9.3 Incomplete contracts and hierarchies
The incomplete contracts approach to issues of coordination focuses on the allocation of decision rights within hierarchies. In other words, it views coordination problems as arising from the allocation of residual decision rights rather than the quality of incentive schemes, and it suggests organisational realignment of decision rights as a response rather than increased effort invested in the design and monitoring of performance under incentive contracts.
Hart and Moore (2005) analyse a hierarchical structure characterized by agents engaged in specialization and agents engaged in coordination. By comparison with Aghion and Tirole (1997), they emphasize ex post efficiency, in the sense that they explain the role of co-ordinators (senior management) as being to choose the highest value ideas from those generated by the specialists. Co-ordinators are more senior because they must have control of the assets (residual decision rights) necessary to implement the projects that they choose (ie, they cannot be vetoed by the specialists who generate ideas). Hart and Moore show that when the gains to coordination are large, it is optimal for the organisation to be centralized; if the gains to coordination are moderate, then the organisation should be decentralized, and if the gains to coordination are small, then it is optimal for the organisation to be split into several independent firms (2005:678).
In Hart and Holmstrom (2010), it is assumed that each organisational unit (firm) generates two kinds of benefits: surplus which is transferable with ownership, and private benefits which are not transferable. The private benefits encompass job satisfaction, positive links between the work of the firm and personal values, personal loyalty to co-workers and managers, and human capital linked to the particular production technology of the firm. Private benefits may also capture the fact that performance assessments of workers hinge on their ability to add value to their firm, not to other firms.
Comparing separate firms with integration, Hart and Holmstrom show that the chief executives of separate firms have the right balance between private benefits and profits, but they do not take into account their effect on other units, whereas under integration they have the right balance between units, but will put less weight on private benefits. However, some weight will be accorded private benefits in the integrated firm, because the chief executives must take into account the potential for disenchanted workers to shade effort in response to decision-making that is inconsistent with their private benefits, but this weight is less than with a narrowly defined firm.
With a broader range of activities, the firm's workforce will be more heterogeneous, making the chief executive experience less empathy for any given group within the firm. The reduction in the intensity of the contact between any particular group in the firm and the chief executive will reduce the ability of any individual group to persuade the boss to pursue a path that has benefits for one group, but reduces value across the full range of productive opportunities. “. . . asset ownership is the means for acquiring essential control rights, but the underlying reason that such control rights are acquired in the first place is that activities need to be brought together under the authority of one boss in order to accomplish strategic goals . . .” (Hart and Holmstrom 2010:511).
At its most general level, Hart and Holmstrom (2010) may be summarised as saying that if the only issue is integration versus non-integration of different firms, then the potential mistakes associated with each form are orthogonal. Non-integration can lead to too little coordination; one unit may veto coordination, even though it is collectively beneficial. Alternatively, an integrated firm may lead to too much coordination, characterised by the reduction in private benefits associated with the loss of independence.
