Organizational Design and Environmental Volatility

Transcription

1 USC FBE APPLIED ECONOMICS WORKSHOP presented by Hekk Rantakar FRIDAY, Nov. 7, 28 :3 pm - 3: pm, Room: HOH-32 Oranzatonal Desn and Envronmental Volatlty Hekk Rantakar Unversty of Southern Calforna Marshall School of Busness Ths Verson: October 28, 28 Abstract I nvestate the mpact of envronmental volatlty and the cost of nformaton on the preferred oranzatonal structure, as determned by the allocaton of decson rhts, the compensaton structure of the manaers and the deree of operatonal nteraton, such as the use of shared dstrbuton and marketn channels across the operatn dvsons. The results are broadly consstent wth the common wsdom reardn the t between oranzatonal desn and the envronment, wth stable envronments enerally populated by thtly nterated and centralzed oranzatons and volatle envronments populated by loosely nterated and decentralzed oranzatons. The relatonshp between decentralzaton and volatlty s, however, re ned n two ways. Frst, the equlbrum relatonshp between decentralzaton and volatlty can be non-monotone, wth decentralzaton arsn as the preferred overnance structure n both hhly stable and hhly volatle envronments. Second, even f decentralzaton and volatlty are enerally postvely assocated n equlbrum, smply decentralzn decson-makn as a response to an ncrease n volatlty wll actually worsen oranzatonal performance unless the other desn parameters are also adjusted approprately. Contact: rantakarmarshall.usc.edu. Prelmnary and ncomplete. Ths paper s a heavly revsed verson of Chapter 2 of my Ph.D. Dssertaton. I would lke to thank my advsors Robert Gbbons and Bent Holmström for many helpful dscussons and contnuous encouraement. The paper has also bene ted from comments by Tony Marno, Rcardo Alonso, the partcpants of ES- SET28, ESAM8, 27 SITE Summer Workshop, and the semnar partcpants at the Unversty of Calforna, San Deo, the Unversty of Mchan, Stanford Unversty and Duke Unversty. All remann errors are my own.

2 Achevn hh performance n a busness results from establshn and mantann a t amon three elements: the stratey of the rm, ts oranzatonal desn, and the envronment n whch t operates. (Roberts, 24:2) Introducton The need for a t amon a rm s stratey, structure and ts operatn envronment has been extensvely dscussed by manaement and stratey scholars at least snce Chandler s Stratey and Structure (962). A queston that has receved partcular attenton s how rms can reoranze ther operatons to reman compettve n ncreasnly turbulent markets. Buldn on ths lterature, ths paper analyzes from an aency-theoretc perspectve how envronmental volatlty and the cost of nformaton about the envronment n uence the stratec orentaton of a rm and the resultn choce of ts oranzatonal structure. The dmenson of stratey that I consder s the choce between (local) responsveness and (lobal) e cency. In short, a rm can enerate value both throuh customzn ts products and ther marketn to meet varyn and chann local tastes (ncreasn customer value) and throuh lare-scale manufacturn and standardzaton (reducn producton costs). The resultn stratec challene faced by all rms s ndn the rht balance between the two. As observed by Porter (996:): "Smultaneous mprovement of cost and d erentaton s possble only when a company bens far behnd the productvty fronter or when the fronter shfts outward. At the fronter, where companes have acheved current best practce, the trade-o between cost and d erentaton s very real ndeed." To mplement ts stratey, the rm chooses ts structure, whch I take to consst of three desn parameters: the allocaton of decson rhts nsde the oranzatonal herarchy, the compensaton structure of the manaers and the level of operatonal nteraton, such as the use of shared dstrbuton and marketn channels amon the operatn dvsons. The level of operatonal nteraton re ects the level of nterdependence across the operatn unts and drectly n uences the rm s ablty to realze value throuh responsveness and e cency. For example, usn shared components or undertakn coordnated product development (ncreases n operatonal nteraton) can help to realze cost savns and syneres. To realze these bene ts, however, the behavor of the operatn unts needs to be ncreasnly coor- Ths partcular termnoloy s most common n the lterature on multnatonal corporatons. See, for example, Bartlett (986), Prahalad and Doz (987) and Bartlett and Ghoshal (989). However, the basc tradeo s also present n the eneral stratey lterature, such as the choce between d erentaton and cost leadershp (Porter, 98). 2

3 dnated, resultn n a loss of responsveness. 2 Choosn mnmal operatonal nteraton s then equvalent to maxmzn the potental for local responsveness by leavn the operatn unts free to adapt to chanes n local condtons wthout concern for nteractons wth the rest of the rm. Increasn the level of operatonal nteraton ncreases the potental e cency of the operatons but reduces the rm s responsveness. Gven the choce of operatonal nteraton, how much of the potental value s actually realzed depends on the remann two choce varables: the allocaton of decson rhts and the compensaton structure of the manaers. Snce the level of operatonal nteraton n uences both the nature and severty of aency con cts nsde the oranzaton, each level of operatonal nteraton s best manaed throuh a partcular allocaton of decson rhts and a choce of compensaton structure. And because the allocaton of decson rhts and the choce of compensaton structure n uence the value actually realzed at any ven level of operatonal nteraton, all three need to be determned smultaneously as the optmal response to a ven envronment. The oranzaton I analyze conssts of two operatn dvsons headed by self-nterested dvson manaers and a pro t-maxmzn headquarters, whle the envronment s characterzed by ts volatlty and the cost of nformaton. The oranzatonal challene s one of coordnated adaptaton: the dvson manaers rst acqure nformaton about ther local condtons, then communcate that nformaton stratecally to the decson-maker(s) and nally the decson-maker(s) use the nformaton avalable to them n choosn how the dvsons wll respond. The role of oranzatonal structure s as follows. The choce of operatonal nteraton, by specfyn the balance between e cency and responsveness, determnes how much coordnaton s needed between the dvsonal responses. The allocaton of decson rhts and the compensaton structure of dvson manaers are used to manae nformaton acquston, communcaton and decson-makn condtonal on the level of operatonal nteraton. Wth respect to decson-makn, I focus on the choce between decentralzaton (decsonmakn authorty deleated to the dvson manaers) and centralzaton (decson-makn authorty retaned by the headquarters). Wth respect to the compensaton structure, I analyze both the strenth of ncentves, as determned by the overall senstvty of manaeral compensaton to performance, and the composton of ncentves, as determned by the relatve weht placed on dvson- and rm-level performance n the compensaton contract. For a ven strenth of ncentves, the composton of ncentves determnes the balance between 2 For example, n the context of multnatonal corporatons, the stratey of local responsveness used to be exempl ed by the hhly autonomous operatn unts of Phlps, whle the stratey of lobal e cency used to be exempl ed by the hhly centralzed operatons of Matsushta (now Panasonc). (Bartlett and Ghoshal, 989) 3

4 how much nformaton s acqured by the dvson manaers and how well that nformaton s transmtted and used n decson-makn. The strenth of ncentves, n turn, n uences the amount of nformaton acqured ven the composton of ncentves. The results are broadly consstent wth the common wsdom reardn the t between stratey, structure and the envronment: volatle envronments are characterzed by oranzatons that pursue a stratey of local responsveness throuh the combnaton of loosely nterated operatons, decentralzed decson-makn and stron dvsonal ncentves, whle stable envronments are enerally populated by rms that pursue a stratey of lobal e - cency throuh the combnaton of thtly nterated operatons, centralzed decson-makn and the use of rm-wde ncentves. 3 Ths pattern arses because of three e ects. Frst, the equlbrum level of operatonal nteraton s decreasn n the volatlty of the envronment. Intutvely, an ncrease n volatlty ncreases the value of local responsveness, whch the oranzaton acheves by reducn the level of operatonal nteraton. Second, loosely nterated oranzatons are always best manaed throuh a decentralzed structure whle centralzed decson-makn s preferred only when the equlbrum level of operatonal nteraton s su cently hh. Thrd, the use of rm-wde ncentves s enerally ncreasn n the level of operatonal nteraton under both overnance structures because an ncrease n nterdependence enerally leads to an ncrease n aency con cts across the dvsons. The results also re ne and qualfy some of these broad patterns, n partcular reardn the relatonshp between volatlty and decentralzaton. It s commonly arued that a decentralzed structure s preferred n more volatle envronments because t s able to respond faster and make better use of local nformaton than a centralzed structure. 4 Ths loc s re ned on two fronts. Frst, the equlbrum relatonshp between volatlty and decentralzaton can be non-monotone. Ths possble non-monotoncty follows from two results. Frst, as the cost of nformaton decreases, the relatve performance of decentralzaton ncreases. Second, the relatve advantae of centralzaton s larest at ntermedate levels of operatonal nteraton, where the equlbrum decsonal bas under decentralzaton s the larest. As a result, for ntermedate costs of nformaton, the preferred structure for a very stable envronment s a thtly nterated but decentralzed oranzaton, and an ncrease n volatlty, whle leadn to a reducton n operatonal nteraton, also leads to centralzaton of decson-makn. Second, even when decentralzaton and volatlty are postvely assocated n equlb- 3 For classc contrbutons, see, for example, Lawrence and Lorsch (967), Galbrath (973,977) and Mnzber (979). In the context of MNCs, see, for example, Prahalad and Doz (987) and Bartlett and Ghoshal (989). For recent contrbutons, see, for example, Brckley et al (23) and Roberts (24). 4 And there exsts some emprcal evdence supportn a postve relatonshp between decentralzaton and volatlty. See, for example, Naar (22) and Wulf (26). 4

5 rum, volatlty s not drectly causn decentralzaton n the present model. Instead, an ncrease n volatlty causes a reducton n operatonal nteraton, whch n turn ncreases the relatve bene ts of decentralzaton. Indeed, ven the equlbrum level of operatonal nteraton, the rest of the equlbrum structure s ndependent of volatlty. As a result, the postve assocaton between volatlty and decentralzaton arses only as a part of the overall adjustment n oranzatonal desn n response to a chane n the envronment. Smply decentralzn decson-makn as a response to an ncrease n volatlty would actually worsen oranzatonal performance, unless the other desn parameters are also adjusted approprately. The remander of the paper s structured as follows. Secton 2 revews the related lterature and secton 3 outlnes the model. Secton 4 derves the expected performance of the oranzaton as a functon of the envronment and the desn parameters. Secton 5 analyzes the optmal choce of the desn parameters and the lnk between the oranzaton and the envronment. Secton 6 concludes. 2 Related Lterature The model bulds drectly on the framework developed n Alonso, Dessen and Matouschek (28) and Rantakar (28a). However, nstead of focusn on the role that the allocaton of decson rhts plays n manan communcaton and decson-makn n oranzatons, I focus on the nteractons amon d erent oranzatonal desn parameters and ther jont t wth the envronment. Because of ths nteratve nature of the framework, the analyss of the present paper s related to several d erent lteratures. A number of papers analyze complementartes amon varous subsets of oranzatonal desn parameters. Mlrom and Roberts (99,995) examne complementartes amon d erent features of modern producton technoloes but pay only lmted attenton to the oranzatonal structure used to overn that producton. Holmström and Mlrom (99,994) analyze the provson of ncentves for multple tasks and extend those results to account for nteractons amon the level of ncentves, asset ownershp and job restrctons. 5 However, ther prmary focus s the manaement of the behavor of a snle aent operatn a xed technoloy and they don t explctly analyze the role of decson-makn and communcaton. Ths paper bulds on both strands, by consdern the nterdependence between the choce of operatn technoloy and the choce of oranzatonal structure that s used to manae that technoloy. 5 See also Holmström (999) 5

6 The papers most closely related to mne both n approach and content are Frebel and Rath (27), Dessen, Garcano and Gertner (27) and Athey and Roberts (2), each of whch looks at the smultaneous determnaton of ncentves and decson-makn authorty from alternatve anles. Frebel and Rath (27) analyze a resource allocaton problem, where dvsonal manaers need to be motvated to exert e ort to enerate hh-qualty projects and then to communcate that nformaton (truthfully) to the headquarters. Dessen, Garcano and Gertner (27) analyze a synery mplementaton problem, where aan the manaers need to be motvated to exert productve e ort but also have prvate nformaton reardn the costs and bene ts of mplementn syneres. Athey and Roberts (2) combne the problem of nducn productve e ort wth a project selecton problem. In all papers, the basc trade-o s between provdn focused ncentves to nduce e ort and balanced ncentves to nduce truthful communcaton and/or approprate decson-makn, wth the allocaton of decson rhts mpactn ths trade-o. The ncentve provson problem n my settn also faces the basc tenson between focused ncentves to motvate nformaton acquston and balanced ncentves to motvate accurate transmsson and use of that nformaton. However, by examnn a d erent problem, some of the nshts and results d er. The stratec nature of communcaton lmts the value of an unnformed prncpal relatve to Athey and Roberts (2). By lookn at moral hazard n nformaton acquston, I can analyze the lnks amon the value of nformaton, the value of ncentve alnment and the allocaton of decson rhts, an ssue that doesn t arse n Dessen, Garcano and Gertner (27). Some of these lnks are present n Frebel and Rath (27), but the frameworks are qualtatvely d erent and yeld d erent predctons. For example, n ther model, decentralzaton s always assocated wth zero ncentve alnment because f nterm reallocaton of resources s desred, the headquarters s always n a better poston to do so. In contrast, n my model, decentralzaton combned wth rm-wde ncentves can outperform centralzaton. Fnally, none of these papers consder the choce of stratey and the resultn level of operatonal nteraton as an endoenous varable. The role of authorty and deleaton n manan aency problems s also examned n a number of other papers. Buldn on the cheap talk lterature that has followed Crawford and Sobel (982), Dessen (22), Harrs and Ravv (25) and Alonso (27), for example, examne how the allocaton of decson rhts can be used to manae the trade-o between based decsons and nformaton losses due to stratec communcaton. 6 Ahon and Trole (997) llustrate how deleaton can be used as a motvatonal tool by allown the aent to freely use the nformaton he learns. My framework embeds both aspects of the problem and jons them wth the possblty of usn monetary ncentves, whch allows us to examne 6 See also Sten (989) and Melumad and Shbano (99) 6

7 the lnk between deleaton and ncentves. Rantakar (28b) examnes the mpact of nosy performance measurement on the wllnness to deleate and Zabojnk (22) analyzes the motvatonal mpact that deleaton has on the mplementaton e ort by the aent. Oranzatonal structures have also been analyzed from varous other anles. The paper closest to mne s Dessen and Santos (26), who analyze, n a team-theoretc model, the lmtatons that the need for coordnated adaptaton mposes on task specalzaton. Coordnaton n ther model s, however, constraned only because nformaton transmsson s exoenously mperfect. Some further perspectves nclude nformaton processn (for example, Marshak and Radner, 972, Bolton and Dewatrpont, 994), problem-solvn (for example, Garcano, 2), screenn for nterdependences (Harrs and Ravv, 22) and coordnaton and expermentaton (Qan, Ronald and Xu, 26). Fnally, whle the economc lterature on oranzatonal desn s stll relatvely youn, there s a lon hstory of manaement and stratey scholars that have analyzed the topc of ths paper. As a result, ths paper owes an ntellectual debt to a lon strn of contrbutons, ncludn Smon (947), Chandler (962,977), Woodward (965), Lawrence and Lorsch (967), Thompson (967), Galbrath (973,977), Mntzber (979) and Porter (98), amon many others, n partcular the later works of Prahalad and Doz (987), Bartlett and Ghoshal (989), Nadler and Tushman (997), Brckley et al (23) and Roberts (24). 3 The Model The oranzaton I consder conssts of two dvsons, each manaed by a stratec dvson manaer (he), and headquarters (she), who ams to maxmze the overall pro tablty of the oranzaton. Ths secton outlnes the payo s, avalable actons and the tmn of events n detal. Dvsonal pro ts and alternatve overnance structures: The oranzaton conssts of two (symmetrc) dvsons, and j: The pro tablty of each dvson depends on both how well the actvtes of the dvson are alned wth ts local condtons and how well the dvsons are coordnated wth each other. Gven the decsons d and d j reardn the operatons of dvsons and j, respectvely, the ex post pro t of dvson s ven by ( ; d ; d j ) = K () (d j d ) 2 ( d ) 2 ; where U ; ndexes the locally optmal decson for dvson ; wth and j 7

8 ndependently dstrbuted and > measurn the volatlty of the envronment. The alnment of the dvson wth ts local condtons s then measured by ( d ) 2 ; whle the alnment wth the other dvson s measured by (d j d ) 2 : The realzed pro ts of the oranzaton are ven by + j : The rst choce varable for the oranzaton s the level of operatonal nteraton 2 [; ); whch measures the level of nterdependences across the oranzaton s actvtes, as determned by the extent to whch the oranzaton uses shared components, manufacturn facltes, dstrbuton networks, sales forces, coordnated product development e orts and the lke across the dvsons. The bene ts of operatonal nteraton come from the potental reducton n operatn costs that results form the elmnaton of duplcated assets, the ncreased scale of the remann operatons and the realzaton of potental syneres across actvtes. These bene ts are captured by an ncreasn and contnuous functon K () : To fully realze these bene ts, however, the behavor of the dvsons needs to be ncreasnly coordnated. For example, the e cency of a common sales force s compromsed f con ctn demands are placed on t by the two dvsons, ntroducn just-n-tme manufacturn and nventory manaement reles on smooth functonn of the supply chan and the value of standardzed producton facltes s reduced f the products manufactured requre con ctn customzaton. Ths nduced value of coordnaton s captured by (d j d ) 2 : To summarze, the arument s two-fold. Frst, the level of operatonal nteraton, whch essentally re ects the underlyn con uraton of productve assets, s a choce varable. 7 Second, when choosn ts level of operatonal nteraton, the oranzaton faces the follown trade-o : an ncrease n operatonal nteraton ncreases the potental e cency of operatons, but ths reduces the exblty of the dvsons n respondn to local condtons. The second choce varable for the oranzaton s the allocaton of authorty over the dvsons, captured by the rht to make the decsons d and d j. I consder two alternatve arranements. Under centralzaton, the headquarters retans control of both decsons, whle under decentralzaton, control over the dvsons s deleated to ther respectve dvson man- 7 As observed by Porter (99:7):"A rm faces an array of optons n both con uraton and coordnaton for each actvty. Con uraton optons rane from concentrated (performn an actvty n one locaton and servn the world from t - e.., one R&D lab, one lare plant) to dspersed (performn each actvty n each country). In the latter case, each country would have a complete value chan. Coordnaton optons rane from none to very hh. For example, f a rm produces ts product n three plants, t could, at one extreme, allow each plant to operate wth full autonomy e.., d erent product standards and features, d erent steps n the producton process, d erent raw materals, d erent part numbers. At the other extreme, the plants could be thtly coordnated by employn the same nformaton systems, the same producton processes, the same parts, and so forth." 8

9 aers. I wll use superscrpt 2 fcent; dec to denote the two overnance structures. 8;9 Dvson manaers: Each dvson s headed by a rsk-neutral dvson manaer (manaers and j, respectvely). Ther behavor, whch conssts of nformaton acquston, communcaton and, n the case of decentralzaton, decson-makn, s controlled throuh the thrd choce varable, whch s ther compensaton structure. I assume that manaer s o ered a lnear ncentve contract T ( ; j ) = A + s ( ; d ; d j ) + s j j ( j ; d ; d j ) ; where (s ; s j ) are the wehts placed on the pro tablty of the two dvsons. normalze ths contract by rewrtn t as We can T ( ; j ) = A + (s ( ; d ; d j ) + ( s) j ( j ; d ; d j )) ; where = s + s j measures the strenth of ncentves and s 2 2 ; measures the deree of ncentve alnment. To relate ths formulaton to the composton of ncentves, note that ths contract s dentcal to a contract that would place a weht 2 ( an addtonal weht (2s s) on rm-wde performance + j and ) on dvsonal performance : The closer s s to =2; the more weht the contract places on rm-wde performance and, as a result, the more alned the nterests of the dvsonal manaers are both wth each other and wth the oranzatonal oals. Tmn of events: The oranzatonal desn parameters (; ; s; ) are used to manae the unfoldn of events summarzed n ure. Frst, the dvson manaers nvest n acqurn nformaton about the local condtons faced by ther dvsons. In partcular, manaer acqures a snal t of the realzed state that s correct wth probablty q and a random draw from U ; wth probablty q at a personal cost of C ; q. The 8 For brevty, we wll only analyze symmetrc dvsons. Because of the assumed symmetry, asymmetrc overnance structures do not arse as equlbrum overnance structures. For asymmetrc dvsons, the qualtatve loc of Rantakar (28a) reardn the relevant tradeo s contnues to hold. Results are avalable from the author on request. 9 We thus assume that deleaton s credble, an aspect whch can be supported throuh both resource allocaton and leal standn. For example, n the context of MNCs, there are several examples where the natonal subsdares have utlzed both ther drect control over natonal resources and ther separate leal ncorporaton to explctly dsobey the nstructons of the parent oranzaton. One of the more arant cases of dsobedence was the refusal by Phlps North Amerca to adapt the nternally developed V2 vdeocassette standard, and nstead decded to sell a VHS product suppled by Matsushta, the archrval of Phlps. A symmetrc contract turns out to be optmal because of the assumed symmetry of the dvsons, so assumn symmetry of compensaton contracts from the bennn s wthout loss of eneralty. 9

10 Dvson manaers nvest n nformaton acquston Decsons are made The level of operatonal nteraton, the allocaton of the decson rhts and the ncentve structure are chosen Dvson manaers communcate wth the decson maker(s) throuh one round of smultaneous cheap talk () Tmn of events Payoffs are realzed m HQ mj HQ j mj m j p t d dj tj pj p t d dj tj pj (A) Centralzaton (B) Decentralzaton () Alternatve overnance structures Fure : The tmn of events and the alternatve overnance structures. manaer does not learn whether the snal s correct or not, so that upon observn a snal t hs posteror expectaton about the local state s ven by E ( jt ) = q t : Forecastn the results, the value of accuracy n terms of expected pro ts wll be quadratc n q : As a result, I de ne p = q 2 and wll refer to p as the qualty of prmary nformaton. The cost of acqurn nformaton s ven by C ; p = 2 3 (p + ln( p )) ; where parameterzes the (marnal) cost of nformaton and 2 =3 s the ex ante varance of local condtons. Ths partcular functonal form smpl es the soluton to the nformaton acquston problem wthout altern the qualtatve nature of the soluton. 2 As a normalzaton, I assume that the marnal cost of nformaton s proportonal to the volatlty of the envronment. Ths assumpton helps to provde a benchmark soluton for the nformaton acquston problem and to separate the e ects of volatlty on the oranzatonal desn. and cost of nformaton () I use ths partcular acquston technoloy for two reasons. Frst, for purely techncal reasons, the smooth posteror facltates the analyss. Second, for descrptve purposes, havn a belef over the relablty of nformaton appears for many settns more plausble than known whether a pece of nformaton s correct or not. 2 As dscussed n an earler verson of the paper, the loc of the results eneralzes to any well-behaved cost functon C ; p wth, for > ; Cp ; p, Cp 2 ; p > ; lm p! C p ; p = ; and Cp ; p :

11 Gven the acquston technoloy, the dvson manaers choose p to maxmze ther expected payo, E T ; j C ; p : I assume that p s observable but not ver able to the oranzatonal partcpants. 3 Havn acqured ther prvate nformaton, the dvson manaers stratecally communcate ther nformaton to the decson-maker(s) throuh one round of smultaneous cheap talk. In the case of centralzaton, communcaton occurs vertcally to the headquarters, whle n the case of decentralzaton, communcaton occurs horzontally between the dvson manaers. Fnally, after communcaton, the decsonmaker(s) choose ther decsons condtonal on ther nformaton. In the case of centralzaton, the headquarters makes decsons to maxmze E cent + cent j condtonal on the messaes (m ; m j ) that she receved n the communcaton stae. In the case of decentralzaton, the dvson manaers make decsons to maxmze E T dec dec ; dec j condtonal on ther nformaton, whch conssts of ther prvate snal t and the messaes (m ; m j ) exchaned n the communcaton stae. The oranzatonal desn problem and the cost of ncentves: In the bennn of the ame, the headquarters chooses the oranzatonal desn parameters to maxmze her payo. As a nal observaton, note that for the problem to be nterestn and for the overnance structure to matter, t needs to be that ncentve provson s costly to the headquarters. Ths result follows because f the oranzaton faced no cost of provdn ncentves, then the optmal soluton would be to set = 2 and s = =2; whch would duplcate the full pro t marn for both dvsonal manaers and thus acheve the pro t-maxmzn soluton. To smplfy the analyss, I take a reduced-form approach to modeln ths cost of ncentves and smply assume that the headquarters faces a cost 2 G () of provdn an ncentve 3 contract of strenth ; wth G () ; G () ; whle ben anostc as to the partcular source of ths cost. The scaln of the cost functon wth volatlty turns out to be a convenent normalzaton for solatn the varous nteractons that are present n the model. 4 Fnally, ven the cost of ncentves, we can wrte the desn problem as the headquarters choosn the overnance structure ; the compensaton structure (s; ) and the level of operatonal nteraton to max X ;;s; k=;j E ( k (; s; ) jp k (; s; )) C ; p k (; s; ) G ; : 3 Observablty of acquston smpl es the analyss sn cantly whle not altern the qualtatve results. Some results on the case of non-observable nformaton acquston are avalable from the author on request. 4 Ths assumpton, toether wth a dscusson of the potental sources for the cost of ncentves are dscussed n Appendx C.

12 4 Expected Pro tablty and Oranzatonal Desn The rst step n the analyss s to derve the expresson for the expected pro ts of the oranzaton condtonal on the desn parameters (; ; s; ) : The soluton follows throuh backward-nducton. I ben by dscussn the equlbrum decsons (secton 4.), followed by the communcaton equlbrum (4.2) and the resultn expected pro tablty of the dvsons condtonal on the qualty of prmary nformaton (4.3). These three steps are dentcal to Alonso, Dessen and Matouschek (28) and Rantakar (28a), wth the excepton of ntroducn mperfect prmary nformaton. I revst these results here because the nshts underlyn ther determnaton play a key role n understandn the rest of the soluton, as the decson-makn and communcaton equlbra determne how ood use s made of the nformaton enerated by the dvson manaers. 5 The remander of secton 4.3 then dscusses how the value of nformaton depends on oranzatonal desn and completes the expresson for the expected pro ts by analyzn the nformaton acquston problem. Secton 5 analyzes the choce of the desn parameters and the relatonshp between overall desn and the envronment. 4. Equlbrum decsons In the decson-makn stae, the decson-maker(s) use the nformaton avalable to them to maxmze ther ndvdual payo s, condtonal on the accuracy q ; q j of the snals (t ; t j ) obtaned at the dvsonal level reardn the local condtons and the messaes (m ; m j ) sent reardn the realzaton of those snals by the dvson manaers n the communcaton stae. Centralzaton: The nformaton avalable to the headquarters (P ) conssts of the messaes m and m j sent by the dvson manaers. She solves maxe ( + j jm ; m j ) ; d ;d j soluton to whch s ven by d cent (s; ) = (+2)E P ( jm )+2E P ( j jm j ) +4 ; where E P ( jm ) = q cent E (t jm ) : 5 The dscusson s, however, by necessty very bref. The reader nterested n further detals s advsed to read ether of the mentoned papers. 2

13 Condtonal on the nformaton avalable to the headquarters, these decsons are, by assumpton, pro t-maxmzn. If = ; the dvsons are fully ndependent and the headquarters chooses d = E P ( jm ) and d j = E P ( j jm j ) : As the level of operatonal nteraton ncreases, the ncreasn mportance of coordnaton makes the decsons ncreasnly nsenstve to nformaton reardn the dvson s own local condtons whle becomn ncreasnly accommodatn to the needs of the other dvson. As! ; the decsons become perfectly coordnated, wth d = d j = E P ( jm )+E P ( j jm j ) 2 : Decentralzaton: The nformaton avalable to manaer conssts of hs prvate snal t and the messaes exchaned n the communcaton stae. Gven the compensaton contract (s; ) ; he solves max d E (s + ( s) j jt ; m ; m j ) and smlarly for manaer j: The equlbrum decsons are ven by d dec (s; ) = s (s+) E ( jt ) + (s+2) E [E j ( j jt j ) jm j ] + 2 (s+)(s+2) E j [E ( jt ) jm ] ; where E [E j ( j jt j ) jm j ] = q dec j E (t j jm j ). As lon as s > s; the dvson manaers place, from the oranzaton s perspectve, excessve weht on the performance of ther own dvson when makn decsons. I wll refer to ths suboptmal use of avalable nformaton as the qualty of decson-makn, takn both the accuracy of the snals and the accuracy of ther transmsson as ven. The key feature of the soluton, whch later plays an mportant role n understandn the choce of overnance structure, s that the payo consequences of ths bas are non-monotone n the level of operatonal nteraton. In partcular, despte the potental own-dvson bas of dvson manaers, the equlbrum decsons convere to the pro t-maxmzn decsons both when! and when! : In the rst case, the dvsons are fully ndependent and, as a result, no coordnaton s needed between the dvsons. In the second case, snce the dvsonal payo s are fully dependent on coordnaton, the manaers are wlln to coordnate ther behavor even absent any rm-wde ncentves. However, whenever some nterdvsonal con ct s present and s nteror, the own-dvson bas leads the manaers to choose decsons that exhbt too much adaptaton (and too lttle coordnaton), wth the bas ben larest when the relatve mportance of coordnaton =( + ) s ntermedate (when the tenson between adaptaton and coordnaton s the larest). Fnally, the mpact of ncentve alnment s mmedate: the qualty of decsonmakn s monotoncally mprovn n the relatve weht placed on rm-wde performance and converes to pro t-maxmzn when only rm-level ncentves are used. 3

14 4.2 Equlbrum communcaton The communcaton stae s modeled as a cheap-talk ame between the prvately nformed dvson manaers and the decson-maker(s). Known how the equlbrum decsons depend on the belefs of the decson-maker(s), the dvson manaers send smultaneously nonver able messaes reardn ther local nformaton n an attempt to nduce more favorable decsons. 6 Of course, n equlbrum, such attempts to mslead the decson-maker(s) are futle and only lead to arbln of nformaton. As a result, the equlbrum characterzed by a partton structure, where the dvson manaers are able to reveal only that ther snal les wthn a certan nterval of the state space. A natural measure of the accuracy of nformaton transmsson s the expected varance of the belefs of the recpent over t condtonal on the receved messae m ; E (E (t jm ) t ) 2 : We can characterze ths varance (and so the coarseness of the most nformatve partton) throuh a snle coe cent ' (s; ) ; whch depends on the partcular overnance structure ; the deree of ncentve alnment s and the level of operatonal nteraton : I wll refer to ' (s; ) 2 (; ) as the qualty of communcaton (ven the accuracy of the manaers prvate snals t and t j ). As ' (s; ) ncreases, communcaton becomes more accurate and becomes perfectly nformatve as ' (s; )! : Centralzaton: In the case of centralzaton, communcaton s from the dvson manaers to the headquarters (vertcal). The qualty of communcaton s ven by ' cent (s; ) = s+ (2s ) 'cent 2 [; ) ; wth (s;) ; 'cent (s;) s < : If = (so that there s no operatonal nteraton); then the equlbrum s fully nformatve. In ths case, the headquarters makes decsons that are fully responsve to local nformaton wthout any concern for coordnaton, thus replcatn the preferences of the dvson manaers for any s. However, whenever > and s > =2; the own-dvson bas of the dvson manaers leads them to prefer decsons that are more adapted to local condtons than what the headquarters wll actually mplement. Ths vertcal con ct s ncreasn n the level of operatonal nteraton (for a ven s) and, as a result, the qualty of vertcal communcaton s monotoncally decreasn n : The qualty of communcaton s naturally mprovn n deree of ncentve alnment and becomes perfect when s! =2 for all. 6 Smultaneous communcaton s preferred over sequental communcaton. The results are avalable from the author on request. 4

15 Decentralzaton: In the case of decentralzaton, communcaton s between the dvson manaers (horzontal). The qualty of communcaton s ven by ' dec (s; ) = +s( s) (s+)(2s ) 'dec 2 [; ) ; wth (s;) (s;) > ; 'dec < : s In contrast wth the soluton under centralzaton, the qualty of communcaton under decentralzaton s at ts worst when = and mprovn n the level of operatonal nteraton. Ths result re ects the d erental use of nformaton under the two overnance structures. Under decentralzaton, the dvson manaer s n control of the operatons of hs dvson. As a result, nstead of needn to persuade the headquarters about the adaptve needs of hs dvson, he s only tryn to persuade the other dvson manaer to be more accommodatn to what he plans to do. As the level of operatonal nteraton s ncreased, the dvson manaers become ncreasnly responsve to each other s behavor, whch reduces the horzontal con ct between the manaers and thus allows for more accurate communcaton. The mpact of ncentve alnment s naturally the same as under centralzaton, wth communcaton becomn perfectly nformatve as s! =2 for all. Fnally, note that so far we have only characterzed the accuracy of nformaton transmsson and not ts value. Intutvely, the value of accurate transmsson wll depend on both the overnance structure and the level of operatonal nteraton. In the case of centralzaton, communcaton s needed for the headquarters to be able to adapt her decsons to local condtons. As a result, the value of accurate communcaton wll be hhest for low levels of operatonal nteraton, when the decsons wll be most responsve to that nformaton. In the case of decentralzaton, the dvson manaers already have access to local nformaton but communcaton s needed to coordnate the responses. As a result, the value of accurate communcaton wll be hhest for hh levels of operatonal nteraton. The net e ect of the value and endoenous accuracy of communcaton s such that for any s > ; the loss due to stratec communcaton s almost always ncreasn n the level 2 of operatonal nteraton under both overnance structures, wth centralzaton enerally more dependent on accurate communcaton. 7 In contrast, the loss due to based decsonmakn under decentralzaton was non-monotone n : The next subsecton analyzes n more detal how these dstortons depend on the oranzatonal structure and thus mpact relatve oranzatonal performance. 7 The excepton occurs under decentralzaton when s s lare. In ths case, for hh ; a further ncrease n can lead to a su cent mprovement n decson-makn that the loss due to stratec communcaton actually decreases. 5

16 4.3 Expected pro ts Havn derved the equlbrum decsons of communcaton d (s; ) ; d j (s; ) and the equlbrum qualty ' (s; ) ; ' j (s; ) ; and for now assumn that the qualty of prmary nformaton enerated by the structure (; ; s; ) s ven by p (:); p j (:) ; we can wrte the expected pro ts of the oranzaton as E X! k (s; ; ) = X K () 2 k=;j k=;j 3 + p k (:) k 2 (s; ) : 3 The rst component, K () 2 ; ves the expected pro ts condtonal on a ven level 3 of operatonal nteraton and no nformaton acquston (p (:) = p j (:) = ). The second component, p k (:) 2 k (s; ) ; measures the mpact that nformatve local snals have on the 3 expected pro tablty n terms of mproved adaptaton to local condtons, where p k (:) s the qualty of nformaton acqured by manaer k and k (s; ) > measures the (marnal) value of that nformaton. Ths expresson captures the basc loc underlyn the soluton. Gven ts level of operatonal nteraton, the oranzaton s able to mprove ts responsveness by ether nducn more nformaton acquston or by usn the exstn nformaton better. The next steps are then to analyze how the value of nformaton k (s; ) depends on the oranzatonal structure and to endoenze the qualty of prmary nformaton, p (:) : 4.3. Value of nformaton: (s; ) The value of nformaton s determned by the mprovement n the equlbrum responsveness of the oranzaton that s caused by a ven ncrease n the qualty of prmary nformaton. The determnants of ths value (for snal t ) are llustrated n ure 2. If = (zero operatonal nteraton), then the value of nformaton s smply the value of adaptaton, ; whch s realzed by dvson : When > ; ths value s reduced for two reasons. Frst, dvson becomes less responsve to nformaton relatve to = : I denote ths reducton n value by (s; ) and t s composed of three e ects. Frst, even under pro t-maxmzn decsons and perfect transmsson of nformaton, the decsons wll be less adaptve because of the postve value of coordnaton. Ths e ect s ven by F B () and t s ncreasn n : Second, under decentralzaton, the equlbrum decsons are based (as lon as s > =2), whch also reduces the value of nformaton. Ths e ect s captured by (; s) and, as arued n secton 4., ths loss s non-monotone n : Thrd, some of the nformaton s lost due to stratec communcaton. Ths e ect s ven by (s; ) V (' (s; )) ; where the rst component measures 6

17 Ψ (β,s) α _ = ϕ (β,s) _ ϕ (β,s) value of adaptaton neatve externalty nformaton mposes on dvson j due to β > reducton n the value of nformaton to dvson due to β > FB loss due to the reducton n the responsveness of proft maxmzn decsons due to β > Λ (β) + Λ (β,s) + Γ (β,s)v(ϕ (β,s)) loss due to based decson makn j value of accurate communcaton Fure 2: Determnants of the value of nformaton accuracy of communcaton loss due to stratec communcaton the value of accurate communcaton and the second component measures the equlbrum qualty of communcaton. As arued n secton 4.2, ths loss s enerally ncreasn n under both overnance structures. Second, and whch s another key feature of the soluton, whle nformaton s always valuable to the dvson don the acquston, t also weakly reduces the pro tablty of the other dvson. Intutvely, the more accurate nformaton a dvson enerates, the more adaptve t wll be. When the level of operatonal nteraton s postve, ths ncrease n adaptveness requres ncreasn accommodaton by the other dvson, whch happens at the expense of ts own adaptveness. I denote ths neatve externalty by j (s; ) and t s ncreasn n under both overnance structures, re ectn the ncreasn mportance of coordnaton. The net e ect of these forces and ther dependency on (; s; ) s llustrated n ure 3, whch plots the value of nformaton for both centralzaton and decentralzaton as a functon of (s; ), toether wth the d erence between the two. 8 The value of nformaton s monotoncally decreasn n under both overnance structures. When s = =2 (so that there s no aency problem n the use and transmsson of nformaton), ths decrease n value s due to the reduced adaptveness of the pro t-maxmzn decsons. For s > =2; the value of nformaton s further reduced because of the loss of nformaton due to stratec communcaton and, n the case of decentralzaton, based decson-makn. Because both of these losses are ncreasn n the level of nterdvsonal con ct, the value of nformaton s also monotoncally decreasn n s under both overnance structures. Panel (), n turn, llustrates whch overnance structure makes relatvely better use of the exstn nformaton for a ven choce of (s; ). 9 The key result to understandn the 8 Because the value of nformaton depends only on equlbrum decsons and communcaton, t s ndependent of ; whch only a ects the amount of prmary nformaton. 9 See Alonso, Dessen and Matouschek (28) and Rantakar (28a) for a more detaled elaboraton of 7

18 Ψ cent (s,β) Ψ dec (s,β) Ψ cent (s,β) Ψ dec (s,β) β/(α+β) /2 β/(α+β) s s /2 β/(α+β) s /2 () Value of nformaton under centralzaton () Value of nformaton under decentralzaton () Dfference n the value of nformaton Fure 3: The relatonshp between oranzatonal desn and the value of nformaton. equlbrum choce of overnance structure s that centralzaton makes better use of exstn nformaton f and only f the level of operatonal nteraton s su cently hh and the deree of ncentve alnment s su cently low. The ntuton for ths result follows from two observatons. Frst, recall that centralzaton s more dependent on accurate communcaton than decentralzaton, whle the loss due to stratec decson-makn under decentralzaton s non-monotone n (wth the equlbrum decsons convern to pro t-maxmzn when! or! ). As a result, the relatve advantae of centralzaton s larest for ntermedate levels of operatonal nteraton (when the qualty of decson-makn s at ts worst). For su cently low levels of operatonal nteraton, the mprovement n the qualty of decson-makn s never su cently lare to outweh the ncreased loss due to stratec communcaton. Second, ncentve alnment mproves the qualty of decson-makn at a faster rate than t mproves the qualty of communcaton. As a result, as ncentve alnment s ncreased, the remann aency losses are ncreasnly due to stratec communcaton, makn decentralzaton ncreasnly attractve Manaeral nformaton acquston: p (:) The nal step of the ame s to solve for the equlbrum level of nformaton acquston. Usn the notaton from above, de ne e (s; ) = s ( (s; )) ( s) j (s; ) > ths result. 8

19 as the perceved value of nformaton, re ectn the d erental wehts placed by the manaer on the performance of the two dvsons. Gven (; s; ) ; manaer solves maxp e p 2 (s; ) C ; p 3 ; whch ves us, usn the assumed functonal form C ; p = 2 equlbrum qualty of prmary nformaton p (; s; ; ) = e (s;) e (s;)+: 3 (p + ln( p )) ; the The propertes of the soluton are summarzed n the follown proposton: Proposton Propertes of p (; s; ; ): () ; p (;s;;) > ; p (;s;;) < ; p (;s;;) s > and p (;s;;) < () p dec case p cent (; s; ; ) p cent (; s; ; ) unless both and s are su cently lare, n whch (; s; ; ) p dec (; s; ; ) Part () of the proposton llustrates the propertes shared by both overnance structures. Frst, the qualty of nformaton acqured s naturally ncreasn n the strenth of ncentves. Second, the qualty of nformaton s decreasn n the level of operatonal nteraton because ncreasn reduces the value of nformaton. Thrd, the qualty of nformaton s ncreasn n the deree of ncentve con ct. Ths result follows because ncreasn s leads the manaer to put more weht on the (postve) value realzed by hs dvson whle placn less weht on the neatve externalty mposed on the other dvson, an e ect whch always outwehs the assocated reducton n the true value of nformaton. It s thus possble to motvate nformaton acquston both throuh the strenth of ncentves and throuh the deree of con ct between the dvson manaers. Fnally, the qualty of nformaton s naturally decreasn n the cost of nformaton. Because I have assumed that the marnal cost of nformaton s proportonal to envronmental volatlty, the qualty of nformaton acqured s ndependent of the level of volatlty, whch allows me to separate the e ects of and on the preferred desn. Havn separated the e ects rst, t s then strahtforward to understand the mpact of any co-movements of and 2 : Part () of the proposton summarzes how the qualty of nformaton acqured depends on the overnance structure. It states that, for a ven (; s; ), the qualty of prmary 9

20 nformaton acqured s hher under decentralzaton unless both the level of operatonal nteraton and the deree of ncentve con ct between the dvson manaers are su cently hh, n whch case the opposte holds. Ths result re ects the d erence n the perceved value of nformaton under the two overnance structures, whch s determned by the dfference n the true value of nformaton (dscussed above) and the d erence n the sze of the neatve externalty. Ths neatve externalty s always hher under decentralzaton, so that decentralzaton s able to enerate more nformaton even when the true value of nformaton s lower. However, when both and s are su cently lare, the d erence n the true value domnates and centralzaton s able to enerate more nformaton. 5 Choce of Oranzatonal Desn Havn derved the expresson for the expected pro ts of the oranzaton as a functon of the desn parameters, we can now analyze the oranzatonal desn problem. Substtutn the mssn components nto the net surplus functon and utlzn the symmetry between the dvsons, we can wrte the desn problem as max K () max 3 3 ;s; (p (; s; ; ) (s; ) C (; p (; s; ; )) G ()) s.t. p (; s; ; ) = e (s;) e (s;)+: We can thus vew the desn problem as composed of two steps. Frst, for any ven level of operatonal nteraton, choose the overnance and compensaton structures (; s; ) to maxmze oranzatonal performance. Ths step maxmzes the net surplus that the oranzaton can realze throuh local responsveness for any ven level of operatonal nteraton and the cost of nformaton and s analyzed n secton 5.. Note that, mportantly, ths soluton s ndependent of the level of volatlty. Intutvely, ven the level of operatonal nteraton, the optmal way to acqure and use nformaton s ndependent of the overall value of that nformaton. Second, choose the level of operatonal nteraton to maxmze overall performance. Gven the soluton to the rst stae, ths step smply balances the bene ts of operatonal nteraton n terms of the mproved potental e cency of the operatons wth the cost of nteraton n terms of the lost local responsveness under the pro t-maxmzn compensaton and overnance structures. Ths soluton s dscussed n secton 5.2, toether wth the lnk between overall oranzatonal desn and envronmental volatlty. To llustrate 2

21 the equlbrum, I wll solve the model numercally. The bene ts of operatonal nteraton and the cost of ncentves are ven by K () = K e r 2 r 3 and G () = B ; ( ) The qualtatve results are not a ected by the partcular functonal forms used Choce of (s ; ) and Consder rst the choce of compensaton structure ven the level of operatonal nteraton and the overnance structure. The rst-order condtons characterzn the soluton are : (s; ) e (s; ) p (:) = G () s : (s; ) e (s; ) p (:) + p s (:) (s;) = : s Because the only role of ncentve strenth ( ) s to motvate nformaton acquston, the choce of smply equates the marnal bene t of the nformaton enerated wth the marnal cost of ncentves. The choce of ncentve alnment (s ), on the other hand, balances two e ects. Increasn the deree of ncentve alnment mproves the use of exstn nformaton and thus ncreases the value of nformaton ( (s; ) =s < ) but ths mprovement comes at the cost of reducn the qualty of nformaton acqured (p (:) =s > ). As to the mpact of the cost of nformaton and the level of operatonal nteraton on these choces, we can make the follown observatons: Cost of nformaton: A reducton n the cost of nformaton ncreases the equlbrum deree of ncentve alnment whle havn an ambuous mpact on the strenth of ncentves. Intutvely, a reducton n the cost of nformaton ncreases the amount of nformaton acqured, whch ncreases the value of ncentve alnment whle allown the oranzaton to economze on ncentve provson. However, because the ncrease n ncentve alnment ncreases the value of nformaton whle reducn the amount of nformaton acqured by the manaer (chanes whch ncrease the value of ncentves), the net mpact on the strenth of ncentves s ambuous. Level of operatonal nteraton: An ncrease n the level of operatonal nteraton has a enerally ambuous mpact on the compensaton structure. Frst, ncreasn the level of operatonal nteraton decreases the value of nformaton, thus decreasn the value of 2 The partcular parameterzaton used for the bene t functon s A = 4; = 2:5; 2 = 3 = :5 and = :2: For the cost of ncentves functon, B = :: 2

22 ncentves. Second, ncreasn the level of operatonal nteraton chanes the aency losses n the use of nformaton. As dscussed n secton 4.3, these losses are ncreasn n the level of operatonal nteraton under centralzaton whle ben non-monotone under decentralzaton. The equlbrum deree of ncentve alnment then enerally parallels the sze of these aency con cts, thus ben ncreasn n the deree of ncentve alnment under centralzaton whle ben non-monotone under decentralzaton. The equlbrum strenth of ncentves, n turn, balances the decreasn value of nformaton wth the varaton n the manaeral nformaton acquston resultn from chanes n the equlbrum deree of ncentve alnment, resultn n a non-monotone relatonshp between the level of operatonal nteraton and the equlbrum strenth of ncentves. 2 The equlbrum compensaton structure (s ; ) determnes for each overnance structure the net value that t can realze throuh local responsveness. The choce of overnance structure s then strahtforward: choose the overnance structure that yelds a hher net value. The dependency of ths choce on and s summarzed n the follown proposton: Proposton 2 Choce of overnance structure: Centralzaton s preferred over decentralzaton f and only f the level of operatonal nteraton and the cost of nformaton are su cently hh Proof. See Appendx A Ths result follows drectly from the dscusson n secton 4.3 on how the two overnance structures d er n ther ablty to enerate and use nformaton. When the level of operatonal nteraton s su cently low, a decentralzed structure s able to both enerate more nformaton and make better use of that nformaton for a ven compensaton structure. When the compensaton structure s endoenous, t s then further able to economze on ncentve provson. For hher levels of operatonal nteraton, the choce of overnance structure depends on the cost of nformaton. In partcular, as the cost of nformaton oes down (and as a result, the equlbrum deree of ncentve alnment oes up), decentralzaton becomes ncreasnly attractve because of the d erental mpact of ncentve alnment on the qualty of decson-makn and communcaton. The equlbrum to ths rst stae of the desn problem s llustrated n ure 4, whch plots the equlbrum compensaton structure under the two overnance structures, toether wth the preferred overnance structure, for two levels of the cost of nformaton. 22 The 2 The relatonshps amon s; and are dscussed more extensvely n Appendx B 22 = :3 and = :7: 22