Authority, Monitoring, and Incentives in Hierarchies*†

Abstract

We study three elements of management control: incentive compensation, performance monitoring, and delegation of authority to managers to contract with lower‐level employees. Using a principal‐agent model, we highlight important direct and indirect interactions between and among these endogenous control elements, themes often emphasized in the economics and accounting literatures using the analogy of a three‐legged stool. We identify circumstances in which control elements are complements or substitutes and exhibit a coherent pattern of practices observed together. For instance, contrary to typical predictions that quality monitoring complements steep effort incentives, we find that when contracting authority adjusts easily to changes in firm circumstances, then both incentive pay and contracting authority substitute for monitoring quality, while incentive pay complements contracting authority. Overall, our findings suggest a number of empirical implications and generally inform a growing literature that documents the presence or absence of complementarities among management control elements.

Managerial performance evaluation and organizational form

“…The existence of different organizational forms is prompted by complementarities between different control mechanisms (Aghion et al, 2014; Milgrom & Roberts, 1990). In particular, decentralization and performance evaluation are complementary control choices (Abernethy et al, 2004; Hofmann & Indjejikian, 2021; Milgrom & Roberts, 1992) and the design of performance evaluation affects the efficiency of an organizational form. In this paper, we study the influence of performance evaluation on the choice of organizational form.…”

“…In concurrent research, BM (2019, 2020) and Hofmann and Indjejikian (2021) also study aspects of organizational design. BM (2019) compare decentralization to non‐integration, where two divisions are run as separate firms and thus cannot implement profit‐sharing.…”

“…In contrast to our study, BM (2020) do not consider centralized organizations and do not allow for firm‐wide performance evaluation. Hofmann and Indjejikian (2021) study the endogenous role of incentive systems and monitoring quality on the firm's choice to delegate the authority to hire and evaluate personnel. In contrast to our paper, they are interested in the organization of layers of hierarchy rather than of divisional production processes along the value chain.…”

Managerial Performance Evaluation and Organizational Form

“…The existence of different organizational forms is prompted by complementarities between different control mechanisms (Aghion et al, 2014;Milgrom & Roberts, 1990). In particular, decentralization and performance evaluation are complementary control choices (Abernethy et al, 2004;Hofmann & Indjejikian, 2021;Milgrom & Roberts, 1992) and the design of performance evaluation affects the efficiency of an organizational form. In this paper, we study the influence of performance evaluation on the choice of organizational form.…”

Transparency in Hierarchies

“…The manager provides more effort with delegated contracting only if the workers' soft signal ψ about a m is sufficiently informative (e.g.,Feltham et al [2016], Hofmann andIndjejikian [2021]). 17 In the proof of Lemma 1, we provide a detailed discussion of the manager's choice of v w and the principal's choice of δ m .18 Technically, R t represents the magnitude of risk borne by the worker's t − 1 teammates plus the manager.1475679x, 2024, 1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1475-679X.12516 by Cochrane Germany, Wiley Online Library on [27/02/2024].…”