No. 232: Incentives and the Scope of Delegation in Hierarchies

We study the optimal allocation of decision rights in organizations when information acquisition and contracting can be delegated within a hierarchy. In a moral-hazard setting with one principal and two agents, projects differ in their input requirements, and acquiring information about these requirements is essential for designing incentives. We distinguish between partial delegation, where an agent acquires information, and full delegation, where the same agent additionally contracts with a subordinate, effectively becoming a middle manager. Our analysis identifies two opposing forces. Partial delegation generates a standard rent-saving effect and is optimally assigned to the agent with the higher productive rent. In contrast, full delegation introduces an activity-reduction effect: a middle manager optimally limits the subordinate’s activity range to economize on incentive costs. This effect reverses the delegation logic, making it optimal to delegate to the agent with the lower productive rent. We show that full delegation can be optimal even without rent savings and despite additional contracting costs, highlighting a novel role of hierarchy as a commitment device that reduces incentive costs.