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First, the theory of coalitions should predict that old organizationsshould be more bureaucratic than younger ones. This idea is based on the analysis of part 4.3. When organizationsget started, their employees are not yet tied by a network of relationships (that is, cliques are not yet fully developed). When the organization matures, there is always at any point of time a substantial fraction of employees bound by their previous personal commitments. Thus, allowing employees to exercise discretion becomes more hazardous. (An alternative explanation for the development of rules over time is the idea that experience allows for a better description of tasks and, therefore, reduces discretion. This explanation, which does not involve coalitions, is certainly relevant. Let us, however, also note that it should not lead to the perception of rules as the lesser of two evils).

Second, the theory of coalitions may well predict that large firms should be more bureaucraticthan smaller ones. The direct control of the veracity of one level of supervision's transmitted information-or, equivalently, its correct use of discretion-becomes harder and harderwhen the (verticaland horizontal) span of control rises.


Most of our conclusions apply to the case of "discriminatory hierarchical coalitions," in which a supervisor monitoring several agents favors some of them, not directly at the expense of the principal, but at that of other agents.38 Consider the principal/supervisor/multiagentsituation, and suppose individual agent performance is observed only by the supervisor and is not must exceed its costs (this leads to a standardargument in favorof rules). Futhermore, even if the basic technology of bookkeeping is reasonablycheap, it must be the case that it is not manipulated with the employee's supervisor's tacit agreement. More generally, an employee's discretion requires fine monitoring by the supervisor to make sure it is used appropriately.In the presence of a coalition, this in turn requires a fine control by the supervisor's supervisor, etc. This accumulation of monitoring costs (when they should have stopped at the first level of supervision in the absence of collusion) makes rules relatively appealing (checks by higher tiers are much cheaper, and can often be done randomly).

38. For instance, foremen or heads give better work conditions to their proteges. Or maintenance officers favor some operations heads. Such an example is given in Dalton (p. 34), in which some operation heads had hundreds of unfinished orders while others had none. The "dominant operation chiefs threatened to block their flow of informal favors to maintenance officers. These favors included (1) cooperation to 'cover up' errors made by maintenance machinists, or at least to share responsibility for them; (2) defense for the need of new maintenance personnel; (3) support in meetings against changes recommended by staff groups that maintenance forces opposed; (4) consideration, and justification to top management of material needed by Maintenance for its success and survival in meeting the demands of Operation."

Similarly, the Department of Defense may favorfirms it has alreadydealt with (Scherer, 1964:

73); and, in business firms, managers may identify with a particular supplier (Pettigrew).

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verifiable (by a court, say). In this case, all information is soft. Hence, if the supervisor colludes with the group of agents, he cannot be given any discretion over the agents' aggregate reward (like in part 3). However, he might be given authority to split a fixed-size reward among the agents as he likes. As long as he colludes only with the whole set of agents, he has no incentive to manipulate the announcements of individual performances.39 If, however, he engages in discriminatory hierarchical coalitions, he destroys the link between individual performance and reward (that is, defeats the purpose of discretion) and, furthermore, promotes wasteful competition for the attainment of favors and privileged information among the agents.40 Like the hierarchical coalition studied in this paper, the discriminatory hierarchical coalition fosters the abandonment of discretion (that is, the introduction of rules).

In a discriminatory hierarchical coalition, the supervisor must choose the agents with whom he wishes to collude. The previous thoughts on the availability of side transfersmay shed some light on who is chosen. One factoris the length of the relationship. A transient agent may thus be at a disadvantage relative to agents with a similarbut permanent position. A second factorlies in the preferences of parties. Thus, parties who are more prone to enforce collusion (or to use fear to coerce favors) will more likely be picked.


5.1. THEORIESOF ORGANIZATION This section points out some of the features that identify the approachin terms of coalitions relative to complementary approaches. For ease of comparison, it focuses on features that distinguish if from other emanations of the basic principal/agent paradigm. For instance, it ignores the theory of bounded rationality,41which takes a very different route (in order to focus on the important phenomena of rules of thumb, limited attention, and imperfect communication, the latter approachabstractsfrom incentive problems and, in particular, from the malicious distortion of information).

Principal/Agent and Compounding Theories. There is not much point reviewing the now well-known principal/agent theory here. Several authors (Williamson, 1967b; Mirrlees, 1976; and Calvo and Wellisz) have extended this theory to multilayer contexts by assuming that intermediate layers have a

39. A similar argument is made by Bhattacharya and Malcomson to justify rank-order tournaments, an instance of a fixed-size reward.

40. Competition between agents can also be wasteful if mutual help between them is crucial for efficiency. It is then preferable to motivate them to form a productive team by suppressing discretion and offering only "low-powered" individual incentives (in the sense of Williamson, 1985).

41. See Simon; Nelson and Winter; Geanakoplos and Milgrom; Sah and Stiglitz.

This content downloaded from on Mon, 28 Oct 2013 01:51:38 AM All use subject to JSTOR Terms and Conditions 206 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 11:2, 1986 choice of supervisory effort. For example, in the simple principal/ supervisor/ agent model, the principal monitors the supervisor who, in turn, supervises the agent (for instance, the probability of discovering that the agent shirks increases with the supervisor's effort). An interesting insight of this literature is to show how slackcan trickle down a hierarchy:inappropriateincentives for the principal to monitor lead to a low supervisory effort in the middle tier, which leads to a low productive effort in the bottom tier (note that by making the supervisory effort exogenous, I emphasized the manipulationof information over supervisory slack). The literature also draws some conclusions about the optimal span of control and size of the vertical structure and about wage differentials.

In the compounding theory, any informationheld by a party about another party (the outcome of supervision broadly defined) is transmitted honestly.

There are no side transfers and coalitions do not form. In terms of organizational design, the compounding theory (1) decomposes the search for the minimal cost of inducing a given organizationalstrategy (efforts, reports, and so on) into n subprograms;(2) puts no emphasis on the hazardsassociated with long-run relationships; (3) uses all informationthat does not reflect on parties that transmit it (that is, all supervisory information); and (4) favors, in multiagent contexts (in which individual performance is not verifiable), the use of (delegated) discretion to reward the agents. None of these properties holds in the presence of coalitions.42 Theory of Moral Hazard in Teams. Moral hazardbetween members of a team arises when only the aggregate performance of the team is observable and verifiable. The associated free rider problem has been discussed much in the economics literature.43 Such a problem may arise in the simple principal/supervisor/agentstructure. As I mentioned in part 2, the supervisor in general also has a productive function on top of the supervisory function: advising, selection, coordination, management, and so forth. Furthermore, the supervisor'sproductive performance is often observed only through the agent's. In other words, the supervisor and the agent form a productive team. This, of course, affects the supervisor's incentives when reporting on the agent's performance. For instance, a Ph.D. adviser may overstate the Ph.D. student's thesis quality, not because they are colluding, but because the adviser is eager to show that he or she obtains the good students and advises them well.

Thus, it would seem that the theories of moral hazard in teams and of coalitions lead to the same type of manipulationof informationby the supervisor, in which the supervisor acts as an advocate for the agent. This is, however, false. To give an example, suppose, as in part 3, that the agent's performance

42. Property (1) does not hold because the cost of inducing a party to take some given action depends on the reward structure of other parties (through the coalition incentive constraints).

43. E.g., Alchian and Demsetz; Williamson, 1975; Holmstrom, 1982.

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(x) depends on his effort (e) and on some productivity parameter (0). Suppose further that the productivity parameter depends on the supervisor's productive effort. On the one hand, if the supervisor can manipulate the observation of performance, he has an incentive to overstate this performance, regardless of the existence of a coalition.44On the other hand, if the supervisor reports on the agent's effort or on the productivity parameter, his behavior is much influenced by the existence of a coalition with the agent. His best interest, in the absence of collusion, is to demonstrate that the agent exerts a low level of effort or faces a favorable productivity parameter. For example, for a given poor performance, the supervisor has every incentive to pass the responsibility for this poor performance on to the agent; and similarly, he tries to take credit for good performance. Thus, everything that reflects poorly on the agent but not on the supervisor is reported by the latter. For instance, in the absence of collusion the foreman ought to supply any evidence that the worker'stask is an easy one. Or the Department of Defense ought to insist that the contractingfirm could have avoided the cost overruns. This contrasts with the findings of part 3.


By contrastwith earlier work, this paper views an organizationas a network of coalitions and contracts that interplay. The model developed in part 3 shows how the introduction of the relevant coalition incentive constraints modifies the optimal incentive scheme. It also shows that a natural coalition occurs between the agent and the supervisor. The words agent and supervisor must be taken in a broad sense; they do not necessarily reflect the traditional hierarchicalordering (as argued in part 6.2). At a more applied level, the ideas developed here are inspired by the direct evidence of the existence of coalitions and side transfers collected in the sociology literature. The indirect evidence was provided by the consistency of the suggestions of the model for organizationalbehavior with observed practice; among them: (1) the supervisor tends to act as an advocate for the agent; (2) short-runrelationships may be desirable; and (3) the supervisor lacks the decision power that his central informationalposition should confer upon him. Hierarchies tend to be run by rules (that is, to be bureaucracies).

In our model, coalitions unambiguously decrease the efficiency of the vertical structure. Coalitions and their enforcement mechanism, side transfers, ought to be fought. This conclusion is extreme. In practice, some side transfersexist because organizationsdo not want to (rather than cannot) curb them. The medicine can do more harm than the illness; preventing long-run relationships between members of a hierarchy may result in efficiency losses.

44. The supervisor may manipulate the accounting procedure if x is a monetary performance (profit);or the quality evaluation if x a quality parameter.

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