will consider both
the structure (here the allocation of tasks) and incentives, whereas A&T take structure as given (that is, the
tasks are independent).
6. Discuss the costs and benefits of specialised task assignment relative to broad task assignment.
What variables are likely to be particularly important in determining the optimal choice between
alternatives?
ECOS3003 Tutorial 4 3
Benefits: exploiting comparative adv; lowering training costs; relative ease at motivating employees to
perform a narrow set of tasks
Costs: cost complementarities; functional myopia; reduced flexibility; difficulties in measuring output
(overall output might be observed but tasks might be hard to monitor)
Specialised task assignment is likely to be preferred when complementarities are relatively high within a
functional area
7. Evaluate the following statement: “It is best to organise as a matrix organisation. Matrix
organisations combine the best of both worlds – functional excellence and product focus.”
The adv of a matrix organisation is combining functional and product focus. The quote ignores the
downside – intersecting lines of authority. Workers report to both function and product managers – getting
incentive right can be a significant problem.
8. . See the Bagby Copy Company case study on pages 413-414 of the text and answer the three
questions.
a. Trade-off that Bagby faces choosing between specialised or broad task assignment as above – but not
that providing incentives important element (if tester can identify that wire harness is defective, but cannot
tell which one is problem, broad assignment might be preferred).
b. Tradeoffs between two methods of grouping wire harness makers into subgroups. Benefits: increased
coordination and communication of employees producing wire harnesses; econ of scale; promotion path
well defined. Problems: emphasis on function rather than total product/output.
Subgroup under control of individual copier manager: increased communication and coordination across
function.
c. Country groupings: enhances specific knowledge use; cost not having better coordination and
information sharing within a product line across country borders
Organising around products – increased coordination around products (information)
Matrix – capitalised on country and product groupings. Problems: overlapping lines of authority and this
can generate incentive problems
9. Question 13-6 on page 418 of the text.
Advantages of Chrysler: single focus – output (customer); better communication among team members;
might result in faster turn-around times (seems to). Disadv – less technical expertise; potential free rider
problems; less career progression
Adv of GM – greater functional expertise brought to bear to any problem (several experts from each
functional area cooperate); better control of free rider problem. Disadv – less communication across
function; functional rather than customer focus; potential conflicts from inter-connecting lines of authority
(are the incentives of individuals on the cross-functional teams aligned with their functional departments or
with these teams?)
In short – trade off between technical expertise of GM with better functional coordination of Chrysler form
ECOS3003 Tutorial 4 4
10. Question 13-7 on page 418 of the text..
a. Country-specific knowledge about tastes laws etc is often important. J&J organisation structure assigns
decision rights to individuals with this knowledge. Performance evaluation and compensation can be based
on country-unit performance to provide appropriate incentives to use this information
b. the organisational structure probably needs to be changed to give regional product managers more power
(cutting across countries). As trade increases, it becomes more important to coordinate advertising, pricing,
marketing etc. Also multi-national customers are going to want to deal with one company contact, not one
for each country. But, country-specific knowledge could still be important – one option in matrix
organisation with overlapping authority between country and product managers – it is important to consider
reinforcing changes in the performance evaluation and rewards systems.