Technical Change, Moral Hazard, and the Decentralization Penalty
29 Pages Posted: 27 Jul 2020
Date Written: July 23, 2020
In a moral-hazard setting, we consider two modes of organizing a firm --- a Centralized mode and a Decentralized mode. In the Centralized mode, perfect monitoring ensures that the welfare-maximizing effort is chosen. In the Decentralized mode, monitoring is imperfect and a profit-driven Principal induces her favorite effort by appropriately rewarding the Agent. The loss in welfare due to decentralization is called the Decentralization Penalty..For certain common contract types, we study the behavior of the Decentralization Penalty in response to changes in the production technology. We find that as production technology improves, the Decentralization Penalty oscillates. The Penalty rises in all intervals where the Penalty changes continuously. After such an interval, there may be a sudden change in the Penalty, and, under reasonable assumptions on costs and expected revenues, the sudden change is a drop. While an improvement in monitoring technology always strengthens the case for the Centralized mode, advances in production technology may do the opposite.
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